Enhanced US Financial Requirements For Non-Bank Mortgage Servicers: What Doesn’t Kill You Makes You Stronger? – Finance and Banking

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US mortgage loan rates go up; re-financings go down, along with
the amount of excess custodial funds from full prepayments to fund
principal and interest servicing advances for mortgage loans in
default or forbearance. Delta variant infections go up; business,
income and jobs go down. Home loan delinquencies go up; servicing
fee income goes down. Mortgage loan servicing advance obligations
go up; servicer financial strength goes down. Required net worth,
capital and liquidity requirements go up; mortgage company
profitability goes down.

That’s the nightmare scenario plaguing housing finance
policy makers, much less the state-chartered, non-bank independent
mortgage bankers they oversee. These up-and-down scenarios are not
necessarily true in all cases, but the specter is enough to cause
federal and state regulators to search for solutions before it is
too late. Unfortunately, though, the solution of choice may
actually precipitate the very downside risk it is designed to
prevent. Maybe it is time to discuss more seriously whether the
liquidity risk of principal and interest servicing advances in
times of materially adverse economic circumstances should be borne
by the government instead of by mortgage servicers, particularly in
the case of Ginnie Mae.

The Need for More Financial Strength

The financial strength of independent, non-bank mortgage
servicers has been under sharp scrutiny by the US Financial
Stability Oversight Council (“FSOC”), the Conference of
State Bank Supervisors (“CSBS”) and the Federal Housing
Finance Agency (“FHFA”), along with Fannie Mae and
Freddie Mac, and Ginnie Mae. At issue is whether such mortgage
servicers can withstand an adverse economic environment. But what
does that really mean?

Well, counterparty risk is one type of concern for government
guarantors of mortgage-backed securities. If a mortgage servicer
cannot fund principal and interest servicing advances contractually
required under program guidelines, the government guarantors must
step in to do so. Moreover, if a mortgage servicer suddenly shuts
its doors, the tasks of collecting and remitting mortgage payments,
helping eligible delinquent borrowers obtain loss mitigation and
pursuing foreclosure when there are no viable alternatives could
wreak havoc on consumers and investors alike, unless a substitute
servicer or sub-servicer seamlessly takes over. And in a really
extreme case, FSOC has questioned whether the failure of one or
more non-bank mortgage servicers could have an adverse impact on
the financial stability of the United States—a scenario that
seemingly is farfetched but nevertheless one for which FSOC has
advocated advance planning to reduce the likelihood of
occurring.

Heightened financial strength requirements for independent,
non-bank mortgage servicers seems to be the solution of choice for
policy makers these days. Fannie Mae, Freddie Mac and Ginnie Mae
long have required eligible participants to meet specified levels
of net worth, capital and liquidity. The CSBS recently has gotten
into the fray, recommending comparable requirements for state
licensing eligibility. FHFA proposed, rescinded and purportedly
plans to re-propose increased financial standards. And Ginnie Mae
recently issued a Request for Input on proposed increased
standards, including the introduction of a highly controversial
risk-based capital ratio requirement; thankfully, Ginnie Mae
subsequently postponed the deadline for comments until October 8,
2021, and acknowledged its intent to pursue alignment with the
related efforts of the FHFA and the CSBS. If and when alignment is
achieved, at least at this point, alignment likely will require
non-bank mortgage servicers to amass more net worth,
more capital and more liquidity than required
under existing standards. But could requiring more
backfire?

Funding Principal and Interest Servicing Advances

Let’s start with the obvious. A third-party mortgage
servicer has no beneficial ownership interest in the underlying
mortgage loans that it services. It simply is a contract service
provider to perform or cause to be performed the underlying
mortgage servicing function for a fee on behalf of the owners of
the loans and related mortgage-backed securities. An obligation to
advance regularly scheduled payments of principal and interest to
securities holders is part of the servicing function for Ginnie
Mae/Fannie Mae/Freddie Mac securitized loans, if the borrowers fail
to make such payments. In the case of Ginnie Mae, such advances
must continue until the loans reinstate or the loans are
repurchased from the pools, either voluntarily based on the level
of delinquency or on a mandatory basis if the loans are modified in
accordance with underlying Federal Housing Administration
(“FHA”)/Department of Veterans Affairs
(“VA”)/US Department of Agriculture’s Rural Housing
Service (“RHS”) requirements. In the case of Fannie Mae
and Freddie Mac, such advances must continue for a much shorter
specified period of time.

