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Nuts and bolts of servicing sales.

Careful preparation before launching a servicing sale is crucial. Devotion to details can either sink or ice a good deal at a good price for the seller.

Gathering bids on bid-deadline day can be an exciting time for sellers of servicing. This is particularly true when the auction produces multiple bids for the portfolio that either meet or exceed the seller's price expectations.

It can be a moment to savor, but it is only one moment in a long process that begins when sellers start to review their servicing portfolio to identify product to sell. But the process doesn't end until the last files are transferred and the final dollars are paid.

Servicing sales are complicated, multifaceted transactions. A successful servicing sale transaction requires expertise in a multitude of disciplines including financial analysis, data processing, loan origination and underwriting, data review and validation, and an in-depth knowledge and understanding of all facets of servicing operations.

If the operational aspects of a servicing sale are not well thought out, planned for and then executed, some serious consequences can result. A hastily conceived or badly executed sale can mean that the return realized from the sale can be diminished through reduced proceeds and/or increased costs, the point at which the sale proceeds are booked or the portfolio transferred can be delayed, and, in a worst-case scenario, the sale could be jeopardized.

Careful and thorough management of the process from the very beginning can ensure that all aspects of the transaction are as upbeat and positive as when the initial congratulatory handshakes are exchanged.

Stratify for success

In any sale, the groundwork for success is laid when the portfolio is first analyzed. A portfolio should be structured to generate optimum price execution in the light of current market conditions and the seller's financial and operational needs. In preparing for a sale, a number of factors should be considered, including what the market is currently sensitive to in terms of product types, note rates, property locations and the like; what the seller has available for sale; and the seller's earnings and/or cash flow needs. The object is to fit those elements together to create a package optimally designed to attract maximum investor interest.

In general, the most attractive package is a homogeneous one. However, depending on the complexion of the overall package, other product and remittance types can often be blended in without affecting the overall desirability of the portfolio.

As part of the selection process, the portfolio should be carefully scrubbed to ensure data integrity. The portfolio should be subjected to a thorough battery of reasonableness and exception tests including:

* Guarantor fee tests--Are the guarantor fees logical in the context of the note rates and the investor pass-through rates for the various pools? If a pool contains excess servicing, the relationship of the various rates should be carefully scrutinized and, if necessary, validated against the appropriate secondary marketing documents to see that they make sense.

* Product tests--Are product types logical in the context of their weighted average maturities, pools, investor categories and other criteria?

* Service fee tests--Are the service fees logical in the context of the product types? On adjustable-rate loans, are they subject to change in light of interest rate adjustments, ceilings or floors?

* Escrow balances--Are they reasonable in light of the portfolio's geographic distribution, delinquency and investor type? Does the current actual escrow balance make sense in relation to the estimated average and the point in time when the test was run?

* Pool and accounting group integrity--Have any loans that were sold into pools or accounting groups as a part of the sale been left out of the sale? Have all the loans in each accounting group been moved from the warehouse investor number into the proper sale investor number?

* Remittance types--Are any unusual remittance types, such as Fannie Mae Rapid Payment Method (RPM) or Express, properly identified? Do the remittance patterns in the portfolio make sense in light of how loans have been sold into the secondary market?

A well-designed, rigorous screening of the portfolio can ensure that it will pass due-diligence review without any data discrepancies. If necessary, tapes can be retrieved from outside entities, such as Freddie Mac or your tax service provider, in order to map your data against their data bases to ensure its completeness.

If mistakes were made in originating or servicing the loans, or in the data used to structure the servicing offering, it will most likely surface in the due-diligence process. If not discovered before the offering is prepared, errors in the data from which the offering was prepared can result in critical components of the servicing portfolio differing from what was disclosed in the offering.

For example, if not properly scrubbed, a portfolio could contain balloon loans in the 30-year segment, or if guarantor fees on some of the pools were loaded incorrectly into the servicing system, servicing fees could be lower than originally disclosed. And while reasonable resolutions can be found for most problems that might arise in due diligence, the seller is obviously in a much stronger position if problems are rectified before the offering is made.

