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Reproduced with permission from BNA’s Banking Report, 109 BBR 1458, 10/30/2017. Copyright 姝 2017 by The

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Acquiring Excess Servicing Fees for Mortgage Loan Servicing Rights

BY LAURENCE PLATT AND JON VAN GORP

Is it possible for an investor to participate in the eco-

nomics of agency residential mortgage servicing rights

(MSRs) without being an approved holder of MSRs?

Acquiring excess servicing fees (ESF) is one way that

investors are exploring to accomplish this objective.

While an investor may not need to be approved as a ser-

vicer or issuer by the Federal Home Loan Mortgage

Corporation (Freddie Mac), the Federal National Mort-

gage Association (Fannie Mae) or the Government Na-

tional Mortgage Association (Ginnie Mae) (collectively,

the Agencies) to acquire ESFs, the Agencies neverthe-

less impose various restrictions on the issuance, pur-

chase, sale, and financing of ESFs.

The focus of this article is creating and selling ESFs

from Agency servicing agreements as a method of fi-

nancing the origination and acquisition of MSRs. Cur-

rently, Agency MSRs make up a majority of the residen-

tial mortgaging servicing market as measured by out-

standing loan balance. The remaining portion of the

residential mortgage servicing market comprises the

so-called ‘‘private label’’ market, which is structured in

much the same way as Agency servicing agreements

and therefore creates a parallel opportunity for the cre-

ation of ESFs. Similarly, MSRs can be financed by loans

secured by MSRs. These secured servicing finance fa-

cilities in many ways resemble ESF transactions be-

cause, among other reasons, when Agency MSRs are

involved, the related Agency must consent to a pledge

of the MSRs in order for the lender to have a valid secu-

rity interest in the MSRs. Readers who understand the

process for creating and funding ESFs from Agency

servicing agreements will be a long way towards under-

standing private label ESFs and loans secured by

Agency MSRs even though these topics are beyond the

scope of this article.

What is an ESF?

An ESF is a portion of the contractual mortgage ser-

vicing fee that exceeds a mutually agreed-upon base

amount that is reasonably necessary to be retained by

the owner of the servicing rights to enable it to dis-

charge its servicing obligations in accordance with ap-

plicable laws, agency guidelines and prudent servicing

standards.

Before discussing the structure of an ESF, it is worth

examining the nature of mortgage servicing rights.

Mortgage servicing rights are created whenever a new

mortgage loan is originated and represent a contract

right to administer the mortgage loans or related

mortgage-backed securities on behalf of the owner of

the loan or the securities. The mortgage servicing fee

represented by a mortgage servicing right is a contrac-

tual amount of the interest rate payable by the borrower

that is earmarked as compensation to a servicer who is

servicing the related mortgage loan. Because these

mortgage servicing fees are in excess of the cost of per-

forming the servicing, the rights to service the loans

have a current value which is roughly equal to the net

present value of the difference between the contractual

Laurence E. Platt is a partner in Mayer Brown

LLP’s Financial Services Regulatory &

Enforcement practice. Based in Washington,

D.C., he can be reached at lplatt@

mayerbrown.com.

Jon Van Gorp is co-leader of Mayer Brown

LLP’s Structured Finance and Capital Markets

practices. Based in Chicago and New York,

he can be reached at jvangorp@

mayerbrown.com.

BNA’

Ban

servicing fee and the cost to service over the expected

duration of a mortgage loan.

This is why mortgage servicing rights trade in the

market for a positive price and it is why they are re-

flected on the books and records of a servicer as an as-

set, the value of which is periodically updated to reflect

changes in underlying valuation assumptions, particu-

larly the duration of the related mortgage loans. For ex-

ample, when interest rates rise, so does the value of

mortgage servicing rights because mortgage loan dura-

tions extend in a rising interest rate environment. The

opposite effect is experienced by owners of mortgage

servicing rights in a declining interest rate environment

because mortgage loan durations decrease as a result of

loan refinancing activity.