Such advances in the ordinary course constitute a liquidity
risk, but not an ultimate credit risk, to the mortgage servicers,
because generally they have a right to reimbursement from
subsequent borrower payments and/or from Fannie Mae or Freddie Mac
or, in the case of Ginnie Mae, mortgage insurance or mortgage
guarantee proceeds. But the source of funds to make such advances
has to come from somewhere. Fannie Mae, Freddie Mac and Ginnie Mae
all permit servicers to use excess custodial funds from full,
voluntary mortgage loan prepayments as an interim source of funds
until such prepayments must be remitted to the investor in the
immediately following month. As long as re-financings continue at a
torrid pace, servicers can replenish the excess custodial funds
from full principal prepayments that they used to fund principal
and interest advances required in one month with those collected in
the next month, and so on and so on. Yet there may come a time when
a steep drop-off in refinancings coupled with high levels of
delinquencies due to COVID-19 or other factors will result in
insufficient excess custodial funds to pay for the required
advances.

Secured servicing advance financings provide a second source of
funds for mortgage servicers to satisfy advance requirements. There
are significant structural impediments to the availability, and
that impact the cost, of such facilities, particularly with respect
to Ginnie Mae. The principal impediment is the inability to fully
realize on the mortgage servicing rights collateral in the case of
a default under the loan agreement, based on agency restrictions.
Unlike Fannie Mae and Freddie Mac, Ginnie Mae does not permit
separate servicing advance facilities, only permits one financing
facility per servicer that is secured by Ginnie Mae mortgage
servicing rights, and provides virtually no protection for secured
creditors if Ginnie Mae declares the servicer in default and seizes
the servicing rights. In addition, the servicer cannot seek
reimbursement for advances directly from Ginnie Mae, instead having
to rely on mortgage insurance or mortgage guarantee proceeds
payable by the FHA, VA or RHS.

To its credit, Ginnie Mae recognized the servicing advance
conundrum for mortgage servicers after US Congress enacted the
Coronavirus Aid, Relief, and Economic Security Act (the “CARES
Act”), which, among other provisions, granted borrowers who
attested that they were experiencing financial hardship directly or
indirectly due to COVID-19 the ability to seek mortgage forbearance
for up to one year on loans sold to Fannie Mae or Freddie Mac or
insured or guaranteed by the FHA, VA or RHS (defined as
“federally-backed mortgage loans”). Such forbearance
automatically triggered principal and interest servicing advances
for insured or guaranteed loans pooled into Ginnie Mae securities
and loans securitized through Fannie Mae or Freddie Mac.

Specifically, on April 10, 2020, Ginnie Mae announced the final
terms of its much-anticipated Pass-Through Assist Program for
Issuers (“PTAP”) of mortgage-backed securities that are
in need of funding for the increased amount of servicer advances
due to the COVID-19 national emergency and forbearances under the
CARES Act and which built upon Ginnie Mae’s then existing
program to assist servicers to fund advances in the wake of 9/11
and natural disasters. But, despite good intentions, the program,
which Ginnie Mae structured as a program of “last
resort,” was lightly used. First, excess custodial funds from
full prepayments discussed above lessened the need for the
facility. Second, embedded in the program are significant
restrictions on executive compensation and distributions while any
draws remain outstanding. Third, draws under the facility mature
after seven months, which is less than the amount of forbearance
afforded borrowers under the CARES Act and subsequent extensions by
FHA, VA and RHS. Fourth, commercial lenders under existing finance
arrangements secured by a servicer’s mortgage servicing rights
have to agree to subordinate the priority of their security
interest to that of Ginnie Mae. Last, the COVID-19 PTAP facility is
documented through a “Master Supervisory Agreement”; many
private commercial loan agreements make it an event of default for
the mortgage servicer borrower to enter into a “supervisory
agreement” with a governmental entity because such agreements
typically are used by prudential regulators with supervised
financial institutions that are deemed to have violated applicable
regulatory requirements, creating the prospects of a cross-default
and in any event a perceived badge of dishonor.

