Creditor Rights: Use Them All!

by Steve Ruterman, guest blogger

Much of the focus of mortgage crisis-related litigation and news coverage has been directed at put-back rights as a potential source of loss mitigation for mortgage creditors, including investors and bond insurers.  However, far less attention has been paid to creditors’ rights to fire servicers for noncompliance, also known as “servicer termination rights.”  Servicer termination rights can be the basis of inexpensive leverage on the servicer, and the potential benefits to creditors can be substantial.

Isaac has previously detailed the trench warfare aspects of formulating loan put-back claims against uncooperative RMBS issuers, so I’ll just summarize them briefly.

Assuming that you have the right as a creditor to begin the put-back process (meaning you have overcome onerous standing prerequisites), you have to obtain the underwriting loan files and the underwriting guidelines in effect at the time of loan origination directly from the seller.  If the trustee is the entity with the right to enforce loan eligibility rights, you must obtain the trustee’s cooperation.  Despite its contractual obligation to do so, the trustee will not always cooperate.  You then have to find someone with unassailable expertise in loan re-underwriting to examine the files, and determine whether the loans were underwritten in conformance with the seller’s guidelines, and were therefore eligible for inclusion in the loan pool at the time of the sale.  Demand on the seller for repurchase of the ineligible loans must then be made.  Given the very material potential costs of such demands on the largest loan sellers, litigation is very likely to ensue.

Worst of all, anyone commencing this process should be prepared to shoulder the expense of such a litigation right from the start; meanwhile, any recovery would not be realized for several years, and may be distributed through the credit waterfall to free-riding creditors if and when it is.  At the end of the day, few investors are prepared to undertake these costs for such remote gains, and this is probably why more investors are not actively pursuing enforcement of their repurchase rights.

However, RMBS creditors typically have additional points of leverage with sellers when the sellers are also the servicers of the loan pool.  These leverage points are cheaper to enforce, and in most cases, work more quickly, as well.  In particular, I am referring to servicer termination rights.

I do not wish to overstate the degree of leverage available to creditors, given the steady erosion of creditor rights which occurred as the frenzy of RMBS issuance accelerated after 2005.  Post-2005 deals typically contain servicer covenants that are more diluted than those found in earlier deals.  Most of these deals contain servicer covenants such as an obligation to make all payments to the trust when due, provide all required reports when due, take no actions that will damage the value or collectability of the loans, and so forth.  Failure to perform may constitute events of servicer default, subject to potential notice and cure periods, depending on the terms of the pooling and servicing agreements (PSAs).

Moreover, I have seen PSAs that define a number of servicer events of default, but are silent on the topic of creditor remedies.  In these cases, there are servicer covenants to do and not do certain things, but there are no contractual remedies or penalties imposed on the servicer if it fails to comply.  That said, these pro forma covenants can often be a source of inexpensive leverage on the servicer, and the potential benefits to creditors can be very substantial.  Indeed, just the credible threat of servicer termination may possibly spur a servicer to cooperate with creditor demands.

Why might a servicer default on covenants to perform seemingly mundane duties?  We are in the process of living through one of the most chaotic periods of the last two RMBS business cycles.  During the last shakeout in the late 1990s, the damage was largely confined to asset classes such as subprime and high loan-to-value, which were relatively tiny compared to the rest of the non-agency market.  The issuers involved were themselves tiny– typically independent, specialty lending shops– and are now defunct.

This time, the value of substantially all classes of non-agency mortgage loans has been drastically reduced, including subprime, Alt-A, jumbo and second lien.  This is because some industry players disregarded their loan underwriting guidelines.  Their abandonment of underwriting guidelines has deservedly garnered a lot of attention, and spawned creditors’ subsequent pursuit of put-back claims.

However, the collapse of internal credit and quality controls at some of the large mortgage loan sellers adversely affected every aspect of their operations.  Recently, for example,  there has been increased reporting on defective and deficient loan documentation, incomplete transfer of loans to securitization trusts, robo-signing of foreclosure documents, industry vendors dedicated to the manufacture of missing loan documents, and so on.

I have found that the internal control trouble extends to basic operational bread and butter issues such as proper remittance of collections due to securitization trusts.  In one case to which I was a party, the servicer accurately recorded daily obligor payment amounts deposited into its collection account, but subsequently made deposits in different amounts into the relevant trust account.  In other words, the servicer took the trouble to account for payments deposited into the collection account properly, but did not use those same records to size the subsequent deposits into the trust account.  This was an obvious lapse in the most basic internal servicing controls, on which the entire concept of securitization relies.  It was also the basis of a servicer event of default and the servicer’s subsequent termination.

What is the process by which events of default can be discovered?  It begins by exercising a creditor right contained in every PSA I have seen– the right to inspect the servicer’s books and records during normal business hours (sometimes the trustee or the trustee’s agent possesses this right).  In order to exercise audit rights associated with uninsured RMBS, the creditor is usually required by the PSA to hold at least 25% to 50% of either a tranche or a class of certificates.  There may be separate contractual language defining the voting control rights necessary to terminate servicers, or to instruct trustees to do so.  When notifying the servicer that such an inspection is forthcoming, it should be made clear that no loan re-underwriting is intended.  This usually results in an adequate level of servicer cooperation, as they are often audited by many different people.

Next, the creditor should engage a forensic auditor to do the work.  Forensic auditing of servicer compliance is cheaper than the put-back work described above, and can usually be completed in a few months rather than a few years.

The benefits of terminating an unsatisfactory servicer and transferring servicing to an independent party in whom creditors have more confidence are potentially immense.  Creditors no longer have to worry about whether the monthly cash transfers are correct, or that monthly reporting is accurate.  I have also found that servicers with poor internal controls are usually poor collectors and loss mitigators.  Thus, improved loan pool performance often results from a successful transfer.

Finally, the new servicer will be in a position to identify several types of ineligible loans that may be put back.  These include fraudulent loans and those with incomplete documentation.  Broader loan put-back efforts are not precluded by a servicing transfer and may proceed in parallel with servicer termination.  In other words, servicer termination, as a cheaper and easier precursor to exercising put-back rights, will ultimately aid creditors in enforcing those rights, on top of the benefits received from improved servicing of their loan pools.  While much of the focus in recent years has been on enforcing put-back rights, and there has been talk of broader efforts to replace servicers, creditors would be wise to make better use of this complementary strategy going forward.

Steve Ruterman is an independent consultant to institutions and institutional investors with significant RMBS exposures and a fan of The Subprime Shakeout.  He recently retired after a 14 year career with MBIA Insurance Corporation, during which he terminated over 20 mortgage loan servicers.  Mr. Ruterman welcomes your comments, and can be reached by email at Steve.Ruterman@yahoo.com.

About igradman

I am an attorney, consultant, book editor, and one of the nation's leading experts on mortgage backed securities litigation. I author The Subprime Shakeout mortgage litigation blog, am the Managing Member of MBS consulting firm IMG Enterprises, LLC, and am the editor of the newly released book, "Way Too Big to Fail: How Government and Private Industry Can Build a Fail-Safe Mortgage System," by Bill Frey. Follow me on Twitter @isaacgradman
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