Because of the way that mortgage servicing rights are

traded in the marketplace, a mortgage servicer is effec-

tively required to prepay for its right to receive servic-

ing fees over time should it perform its obligations as

servicer. This model has from time to time come under

scrutiny as it is believed to be an economic barrier to

entry for new and capable market participants.

There are few other examples in the world of vendor

service contracts where the vendor is required to effec-

tively cash-collateralize its obligation to perform. This

model faced scrutiny following the credit crisis of the

last decade when many servicers lobbied the Agencies

to adopt a pay-as-you-go model where an up-front pay-

ment would not be required to acquire mortgage servic-

ing rights. This so-called fee-for-service model was

eventually rejected after several rounds of comment

and debate in favor of the traditional approach of ser-

vicers purchasing mortgage servicing rights to acquire

the right to service for the contractual servicing fees.

The rejection of the fee-for-service model in favor of

the traditional model drove servicers to become more

creative about financing the up-front payment. The ESF

market developed as a result of those efforts. Transfer-

ring the ESF for value was a way for servicers to eco-

nomically bifurcate the financial ownership of servicing

from the platform-level components of developing and

managing a successful mortgage servicer. For many

servicers with limited capital, this was essential to their

growth and profitability because without scale and le-

verage, mortgage servicing is a challenging business.

‘‘Owning’’ an ESF does not represent an ownership

interest in the servicing agreement or in the underlying

mortgage loans. Rather, it represents an interest in the

servicing fee income as and when received by the ser-

vicer. Generally speaking, the excess servicing strip is

intended to leave enough of a base servicing fee behind

with the sponsoring servicer so that it still has a profit-

making incentive to perform its servicing obligations.

If servicing fees are not received by the servicer, such

as when a borrower does not make regularly scheduled

monthly mortgage payments, there is no excess to be

paid to a holder of ESFs. Much like the economics of an

interest-only strip, the ESF effectively evaporates if the

mortgage loan prepays and the related servicing fee is

no longer payable.

Similarly, if the investor terminates the servicing

agreement with or without cause, then the holder’s in-

terest in the servicing fees payable under the termi-

nated servicing agreement expires as well, except per-

haps for any interest in a termination fee payable by the

investor in the case of termination without cause. If the

loan is repurchased from a Ginnie Mae pool based on

the delinquency status of the loan or to modify the loan

in accordance with FHA loss mitigation rules, the re-

sulting right to Ginnie Mae excess servicing fees gener-

ally would terminate as well.

Why do the Agencies Restrict the Sale

of ESFs?

The Agencies’ treatment of interests in ESFs arose

out of their treatment of security interests in residential

mortgage servicing rights. Approximately 25 years ago,

each Agency for the first time publicly promulgated its

respective version of a master form Acknowledgment

Agreement (AA). While the problem the AA sought to

address was a simple one, the solution was perhaps less

so: under what conditions should a loan servicer be per-

mitted to grant a security interest in MSRs to a financ-

ing source?

Why the resistance? The Agencies did not want to

deal with third parties that claimed to have an interest

in an Agency-approved servicer’s MSRs. The rights of a

third party to the servicing, if and when the Agency ter-

minated the servicing rights based on the servicer’s

breach of the Agency servicing agreement, was a par-

ticular concern. They feared that the third party would

claim that the Agency did not have sufficient cause to

terminate and seek to intervene to prevent the extin-

guishment of the third party’s derivative rights to the

MSRs as collateral for its financing.

In addition, the agencies did not want to deal with

third parties for which it had no contractual privity or

relationship when the third party sought to foreclose on

its interest in the MSRs and cause the transfer of the

MSRs away from the approved servicer, particularly if

the servicer challenged the propriety of the foreclosure.

There was no room for a third party in the context of a

servicing agreement between two parties.