A third source of funds is the servicer’s own funds, which
is where the net worth, capital and liquidity requirements come
into play. In an adverse economic environment resulting in high
levels of borrower defaults and corresponding high levels of
principal and interest servicing advance requirements, servicers
may have difficulty self-funding such advances and waiting for
reimbursement in accordance with agency requirements. And
that’s why agency alignment likely will require non-bank
mortgage servicers to amass more net worth, more capital and more
liquidity.

The Downside to “More”

More” likely comes at a cost-lower margins
resulting from the cost of capital and the like and perhaps lower
valuations and less interest of private capital to invest in
mortgage servicers. Some mortgage servicers may not be able to meet
and maintain these new requirements, thus falling out of
eligibility to service agency mortgage loans and perhaps resulting
in an increase in the concentration of agency servicing among fewer
mortgage servicers. Those that can meet and maintain these higher
financial standards presumably will be in a financially better
position and, if the returns are good enough and capital is
plentiful, may elect to increase their holdings. Ergo, what
doesn’t kill you makes you stronger. Or, at least, may make you
stronger? And then again, it may make you weaker.

More,” however, begs the question of why
mortgage servicers alone should bear the liquidity risk of
increased principal and interest servicing advances in an adverse
economic environment, particularly when reimbursement for advances
often is prolonged. Ginnie Mae servicing is where the issue is most
acute. As mentioned above, unlike Fannie Mae and Freddie Mac, there
is no time limit on advancing regulatory scheduled payments of
principal and interest on a pooled loan in delinquency or
forbearance, unless and until the loans are repurchased based on
strict Ginnie Mae guidelines and which repurchases themselves
require funds available to the servicer to execute. Last year,
Ginnie Mae made it even worse for servicers by imposing seasoning
requirements on servicers that repurchase certain delinquent loans,
reinstate the loans through options other than loan modification
(even when such reinstatement is mandated by the underlying federal
agency’s loss mitigation waterfall of options) and then seek to
re-pool the loans, thus prolonging the time it takes to recoup
their repurchase funds.

Time for the Government to Step Up

But there is another way than simply requiring servicers to have
and maintain more and more net worth, capital and
liquidity to manage the advance risk in an adverse economic
environment. Ginnie Mae itself could fund principal and interest
advances when certain macro-economic and other characteristics of
an adverse economic environment present themselves or when, by
federal legislation or executive action, borrowers are temporarily
relieved from their obligations to make regularly scheduled monthly
payments. Fannie Mae and Freddie Mac already cap a servicer’s
advance obligations for regularly scheduled payments of principal
and interest on delinquent loans, without regard to the existence
of adverse economic circumstances. Why can’t Ginnie Mae do the
same in a more limited way?

The underlying rationale for a different paradigm than exists
today is that mortgage servicers are mere service providers and
should not have to bear the servicing advance requirements when
profound, material adverse changes occur in the economy at large,
given that the servicer has no beneficial ownership of the pooled
mortgage loans and the related securities. Ironically, the holders
of Ginnie Mae guaranteed, mortgage-backed securities are insulated
against the risk of borrower delinquencies in adverse economic
circumstances, but their service providers are not. Maybe it is
time to re-think the servicer’s advance obligations—not
whether the securities holders should receive these advances,
because that might turn the market for Ginnie Mae securities upside
down—but whether there should be a ceiling on the
servicer’s obligation to make these advances to securities
holders in periods of adverse economic circumstances. In other
words, while policy makers are justifiably concerned about the
potential impact of adverse economic circumstances on non-bank,
independent mortgage servicers, maybe they also should be looking
in the mirror to find solutions.

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