Nonbank mortgage servicers are taking a big chance on servicer advance receivables, and it's quickly becoming a multibillion-dollar market. So far, it’s worked out well. But digging deeper into recent deals, investors should be reminded that, like in any other gamble, the house ultimately wins.
Because while the securitizations of advance receivables are nothing new, the rules have changed.
Issuance of securities backed by servicer advance receivables has increased significantly recently and is expected to continue to grow, albeit at a slower pace in 2014, fueled by nonbank servicers and demand from investors.
Large banks will continue to rid themselves of their most seriously delinquent loans in 2014, although in smaller volumes.
“The banks recently shed a majority of their high-risk loans, providing an opportunity for special services to grow rapidly,” said analysts at Barclays in a 2014 securitization outlook report. Barclays expects less servicing transfers in 2014 since banks have already transferred the bulk of the riskiest loans and new delinquencies are declining.
Standard & Poor’s rated $7.8 billion in servicer advance securities from the second quarter of 2012 through the end of the first quarter of 2013, up from $7.7 billion from the two-year period ending in the first quarter of 2012.
Ocwen and Nationstar, two of the biggest players in the nonbank servicing space, are also the most prolific issuers of servicing advance receivables securitizations.
Ocwen through Home Loan Servicing Solutions (HLSS) has become a prolific issuer in the market over 2013. Ocwen set up HLSS as a separate company which issues servicing advance receivables from a master trust for private-label servicing.
HLSS priced its latest deal in December; a $850 million servicer advance receivable ABS, according to a presale report issued in December by Standard & Poor’s.
The master trust issued $273 million, triple-A $13.9 million, double-A, $6.7 million single-A and $6.1 million triple notes, secured by servicing advance receivables. HLSS via its term note program has come to market a total of eight times in 2013.
“Strong executions in the ABS term note market,” said HLSS president John VanVlack, “are continuing to reduce borrowing costs beyond the firm’s expectations.”
Nationstar has also priced a number of asset-backed term notes in 2013. In November, the servicer launched and closed an advance servicing securitization. The securitization, said Jay Bray, CEO of Nationstar, during the company’s 3Q conference call, “is a continuation of our initiative to reduce the costs of funding for servicer advances.” Bray is on the record stating that Nationstar is reducing activity in the mortgage origination space in favor of a larger slice of the servicing pie.
In June, Nationstar priced $2 billion of advance securitizations that the servicer said provided an incremental 1.75% interest rate savings to existing advance credit facilities.
Analysts at Compass Point Research and Trading said in a note to clients in June that the 1.75% of interest expense savings is 0.75% better than NSM assumed and on the $2 billion deal and translated into an additional ten cents a share above the company’s guidance.
In addition, the advance rate increased from roughly 85% to 93%, which means that it lowered the capital required to finance the debt. Analysts at Compass said that the better advance rate unties approximately $160 million of capital from the $300 million required to finance previous advance facilities.
Nationstar subsequently issued a press release confirming that advance securitizations were $1 billion of fixed rate notes and $1 billion of variable funding notes with a weighted average interest rate of 2.1%. The weighted average term is three years. Credit Suisse, Wells Fargo Securities, and Royal Bank of Scotland were lead managers on the deal.
“We expect NSM to issue $3 billion to $5 billion of securitizations in the back half of this year after the $101 billion of private-label servicing from the Bank of America deal is boarded near the end of June or early July,” said analysts at Compass. “There are over $4 billion of advances associated with this block of servicing.”
Nationstar is one of the biggest nonbank mortgage servicers, having acquired serving rights on a number of portfolios of loans over the past 15 months. It is majority-owned by private equity firm Fortress Investment Group.
“This securitization is yet another example of Nationstar executing on our stated goals of lowering advance funding costs and increasing the profitability of our servicing segment,” said Bray. “This execution also diversifies our funding sources and exchanges floating-rate debt with fixed-rate term debt locked in at extremely favorable rates,” he added.