The first AAs issued in 1991 by Fannie Mae and Fred-

die Mac and shortly thereafter by Ginnie Mae repre-

sented the culmination of extensive negotiations with

the industry through the Mortgage Bankers Associa-

tion. While each Agency has issued variations to its re-

spective form over the years, the construct remains ba-

sically the same. They preapprove the grant of a secu-

rity interest to a third party, and then address what

happens to that interest if there is a default under either

the servicing agreement with the applicable Agency or

the loan and security agreement with the third party.

With a few tweaks, the form AA is also used by each

Agency to approve ESF arrangements.

The evolution of AAs has been a priority for the mort-

gage servicers because of the capital required to con-

tinue to aggregate mortgage servicing rights. As a re-

sult, they have continually pressed the Agencies to be

more accommodating to the comments of their financ-

ing sources and ESF buyers. They view this as an essen-

tial component to their continued economic viability

and stability.

The Agencies have an interest in achieving this result

as well. Despite not being persuaded to move to a fee-

for-service model, which was advocated by many

mortgage-servicers, the Agencies are keenly aware of

the systemic risks, the volatility and other challenges

associated with owning mortgaging-servicing rights.

Creating ways to facilitate a robust ESF market through

effective AAs not only promotes the growth and devel-

10-30-17 COPYRIGHT 姝 2017 BY THE BUREAU OF NATIONAL AFFAIRS, INC. BBR ISSN 0891-0634

opment of mortgage servicers but it also is an effective

hedge against economic factors that may put a mort-

gage servicer out of business when it is otherwise per-

forming its loan-servicing functions at a high level.

How Do the AAs Work?

All but one of the Agencies prohibit the grant of a se-

curity interest in their MSRs or the sale of an ESF with-

out prior written approval. Failure to obtain approval

would be a violation of the related servicing guide al-

lowing the related Agency to exercise remedies up to

and including termination for servicer non-compliance.

Ginnie Mae presently does not require prior approval of

a pledge or sale of ESFs, presumably because, in its

view, the transaction does not represent the conveyance

of an interest in the servicing rights themselves. The

consequence of that, however, is that Ginnie Mae does

not recognize the interests of, and will not otherwise

deal with, the investor, unless the investor elects to ex-

ecute an AA.

Each Agency evidences approval through the execu-

tion of the master form AA, which the Agency may ex-

ecute in its sole discretion. While Ginnie Mae does not

limit the purposes for which an AA may be executed,

Fannie Mae and Freddie Mac both do. Freddie Mac, for

example, limits the use of proceeds for which an AA is

required: (a) to fund servicer’s purchase of additional

mortgage servicing portfolios; (b) to provide collateral

for servicer’s warehouse lines of credit; (c) to effect ser-

vicer’s purchase of a mortgage banking company or (d)

to fund servicer’s working capital consistent with its

residential mortgage business operations. Fannie Mae

does not explicitly include working capital as a permit-

ted purpose but does permit funding-required servicing

activities, which arguably is the same thing.

Generally speaking, each form AA evidences the ap-

plicable Agency’s approval of the pledge or transfer of

MSRs or ESFs, as applicable. No Agency obligates itself

to execute an AA with a secured party or an ESF inves-

tor. Moreover, Ginnie Mae only permits a single AA to

be in effect at any one time and does not distinguish be-

tween a security interest in advances and a security in-

terest in the MSRs. Fannie Mae and Freddie Mac, on

the other hand, may permit more than one AA based on

discrete pools of MSRs or advances. Each Agency will

review the underlying documents as a condition to their

potential approval.

The AAs basically divide the world into halves. The

first half is what happens if there is a default under the

secured party’s loan and security agreement, and the

second half is what happens if there is a default under

the Agency servicing agreement. A key concern of the

secured party is whether it can realize on its collateral

if the servicer defaults on its contractual obligations un-

der the loan and security agreement.

What Are the Rights of the Owner

Under the AA?