Offering size

The size of the portfolio offered for sale has an important influence on the range of prices that the seller typically will receive. As a general rule, buyers segregate themselves into one of three tiers based on size: those who look at packages of less than approximately $100 million in size; those who only consider packages of more than approximately $350 million, and those who look for mid-sized packages.

Beyond these three general tiers, there is a further group of buyers who will often bid aggressively to win a package as the size increases into and in excess of the billion-dollar level. In general, larger-sized packages will generate the highest premiums, as they attract national buyers who have lower costs of capital and lower servicing costs resulting from their operations' economies of scale.

Notwithstanding the general guidelines discussed here for structuring a package for optimum execution, there are a large number of niche markets with active buyers. Buyers exist for a wide variety of packages, including those with high weighted average coupons (WACs) and/or high delinquencies, those with esoteric product types and even those from sellers in financial distress. The key is to structure your package to optimize its appeal to those buyers who are most likely to bid on your portfolio.

Bid review

One of the most critical and exciting times in the sale process is when bids are received on a portfolio. When the bids are in hand, it is crucial that the bid letters are carefully reviewed to ensure that all contingencies and terms are understood and correctly priced.

It may be that the bid with the highest nominal price is not the one that yields the highest net cash returns. The population of buyers for servicing rights is a dynamic one. Coming in and out of the market we see new entities seeking to invest in servicing rights, and established companies seeking to build their portfolios through select acquisitions.

Not infrequently, the highest bid will come from a new player in the servicing marketplace. It is important that you investigate and have a good understanding of any potential buyer, so the risks associated with proceeding with a particular buyer can be thoroughly assessed and managed.

All bid contingencies should be analyzed and priced. To the extent a purchaser provides his or her own bid letter, terms and conditions outside those provided for in the offering can be negotiated to be more in line with industry standards or what is reasonable in light of the portfolio being sold and transferred. The nature and extent of any approvals required (e.g., from the bidder's board of directors or parent company) in the bid letter should be thoroughly understood and, if possible, obtained before the bid letter is signed.

Transfer dates are often dictated by the time needed to conduct due diligence, execute a purchase and sale agreement and receive agency approval for the transfer. Sale dates can be structured to either coincide with the transfer date or precede the transfer date to meet the bookability needs of either the seller or buyer. Each structure has economic consequences that should be correctly analyzed to understand the impact on the net return generated by the sale.

Due-diligence review

The next and perhaps most critical major step in the sale process is the purchaser's due-diligence review. The extent and nature of a due-diligence review will vary with the portfolio being sold, the risk profile of the purchaser and the purchaser's knowledge of and experience with the seller and the seller's product. Sellers and purchasers need to work closely together in preparing for a due-diligence visit, to ensure that the seller has available all the materials necessary for the purchaser to assess the portfolio when the purchaser arrives.

Sellers should develop a thorough understanding of what the purchaser will want to look at so they can ensure that files, reports, data access and any other materials will be ready for the purchaser's review. All reports should be checked for accuracy. Any inconsistencies with the offering should be researched and resolved before the due-diligence visit.

To prepare for the visit, a seller should try to elicit from the buyer's due-diligence questionnaire what the buyer will be focusing on. Although every buyer has a unique profile and process, buyers, in general, will focus on four key areas: the credit quality and underwriting of the loan collateral underlying the servicing rights, document correctness and completeness, the seller's servicing practices and methodologies, and the accuracy of the portfolio offering document.

It is important to understand the areas of responsibilities of the team that will be conducting the due-diligence review. Buyers whose focus is on credit quality of the collateral will include a relatively large number of underwriters in their team. Others will focus more on the seller's servicing practices, while some look to the purchase and sale agreement to provide much of the protection that others seek to obtain from their on-site visit.