WHY SECURITIZATION FITS
Banks have been exiting the mortgage servicing business because new capital requirements make it less attractive to keep these rights on their books. The biggest challenge for banks has been servicing defaulted loans — particularly those guaranteed or insured by the federal government through Fannie Mae, Freddie Mac and the Federal Housing Administration — and many banks wound up in hot water with their regulators for their improper handling of foreclosures.
Proposed capital rules are also driving banks to scale back in mortgage servicing.
Under Basel III capital requirements, the maximum value of mortgage servicing rights that can be counted toward a bank’s tier 1 capital is 10%. The big worry is that banks will have to set aside more capital for mortgage servicing rights and also could incur exorbitant penalties if servicing assets exceed the 10% cap.
The market’s recent changes are largely driven by participation of private equity through investments in mortgage servicing companies, which has placed a greater emphasis on total returns and the use of leverage.
Mortgage servicers don’t just collect interest and principal payments and distribute them to holders of mortgage-backed securities; they also advance funds to investors when borrowers miss payments. These advances are eventually reimbursed from the proceeds of the trust, but it can take months, and in some cases, years.
As a result, securitizing advance receivables can be especially useful for funding long term at cheaper rates.
Bray said that another $400 billion servicing pipeline is in the process of being sold and “a lot of that servicing needs to be moved and there are not a lot of guys that can move it, take it, absorb it and provide the amount of infrastructure to handle that servicing,” he said.
SERVICER ADVANCE ABS TODAY
As mortgage servicers take a shine to this once-obscure asset class, the size and complexity of servicer advance transactions has also increased. Servicers are increasing their use of unconventional features and product types, which could increase risks for investors.
While it’s true that servicers are reimbursed for advances before RMBS security holders are paid, unconventional features in servicer advance deals today create new risks for investors. Servicers have a super-senior right to reimbursement off of all cash flows into the trust because the servicer in the underlying mortgage deal is obligated to make out-of-pocket payments that are meant to serve as a source of liquidity, not a source of credit support.
Both Nationstar and Ocwen, in their latest deals, have issued five-year bonds in addition to the one-year and three-year seen in past deals; a trend that came about to take advantage of low interest rates and high investor demand. But extending the term on the bond exposes it to the risk of unexpected delays, reductions or interruptions.
S&P explains in its report that the term ABS classes have fixed principal balances for a defined period of time, at the end of which these ABS are either refinanced with new bonds, or begin to amortize, typically according to a preset amortization schedule. However, longer dated bonds won’t receive any principal payments during the five-year revolving payments. This “increases the risk that the principal will not be repaid on the notes as it becomes more difficult to predict future advances and recoveries,” explained S&P analysts.
Extending the term of the loan makes it more difficult to predict recoveries based on historical performance compared to shorter dated bonds. Changes in the amount of advances made over time and in their recoveries could cause shortfalls to the longer-term notes even if the transaction fails the collateral test, explained S&P.
Another trend going forward will be the securitization of agency servicer advances. “As the overall pool of seriously delinquent mortgage loans shrinks, special servicers will continue to diversify their servicing portfolios with prime and government-sponsored enterprise loans and to build out their origination,” said Barclays.
Nationstar’s January 2013 deal, NAAFT 2013-1, was backed solely by servicer advance receivables made on Freddie Mac-backed residential loans. The Notes carried a weighted average fixed interest rate of 1.46% and a weighted average term of 3- years. They replaced $300 million in existing Agency servicing advance facilities that carried a weighted average floating rate of Libor plus 2.86%, or 3.10% in total, resulting in a reduction in rate of 1.65% as of Jan. 24, 2013.
S&P said that the collateral is similar to non-agency advances except that agency collateral is exposed to set-off risk. Set-off risk occurs when a debtor is able to reduce the outstanding amount of its debt by the amount of any unpaid claims it has against a defaulting originator. As a result, the agency must waive its right of set-off to the servicer. The servicer must provide a representation and warranty stating that none of the advance receivables are subject to a right of set-off.
This may seem like a minor sticking point, but the devil is in the details. As the market continues to grow, it’s important that everyone — agencies and investors alike — know the game before they start to gamble.