While Article 9 of the applicable version of the Uni-

form Commercial Code may address how to foreclose

on a contract, which is a ‘‘general intangible’’ in UCC

parlance, the secured party’s right to replace the ser-

vicer is not self-executing. The counterparty to the ser-

vicing agreement has some say on who is the servicer.

In the case of Agency-servicing agreements, the Agency

has no other contractual relationship with the secured

party that would enable the secured party to replace the

servicer with a new servicer of its choice. The AA ad-

dresses this problem by authorizing the secured party

to seek to transfer the servicing rights to another ap-

proved servicer in accordance with standard Agency

procedures if the servicer defaults under the loan and

security agreement with the secured party and does not

cure the default.

The servicer is required under the AA to waive any

right to contest the secured party’s claim of a default

and request for transfer of the servicing. The servicer

always can contest the default as being between it and

the secured party, but the Agency will not get in the

middle of that dispute. It is authorized by the servicer

under the AA to rely on the secured party’s request for

a transfer of the servicing without any requirement to

look behind the request and determine its validity. The

foreclosing secured party, however, is required to com-

ply with the Agency’s standard procedures for servicing

transfers.

This means that any such transfer cannot be done

overnight, and the Agency has to approve both the

transferee and the timing of the transfer and may im-

pose conditions on the transfer in the ordinary course.

There are not many differences among the three AAs on

this point, although Ginnie Mae provides for the op-

tional preapproval of a backup servicer.

What is the Seniority of Agencies’

Interests Under the AAs?

All of the Agencies view their interests in the MSRs

as senior to any interest and require the secured party

to acknowledge that its interest is subordinate to the se-

nior interests of such Agency. Each can terminate the

servicing agreement in accordance with its established

guidelines. The secured party agrees that it may not in-

terfere with or challenge the termination. At the point

of termination by the Agencies, the Agencies differ

somewhat as to what extent they will continue to recog-

nize any interest of the secured party to the MSRs.

Ginnie Mae is the least favorable to the secured

party. Post-termination, it gives the secured party the

right to cure a monetary default by the prior servicer,

but the secured party must elect to cure the monetary

default within one business day. For non-monetary de-

faults, there is no cure right. If the monetary default is

cured, then the secured party may cause the immediate

transfer of the servicing rights to itself if it is an ap-

proved issuer or a preapproved backup servicer. If the

monetary default is not cured, or for other defaults for

which the secured party has no cure rights, the secured

party’s security interest in the servicing rights automati-

cally is extinguished and Ginnie Mae assumes no con-

tractual obligation to pay any amounts to the secured

party, including reimbursement for subsequently col-

lected advances.

While the Ginnie Mae standard may be the least fa-

vorable of all three Agencies, it represents an improve-

ment from prior Ginnie Mae AAs, which required the

secured party to cure monetary defaults by a prior ser-

vicer. As a result, very few, if any, deals were done with

AAs from Ginnie Mae. The revised form effectively

gives secured parties a right to make this decision at the

BANKING REPORT ISSN 0891-0634 BNA 10-30-17

line of scrimmage. At the time a monetary default

arises, the secured party can ascertain the magnitude of

cure and, if it is too expensive, simply forgo its right to

cure and by doing so forfeit its rights in the related

MSR.

Unlike Fannie Mae and Freddie Mac, Ginnie Mae is

exempt from the U.S. Bankruptcy Code. Bankruptcy

courts have no jurisdiction to impair Ginnie Mae’s un-

fettered right to seize the servicer’s Ginnie Mae servic-

ing rights upon a voluntary or involuntary filing of the

issuer for bankruptcy, free and clear of any third-party

security interest or other purported interest, and the se-

curity interest will have no continuing property interest

in the MSRs.