Regardless of the focus of the due-diligence team, sellers should always have a knowledgeable underwriter available. It is not uncommon for the buyer's underwriter to develop a list of exceptions that result from his or her failing to incorporate master commitment waivers or compensating factors in his or her underwriting review. Sellers should be sure they get the opportunity to review any files the buyer has questioned. Generally, a buyer's concerns can be allayed by the seller's explanation of the underwriting decision.

It's best to have people available to talk with the review team who are knowledgeable about their technical areas, but who recognize that the buyer's concerns should be limited to the asset being bought, and the ability of the seller to stand behind its warranties. Your brilliant but demanding tax expert, who can extrapolate any operational problem to its most dire (albeit unlikely) consequence, may not be the best candidate to meet with the buyer's due-diligence team. A similar calming temperament is obviously important for your underwriter.

Potential problems

Perhaps a seller's greatest fear is to have problems arise at due diligence. At the point of due-diligence, the seller has invested time and money in consummating the sale with that buyer, and the consequences of having problems occur at this stage can be severe. When a seller has a need to book a sale by a certain time, the situation becomes even more problematic.

In addition to the problems that can result from the failure to capture data errors prior to preparing the offering, problems can arise from other circumstances as well. These include:

* Losing control of the due-diligence process--Having a due-diligence team wandering your halls can create its own difficulties. If someone bumps into your insurance supervisor--the one who can see a cloud behind every silver lining--he or she might proceed to complain about every insurance problem you've ever had or to pontificate on your production department's "inability to produce a quality loan." Such discussions can mushroom into real problems.

* Not having reports and/or files ready when the due-diligence team arrives--Although these and other problems often amount more to form than substance, due-diligence visits can run into trouble and, on occasion fail, if the purchaser becomes convinced, however unfairly, that the seller lacks control of his or her shop. It's important to remember that due-diligence is, in part, a continuation of the marketing process. You should not allow to slip by any opportunity to market to the buyer the quality of your portfolio and your company.

Sellers can take comfort in the fact that there are solutions to most problems that are fair and equitable. If properly addressed, few transactions should fail as a result of due-diligence findings.

However, the best resolution is always to prepare thoroughly and carefully for the sale.

Transaction timetable

A general transaction schedule would be as follows:

The servicing portfolio is stratified and evaluated with several optimum sale portfolios selected. TIME INVOLVED: One week.

A sale portfolio is selected, and an offering is prepared and distributed to all potential buyers. TIME INVOLVED: Three days.

The portfolio is marketed to potential buyers and bids solicited. A winning bid is negotiated, and a bid letter and good-faith deposit are received. TIME INVOLVED: Two to three weeks.

The buyer tells the seller what its due-diligence needs are. The seller prepares for due-diligence visit from the buyer. TIME INVOLVED: One to two weeks.

The buyer conducts its due-diligence visit. Any discrepancies raised by the due-diligence visit are addressed and resolved. TIME INVOLVED: One to two weeks.

The purchase and sale agreement is negotiated with buyer. TIME INVOLVED: Up to one week.

At a time no later than the investor cutoff date following execution of the purchase and sale agreement, packages are submitted to the appropriate investor for approval of the transfer. Fannie Mae, Freddie Mac and GNMA now all require 30 days to process a transfer-approval request.

During this time, sellers should complete all the operational steps necessary for transferring the portfolio. Physical transfer of the portfolio will take place at an agreed-upon time, in conjunction with the transfer date specified in the investor approval form. Final payment is generally due at this time. In all, it is about a 90-day cycle from deciding to sell to final transfer.

Portfolios can be sold and transferred at the same time (a "simultaneous sale and transfer"), or the transaction can be structured with a separate "sale date" and "transfer date." At the time of the sale, all rights and risks of ownership pass to the buyer.

