On the rack

News Analysis

On the rack

Recent limitations on liability leave unanswered questions for mortgage servicers

The 21 April FHFA announcement that agency mortgage servicers will have to fund no more than four months of missed payments on a loan in forbearance (SCI 22 April) only partially lifts the dark cloud over the servicers, say market sources.

“The announcement was a welcome development and we were very happy to see it, but there is more work to be done,” says Michael McElroy, a partner in Mayer Brown’s Washington, DC office and a member of the firm’s banking and finance practice.

First, the mortgage servicers have to fund up to 120 days of missed mortgage payments and, in the case of Fannie Mae servicers, they will also have to fund principal payments, should deals become due in the next four months. These sums could be very considerable.

Second, there is as yet no guidance as to when the servicers will be reimbursed by the GSEs for their outlay. In theory, the servicers could be carrying the deficit on their books for a number of years and they will be obliged to seek lending to support it.

The situation, in both cases, is worse for the non-bank servicers, such as PennyMac, New Residential and Lakeview. They are much more thinly capitalised than banks and have less access to funding (SCI 30 March).

Their share of the mortgage origination servicing market has also grown significantly since the financial crisis of 2008/2009, as banks have retreated, in part due to more rigorous capital ratios that were imposed upon them.

So the non-bank servicers have a crucial role in the US mortgage market, but are less capitalised and creditworthy than banks, and those fault lines are now being exposed mercilessly.

While there is confidence in the market that the servicers will get their money back, they face, in many cases, a short-term liquidity crunch. The problem is further exacerbated by the fact that most servicers operate a highly leveraged business model.

“The servicers are highly leveraged because they have to be – this is a capital intensive business. They have to turn money later into money now. Their leverage ratios, which used to be high but sustainable, are now extremely high with the added pressure of a lack of certainty in the timing of repayment on advances,” says McElroy.

Equity price action reflects the stress under which the servicers labour. On 4 March, PennyMac Mortgage Investment Trust was trading at US$22.16 but on 24 March it had collapsed to US$5.72. There has since been a recovery of sorts to US$9.72. New Residential Investment Corporation follows a similar path: it sold off from US$16.44 on 4 March to US$4.33 on 3 April and closed on 6 May at US$6.11.

In large measure a collapse in equity valuation reflects general price action since the Covid-19 crisis swept the market, but there is also awareness by investors that the servicers face peculiar and specific difficulties.

As yet, no mortgage servicer appears to be hovering on the edge of insolvency, but they are experiencing significant amounts of strain, say market watchers. “We haven’t heard of one taking the long march - or the short march - to bankruptcy, but they are certainly scrambling to find funding sources,” says Don Brown, market risk modelling expert at RiskSpan.

What shape or form that funding source will take is currently being debated. Lending facilities may be extended to the non-bank servicers from depository institutions, either as part of a Federal scheme or as part of private initiatives. The servicers might pledge the receivables against a loan, but it remains unclear whether banks would be keen to take on the risk of that type of lending in the current climate.

Servicing advance deals might be structured, whereby investors make the advances to the non-bank servicers to be passed on, for which investors get paid a fee. This became a popular structure in the wake of the financial crisis, particularly in non-agency MBS deals.

But no-one knows yet and it seems clear that the servicers need more help than they are getting so far. The current opaqueness surrounding reimbursement is probably due to the extraordinary complexity of the current crisis and the speed with which it descended on the global economy, so that the Federal Reserve and the Treasury have many competing items on their in-tray.

However, it is also a lively possibility, agree sources, that FHFA director Mark Calabria is dragging his feet on the issue. In the year since his appointment, his declared aim has been to remove the GSEs from conservatorship and return the entities to private ownership.

The current crisis has not made this task any easier, to say the least. Far from diminishing their role in the US mortgage market, recent developments have enlarged it still further, and he may be unwilling to set terms for a additional enlargement just yet.

Non-agency mortgage servicers operate outside the comforting GSE umbrella, so they are even further out in the cold. Agency MBS are, of course, guaranteed by the government, which is why servicers are required to cover missed interest payments by borrowers in forbearance.

Private label MBS offer no such guarantees, and yet, in some cases, servicers are still obliged to make good interest and principal. Experts agree that this area is something of a minefield, with servicer obligations - under what are called pooling and servicing agreements - varying from deal to deal and according to the valuation of properties that are covered.

In those deals in which servicers are on the hook, they are obliged to advance interest and principal until the point that they deem such payments are not recoverable. This gives them some room for manoeuvre.

“In the current climate, I think an aggressive servicer might get its legal team to interpret to the pooling and servicing agreement to say those advances are not recoverable,” suggests Brown.

One consolation is that the non-agency sector is now a small part of the entire US MBS market. At the end of 2019, outstanding principal in the mortgage-related security market was US$10.3trn, of which the non-agency sector comprised US$1.7trn, or 16%.

Simon Boughey

07/05/2020 16:52:57

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