Fannie Mae and Freddie Mac each permit the se-

cured party to cure the default and take over the MSRs

when the Agency terminates the servicer for cause and

seizes the servicing rights. They provide a longer cure

period than Ginnie Mae, but differ in the length of time

within which a cure may be elected. Following the sei-

zure of the MSRs, the two Agencies immediately trans-

fer the servicing to an interim servicer while the se-

cured party determines whether to cure the default and

the Agency decides whether to sell the servicing to an-

other approved servicer or retain the servicing for its

own account.

If the Agency decides to sell, it commits to give the

secured party the net sales proceeds up to the secured

party’s interest, after deducting amounts due from the

terminated servicer, the Agency’s costs and expenses to

sell and prepare for sale and amounts projected by the

Agency that may become due by virtue of breaches of

selling representations and warranties and covenants.

Freddie Mac qualifies this obligation to pay over net

sales proceeds to the secured party in circumstances

where it sells the servicing to a purchaser that assumes

the original selling representations and warranties and

responsibility for past servicing errors.

If the Agency decides to retain the servicing, Fannie

Mae, but not Freddie Mac, commits to give the secured

party an amount equal to the appraised market value of

the servicing up to its interest, net of comparable costs

and expenses. In either case, the secured party bears

the risks of deduction from sales proceeds of all of the

amounts due or projected to be due by the terminated

servicer to the Agency, regardless of whether the

pledged collateral represents only a portion of the ser-

vicing of the terminated servicer.

Do the AAs Treat ESFs Differently than

Security Interests?

It is easy enough in an AA to search and replace

‘‘grant of a security interest in MSRs’’ with ‘‘sale and

transfer of an ESF,’’ and by and large that is what the

Agencies have done. There are key differences, how-

ever. The first and most important difference relates to

the willingness of the Agencies to approve an ESF ar-

rangement in the first place. Because there is a concern

on the part of the Agencies that the actual sale and

transfer of an interest in the servicing fee income may

make it more likely that they will face a third-party

claim if they terminate the servicing, potential investors

should not assume that Fannie Mae and Freddie Mac

will approve of an ESF arrangement.

On the one hand, they understand the need for liquid-

ity that state-chartered, non-depositories have with re-

spect to their servicing asset, but Fannie Mae and Fred-

die Mac zealously protect their superior interests in the

MSRs. Furthermore, even if Fannie Mae or Freddie Mac

were to approve of an ESF arrangement, their approval

may come with conditions. For example, if the servicing

strip is too large, the Agencies may be concerned that

the retained portion of the ESF is insufficient to provide

a profit-making incentive to perform its servicing obli-

gations and avoid for-cause servicer terminations.

This is a particularly important issue in the default

servicing context where the task of servicing, particu-

larly on government insured loans, is labor-intensive

and costly. As a practical matter, this usually means

that no more than 50% of the servicing fee can be struc-

tured as an excess servicing strip. Some servicers con-

duct stress tests to determine if it will have sufficient in-

come to fund its default servicing operations with re-

duced servicing fees based on a range of default

assumptions, because regulators may question the rea-

sonableness of the approach even if there are no ex-

press regulatory limitations.

Conclusion

Many investors who do not want to be licensed hold-

ers of mortgage loan servicing rights have looked at

ESFs as a means of participating in the economics of

mortgage servicing without the direct expenses and po-

tential legal liabilities associated with holding servicing

rights. Given the indirect nature of the interest, though,

it is important for investors to realize what they do not

have just as much as what they do have when acquiring

an ESF.

Like the underlying servicing rights, an ESF can

evaporate as a result of prepayments or termination of

the related servicing agreement, but the holder of the

ESF is at least one step removed from the control of the

servicing asset. Yet, despite the risks involved, partner-

ing with a quality servicer can provide the classic win-

win for both sides, enhanced liquidity for the approved

servicer, and a unique alternative investment for the

ESF holder.

10-30-17 COPYRIGHT 姝 2017 BY THE BUREAU OF NATIONAL AFFAIRS, INC. BBR ISSN 0891-0634