What Is an Excess Servicing Spread Sale?

An excess servicing spread sale carves the servicing fee in two and sells part of the top slice while the seller keeps servicing the loans. The seller keeps three things: a base servicing fee for doing the work, its share of the spread above that base, and the obligation to service. In one older, public example, a 2011 excess servicing spread sale filed with the Securities and Exchange Commission (SEC) between a servicer, as seller, and an investor, as purchaser, the buyer took the seller’s rights, “severable from each (and all) of the other rights under the applicable Servicing Agreements, to 65% of the Total Servicing Spread.” The seller kept the other 35 percent as the retained servicing spread, and drew a separate base servicing fee of 0.06 percent a year on the outstanding balances. Those are that agreement’s numbers. What the seller sold is a cash flow, not a job.

Why does the fee get split this way?

In our view the fee gets split this way because the buyer wants the economics of servicing without the operational and regulatory burden. In our view, too, a buyer that is not an approved servicer cannot hold the servicing itself. The structure exists to sever a payment stream from the duties that go with it. The definition does the work: the excess spread is described as severable from every other right under the servicing agreements. Everything the agency cares about, meaning who services, who advances, and who answers for performance, stays where it was.

That framing also explains the base fee. In the 2011 agreement, the base servicing fee for the loans the seller services is the serviced balance at the measurement date, times the base rate, times one-twelfth. For the first collection period on part of the portfolio the fraction was one-twenty-fourth. In our view it is priced to cover the cost of servicing rather than to generate return. The return is in the spread, and the spread is what moved.

What exactly is in the total servicing spread?

The total servicing spread, in the 2011 agreement, is the fee collections left after the base fee, plus the other amounts the agencies pay on the servicing rights, including termination fees. A third limb adds repurchase-price receipts from the prior owner of the servicing. The definition’s exclusions are, in our view, where deals get argued. The definition’s first two limbs read “the Servicing Spread Collections received during such Collection Period and remaining after payment of the Base Servicing Fee” and “all other amounts payable by the Agencies to Seller with respect to the Mortgage Servicing Rights, including any termination fees,” but “excluding all Ancillary Income and reimbursements received for advances and other out-of-pocket expenditures from an Agency by Seller in accordance with the Servicing Agreements.”

In the 2011 agreement, ancillary income, which the agreement defines to include late fees, returned-check and assignment fees, and modification and incentive income, stays with the seller. Advance reimbursements stay with the seller. Termination fees are shared. A buyer negotiating this definition is really negotiating what happens on the edges of the portfolio, and in our view those edges, not the headline split, are where the seller’s economics move.

Who gets paid first?

Termination payments get paid first, split 65 percent and 35 percent pro rata, through a waterfall in a custodial account a third party maintains. In our view the sting for the seller is in the provisos, not the ordering. In the 2011 agreement the priority runs five deep. The seller directs the account until an access termination notice is delivered under the control agreement, after which the buyer directs it. The base servicing fee comes second, and the seller may draw it during the month; any accrued and unpaid base fee comes third on the distribution date. Fourth, pro rata, come the buyer’s excess spread and the seller’s retained spread for the collection period just closed, a calendar month, and fifth, anything remaining goes to the seller.

The seller’s base fee sits second, ahead of the rest of both parties’ spread for the month just closed. But two provisos attach to the fourth tier, and both attach to the seller’s share alone. Indemnity payments then due to the buyer come out of the retained spread. While a reserve event continues, the retained spread goes into the reserve, as far as needed to fill it, before it reaches the seller. The buyer’s share carries neither proviso. In a stressed month the servicer gets paid for servicing and waits for its equity. Two more sentences in the same agreement cut the same way: the base fee is payable “only to the extent funds are available therefor” in the custodial account, and if servicing moves to a subservicer the subservicer’s fees are the seller’s, and “in no event” reduce what is allocable to the excess spread.

What happens if the seller’s credit deteriorates?

If the seller’s credit deteriorates, a reserve builds; in the 2011 agreement the trigger is set on the seller’s own financial condition. A reserve account deposit event occurs if the seller’s tangible net worth “falls below $150,000,000” or the seller “defaults in any indebtedness in excess of $10,000,000.” On each distribution date while the event continues, the seller’s retained spread moves into the reserve until the reserve equals “25% of the fair market value” of the spread expected over the remaining life of the loans, measured when the event first occurred. The buyer proposes that value, and the buyer’s number governs until any dispute is resolved. If the seller objects and the parties cannot agree within five business days of the objection, a valuation expert decides, and the seller pays the expert. Once the event ends and the buyer’s indemnities are paid, the seller may direct the reserve’s release.

In our view that is a large number, and it arrives at the moment the seller can least spare it. Under the 2011 agreement’s terms, a breach elsewhere in the capital structure can pull a quarter of the remaining spread value into a reserve here.

Is it a sale or a loan?

Whether it is a sale or a loan is answered twice in the 2011 agreement: the parties say sale, and then they draft for the possibility that a court disagrees. The intent language is unambiguous. The parties intend the transfer to “constitute a valid sale of the Excess Servicing Spread from Seller to Purchaser, conveying good title to the Excess Servicing Spread free and clear of any Lien,” and intend that the beneficial interest not form part of the seller’s estate in bankruptcy. They agree to treat it “as an absolute sale for tax purposes, and as an absolute and complete conveyance of title for property law purposes,” and neither intends a loan, “[e]xcept for financial accounting purposes.” The buyer’s closing conditions include a law firm’s written opinion on the characterization of the transfer as a sale.

