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Secondary market.

On September 26, 1991, the Federal Deposit Insurance Corporation (FDIC), as receiver of Southeast Bank, N.A., repudiated a private mortgage loan servicing arrangement between Southeast Bank and Sears Mortgage Corporation. This unprecedented action threatens to severely damage the multi-billion dollar market for private investor mortgage servicing rights, greatly reduce the value of these rights as capital for banks and thrifts and increase the cost of mortgage financing for homeowners.

It is MBA's understanding that prior to the FDIC's action on September 26, the FDIC had repudiated mortgage servicing arrangements only in cases of abuse or overreaching by the servicer. This policy, although not formally stated, permitted the continued stable growth of a mortgage servicing market by preserving the status of mortgage servicing as a discrete liquid asset with an ascertainable and reasonably predictable value. Without a strong statement to the contrary, the FDIC's action appears to reflect a new policy - that repudiation will occur whenever it is deemed to be in the interests of the FDIC notwithstanding the existence of contractual obligations to servicers previously negotiated in good faith. We understand that the FDIC is studying the issue of repudiation of all contracts, including servicing contracts, with a view towards adopting policy guidelines on the subject.

It can be anticipated that the FDIC's action in the Sears/Southeast case may, if allowed to stand as the official FDIC policy, result in the following consequences: * It may significantly decrease the value of $37 to $47 billion

in private investor mortgage servicing rights that

are currently on the balance sheets of federally insured

depository institutions. To the extent that purchased

mortgage servicing rights are treated as marketable assets,

it is because they may be valued with reference to

an existing and active market. * It may severely impair the regulatory capital of a large

number of insured banks and thrifts. Banks and thrifts

are now required to do quarterly and annual market value

analyses of the mortgage servicing rights they show as

assets. If the servicing market believes that there are significant

risks that a mortgage servicing affiliate of a

bank/thrift can lose the right to continue servicing on behalf

of a financial institution seized by the FDIC, then the

market value of such servicing rights is zero. Because

such servicing is on the balance sheet, an adverse valuation

will reduce the institution's regulatory capital. * A policy of repudiating servicing contracts would extinguish

the active market through which insured depository

institutions are able to increase their capital and raise

badly needed liquidity. * The threat of repudiation can increase the cost of residential

mortgages to homeowners throughout the United

States. Because originators can sell servicing rights (i.e.,

"sale of a mortgage-servicing released") for a reasonably

predictable sum, it can afford to reduce the interest rate

and other financing cost of the loan. In today's highly

competitive mortgage financing market, these savings

are consistently passed along to the homebuyers.

FIRREA permits servicers to offset repudiation costs

Section 212(e) of FIRREA (12 U.S.C Section 1821[e]) gives the conservator or receiver of any insured institution the authority to "disaffirm or repudiate" any contract or lease to which the institution is a party if the conservator/receiver determines that 1) the contract is burdensome and, 2) repudiation will promote the orderly administration of the institution's affairs. However, the FDIC's power to disaffirm, avoid or repudiate contracts is not unlimited.

Section 212(e) (8) (C) of FIRREA states that the FDIC "... whether acting as such or as conservator or receiver of an insured depository institution, may not avoid any transfer of money or other property in connection with any qualified financial contract with an insured depository institution" unless "the Corporation determines that the transferee had actual intent to hinder, delay or defraud such institution, the creditors of such institution, or any conservator or receiver appointed for such institution." (Emphasis added.) FIRREA gives a private party the right under a qualified financial contract to "offset or net out any termination value, payment amount or other transfer obligation arising under or in connection with one or more contracts and agreements" that are terminated. FIRREA defines a qualified financial contract, among other types of contracts, as a securities contract that includes mortgage loans, mortgage-related securities and any interest in any mortgage loan or mortgage-related security. (Section 212[e][8][D]. [Emphasis added.]) Servicing contracts typically require the investor to pay a termination fee in the event the investor terminates the servicing contract. The FDIC's failure to permit a termination fee to be offset or netted out conflicts with Section 212[(e)(8)(A) of FIRREA. We believe that servicing contracts clearly falls within the definition of a qualified financial contract.

Congress had the foresight to provide these provisions to ensure that contracts relating to market-based liquid assets are not impaired to an extent that undermines the market stability of those assets. Congress did not want government interference with the contract expectations of free-market participants unless there was clear evidence of fraudulent activity or bad faith. Congress established that the parties to arm's length contracts are provided reasonable and necessary legal protection for compensatory damages resulting from the loss of a contract right; in this case the termination fee associated with a right to mortgage servicing cash flows.

MBA has recently met with the FDIC on this issue. The FDIC believes that because it has rarely repudiated servicing contracts, the market should automatically realize that it is not FDIC's policy to repudiate such contracts. MBA maintains that the market cannot work efficiently without clear information and guidance provided by the FDIC that it will not repudiate existing arm's length servicing arrangements. MBA is planning future meetings with the FDIC on this issue.
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Author:Taliefero, Michael S.
Publication:Mortgage Banking
Date:Mar 1, 1992
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