The accounting profession has established requirements that must be met for a sale to be bookable. Care must be taken not to structure the sale/subservicing in a way that would jeopardize the bookability of the transaction, but, in general, on the sale date the buyer begins receiving servicing income and assumes prepayment and foreclosure risk. Between the time of sale and transfer, the seller typically subservices the loans on behalf of the buyer for a per-loan subservicing fee. Various structures exist to allocate the value of the custodial accounts held by the seller and the value of the unpaid portion of the purchase price due the seller.

Final terms

Negotiating a purchase and sale agreement and transfer instructions should provide you with clear operations should provide you with clear operational guidelines, as well as allocate the responsibilities in the sale and transfer process. Both documents must be carefully reviewed and any abnormal or unreasonable requirements negotiated.

Contracts can saddle a seller with terms, conditions or obligations that can be costly and/or unreasonable. If not fairly structured, sellers could find themselves with tasks extending beyond the transfer date, resulting in potential delays in the receipt of the purchase proceeds. Sellers should be sure that their purchase and sale agreement provides the proper protections and opportunities to redress any claims made by purchasers and that it ensures that sellers are protected from liability for losses that might arise from activities they don't control.

Sellers should be sure that all operational requirements are understood by the parties responsible for implementing them. A variety of terms and conditions exist in the marketplace with respect to prepayment protection, payment of tax and insurance bills around the transfer date, preparation of files and so forth.

Be sure you can live with the terms you agree to. For example, a first draft of the contract may require that you pay all taxes due within 60 days of the transfer date. This may or may not be reasonable depending on a number of factors, including the time of year, the geographic distribution of the portfolio, the age of the portfolio and the ability of the taxing authorities to provide you or your tax service with the tax bills prior to the transfer date.

Other considerations

All operational aspects of a servicing transfer must be carefully and properly addressed. A partial listing of the more-critical logistical matters tied to transfers would include the following:

* A careful inventory of the loan files and the critical security documents should be prepared early in the sale process. Any missing files or documents should be retrieved prior to the transfer date.

* Borrower notification letters ("goodbye letters") must be properly constructed and mailed to meet agency, regulatory and (on occasion) state law requirements.

* Private mortgage insurance, flood, hazard and other insurance notifications and endorsements must be properly prepared and distributed before the transfer date.

* Notifications of tax authorities or services must be properly handled. Tape-to-tape notifications can be used to expedite the process and minimize costs.

* Assignments must be prepared following agency, state and county requirements. If all the information necessary to prepare the assignments is not on the seller's computer system (which is usually the case), arrangements have to be made to obtain copies of the recorded deeds and/or final title policies, and/or to enter into an agreement with a third-party provider to prepare all required assignments by the transfer date.

* Lien releases must be obtained from any entity having a lien on the servicing as evidenced by a Uniform Commercial Code (UCC) filing. UCC liens should be carefully reviewed, as they can be poorly written and can result in the unintentional encumbering of the servicing portfolio. As a rule, UCC releases must be obtained before a sale can be effected.

* Deficiencies in data needed to transfer the servicing, but not needed to prepare the offering, such as complete escrow payee information, must be rectified prior to transferring the portfolio.

Many of the items involved in servicing transfers require arcane knowledge--such as how to get liens removed when the entity filing them has declared bankruptcy. Even the most seasoned sellers can encounter problems, terms, conditions or requirements they haven't encountered before. All sellers should be prepared to respond to these contingencies as they occur.

Obtaining investor approval

Among the many tasks required to successfully transfer a servicing portfolio, the preparation of investor approval forms is one that merits special mention. This is the case because investor approval is mandatory for virtually all servicing sales and transfers. The paperwork must be correctly prepared within the time frames required by Fannie Mae, Freddie Mac and GNMA. Each agency asks for different forms and even diskettes. If not prepared right and submitted on time, transfers and sales can be delayed a month or more.

In general, forms must be submitted to the agency no later than one month before the desired transfer date. Each agency requires that a transfer occur on the first business day following their accounting cutoff date. Although the agencies, on occasion, have accommodated the need to process a request more quickly or modify a request once received, it's best to ensure that all forms and disks are completely filled out and submitted within required time frames.