And then the fallback. If the conveyance “is characterized by a court or governmental authority as security for a loan rather than a sale,” the seller is deemed to have granted a security interest in the spread and its proceeds “as security for a loan in the amount of the Purchase Price.” The agreement also grants the buyer, from the start, a first priority security interest in both accounts and everything deposited in them.

The intent clause is the deal the parties want; the recharacterization clause is the deal they get if a bankruptcy court looks at it differently. In our view that pairing, not the intent language alone, is what the buyer’s position against the seller’s estate rests on if the servicer enters bankruptcy.

What does the agency say about all this?

The agency says it may consent, in its sole discretion and for limited purposes, and that the buyer’s interest is subordinate to all of Fannie Mae’s rights. It also says the interest lasts only as long as the seller keeps the servicing and stays out of default. Fannie Mae Servicing Guide A2-7-02 (11/25/2015) permits a sale, assignment, transfer, pledge, or hypothecation of excess servicing compensation, and separately of the right to receive reimbursement of servicing advances, but only with the “prior written consent of Fannie Mae, in its sole discretion,” requested at least 30 days before the proposed effective date. The purposes are limited: funding the acquisition and servicing of additional portfolios, collateral for warehouse lines, or purchasing all or substantially all of the assets of a mortgage banking company. We read Fannie Mae’s section for this article and not Freddie Mac’s or Ginnie Mae’s. The 2011 deal’s own closing papers include a Freddie Mac acknowledgment agreement, defined as the one under which “Freddie Mac consents to the sale of the Excess Servicing Spread.”

The instrument that governs an excess spread sale at Fannie Mae is the subordination of interest agreement. The seller, the purchaser, and Fannie Mae all sign it, and it prevails over the purchase agreement wherever the two conflict. Under it “the purchaser or financier’s interest is subordinate to all of Fannie Mae’s rights, powers, and prerogatives” under that agreement and the Lender Contract, and the purchaser “has no claim or entitlement as a secured creditor against Fannie Mae, and Fannie Mae has no duty or obligation to the purchaser or financier, except as otherwise expressly provided in the subordination of interest agreement.” Fannie Mae keeps the right to terminate, sell, or transfer the servicing that creates the income. A servicer that proceeds without approval or without the agreement risks suspension of its selling and servicing rights or termination of its Lender Contract. In our view the sentence buyers underprice is the one that follows: the purchaser’s right to the excess compensation “will exist only as long as the seller/servicer is the servicer of the mortgage loans as to which an interest in excess servicing compensation has been transferred and is not in default of its obligations to Fannie Mae.” At Fannie Mae the acknowledgment agreement, with its parallel subordination, governs a pledge of servicing; where an excess spread transfer is secured by a pledge, the subordination of interest agreement carries provisions like it. Whether Freddie Mac’s acknowledgment agreement carries the same limit on the buyer’s interest is a question we did not take up here.

What is the seller really promising?

The seller is really promising continuity, and it is handing the buyer a consent right over its own portfolio decisions. In the 2011 agreement the seller covenants to service “in accordance with Accepted Servicing Practices” and to perform “in all material respects” under its servicing agreements and the law that applies to them. On termination of a servicing agreement, the seller “shall remain liable to Purchaser and the applicable Agency for all liabilities and obligations incurred by Servicer or its designee while Seller or its designee was acting as Servicer thereunder.” And without the buyer’s express written consent, “which consent may be withheld in its absolute discretion,” the seller may not terminate or amend its servicing rights, consent to a change in its servicing agreements, or enter into other agency arrangements reasonably material to the buyer, with one carve-out, for changes to servicing agreements on loans the seller itself owns that leave the total servicing spread untouched. A transfer or sale of the servicing rights to another servicer takes, to the extent the law permits, the buyer’s prior written consent and the buyer’s participation in the sale. That clause states no standard for the consent. Amendments to the deal documents themselves take a consent that “shall not be unreasonably withheld, delayed or conditioned.”

In our view the transfer consent reaches furthest into the seller’s future. The 2011 agreement puts a third party into most future decisions about the underlying servicing, including a bulk sale the seller might want to run years later. It drafts three different consent formulations for three different decisions. It is a sale that quietly encumbers strategic flexibility.

Where the value sits

The value sits where the spread definition draws its edges, where the reserve trigger is set, where the waterfall’s provisos land, and in whatever standard, if any, governs the buyer’s consent to a later transfer. In our view the percentage split gets the attention in the term sheet and little of the value, because it is the one number both sides model correctly. Each of the four is set by the parties’ own paper: the 2011 agreement carves ancillary income out and shares termination fees, sets its reserve trigger on two credit tests, attaches its provisos to one side of the waterfall, and writes three consent formulations into three clauses, and Fannie Mae’s Guide “does not specify the precise terms or provisions” of the purchase agreement.

In our view the default is the trap. At Fannie Mae the buyer’s interest lasts only as long as the seller services the loans and is not in default. Nothing in the Guide’s description of the subordination of interest agreement protects the buyer from that. The seller’s retained share, for its part, sits behind the buyer’s indemnities and its own reserve.

Which of the four carries the value in a given deal turns on facts particular to it. Those facts are the agency, whether the transfer is secured by a pledge, the seller’s covenants elsewhere in its capital structure, the portfolio’s actual ancillary income, and the seller’s later plans for the servicing. That is the work.

The agency’s side of a servicer default, and what it takes from the servicer, is covered in our article on what an acknowledgment agreement gives the agency if the servicer defaults. Where the servicing is performed by a third party rather than the named servicer, the provisions that matter are different again and are covered in what to negotiate in a subservicing agreement.