GNMA has perhaps the most complex requirements for requesting approval to transfer a servicing portfolio. Some of the information requested is generally not available to the servicing department that typically prepares the approval request--such as when pools were issued or certified. Be aware that there are a number of forms that must be completed by entities other than the buyer or seller and submitted with the request package.

Finally, GNMA approvals are the most expensive to obtain. Fannie Mae and Freddie Mac charge a flat $500 fee to process an approval request, whereas GNMA charges $250 per pool; which can result in a fee in the tens of thousands of dollars.

Today's market

Most buying interest today continues to be for current production, fixed-rate, conventional conforming packages. Buyers continue to bid aggressively for such portfolios possessing either a national complexion or a desirable regional concentration. Southeastern and Midwestern servicing packages remain highly sought after.

Some traditional buyers have reduced their demand for California servicing in large part due to concerns about California's economy. This reduced demand has softened prices for California servicing compared with levels seen last summer. However, these concerns have abated somewhat, as owners of non-recourse, conventional, conforming servicing portfolios recognize a number of factors. These include the fact that California delinquencies on these portfolios remain low; the owner's maximum exposure in any foreclosure scenario (excluding the risk of faulty origination, which is born by the seller) is several hundred dollars; and a slow California economy results in overall lower prepayments, which improves returns on the overall investment.

Recently, the California market has seen renewed interest from buyers, in part, because they are recognizing how their investment is performing in a slower economic environment. The renewed interest also has come, in part, as a reaction to the premium prices required to win similar packages from some other regions of the country.

Who is buying?

Buyers and sellers find that activity in the bulk acquisitions market changes frequently in response to market conditions. For instance, just a few years ago, the S&Ls were some of the most-active buyers of servicing. Today, due in large part to changing regulatory requirements with respect to acquired servicing, thrifts do not play a large role in the acquisition of servicing.

However, the market is continuing to see new entrants attracted by the yields available in the servicing market. These new investors follow a variety of approaches--sometimes building from an existing servicing platform, others starting from scratch, while still others will contract out much or all of the servicing and due-diligence activity.

Sellers should obtain as much information as they can about the buyer with which they are considering dealing. They should gain comfort with regard to the buyer's reputation, its due-diligence profile and its standing with the agencies. The seller should also investigate whether the buyer has failed to complete any transactions and, if so, for what reason.

If the buyer is new to the marketplace, sellers will want good information about its background, experience, funding sources and agency standing. The agencies are beginning to track loan performance by originator even when the servicing has been transferred to a new servicer. How well the buyer services the loans could well affect the seller's future relations with the agency.

Making it work

Servicing is a complex financial asset--successfully selling and transferring a portfolio takes knowledge, time and effort. Financial, operational and legal risks all are involved. A firm that has never sold servicing before will need guidance throughout the stratification, marketing, negotiating, due-diligence and operational process. Because of the risks involved, the amount of specialized knowledge required, the relative importance of a servicing sale to a company's business plan and that fact that many companies don't have the staff to devote to such an infrequently occurring project, even experienced firms generally rely on experienced partners in these transactions.

Beyond simply avoiding problems, efficiently managed sales and transfers can result in purchasers paying above-market premiums for the seller's product in future transactions. Making use of the best resources possible in conducting a servicing-sale transaction will generally turn out to be a high-yielding investment. This is the case, not only in terms of generating optimal proceeds at the end of the transaction, but also in terms of maximizing the comfort of the seller that the deal will be concluded on time and with the most control.

Steven Tannehill is senior vice president of Countrywide Servicing Exchange, Pasadena, California.
COPYRIGHT 1993 Mortgage Bankers Association of America
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1993 Gale, Cengage Learning. All rights reserved.

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Author:Tannehill, Steven
Publication:Mortgage Banking
Article Type:Cover Story
Date:Jun 1, 1993
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