Role of Mortgage Servicing Assets in Bank Failures

Of the 518 banking institutions that failed between 2007 and year-end 2015, 66 had MSAs on their books at the date of failure.³⁰ In statutorily mandated MLRs of failures of insured depository institutions, problems with MSAs were described as a significant factor leading to the failure of one institution and as contributing to the failures of three others. A broader review of financial data reported by failed banks, and indirect evidence from FDIC receiverships, suggests that problems with MSAs were likely among the issues that other failed institutions were facing.

Financial Data Reported by Failed Insured Depository Institutions

Information about the 20 failed insured depository institutions that had the largest MSA holdings as of the date of their last financial statement is presented in table 1. A number of these institutions reported significant reductions in the values of their MSAs during the quarters (in some cases years) leading up to their failure. As a percentage of peak MSA values recorded after 2004 but before failure, there were subsequent material reductions in the value of MSAs ranging from 33 to 99 percent in 11 of the 20 failed institutions.

Table 1. Failed insured depository institutions with 20 largest MSAs
Millions of dollars, except as noted

Name	City	State	Last financial reporting date				Quarter with highest amount of MSA since 2004:Q4					Quarter with highest amount of 1-4 family serviced since 2004:Q4
			Date	MSA	MSA to tier 1 capital	1-4 Family serviced amount 1	Qtrs from last report date	Max MSA	MSA to tier 1 capital	Change from last report	Percent change	Qtrs from last report date	1-4 Family serviced amount	Change from last report	Percent change
Washington Mutual Bank	Henderson	NV	2008:Q2	$6,175	29.1%	$0	8	$9,162	42.3%	($2,987)	-32.6%
IndyMac Bank, F.S.B.	Pasadena	CA	2008:Q2	$2,546	263.9%	$0	1	$2,560	139.3%	($14)	-0.6%
AmTrust Bank	Cleveland	OH	2009:Q3	$286	101.2%	$0	0	$286	101.2%	$0	0.0%
Doral Bank	San Juan	PR	2014:Q4	$90	68.7%	$6,375	29	$164	29.3%	($74)	-45.0%	29	$11,337	($4,962)	-43.8%
Charter Bank	Santa Fe	NM	2009:Q4	$29	Neg.	$0	2	$44	48.5%	($15)	-34.6%
Downey Savings and Loan Association, F.A.	Newport Beach	CA	2008:Q3	$23	2.4%	$0	1	$24	2.5%	($1)	-3.2%
TierOne Bank	Lincoln	NE	2010:Q1	$19	25.9%	$0	0	$19	25.9%	$0	0.0%
Franklin Bank, S.S.B.	Houston	TX	2008:Q3	$16	14.3%	$1,214	1	$18	5.3%	($1)	-7.7%	0	$1,214	$0	0.0%
R-G Premier Bank of Puerto Rico	Hato Rey	PR	2010:Q1	$14	6.3%	$1,043	16	$46	7.7%	($33)	-70.2%	18	$2,555	($1,513)	-59.2%
New South Federal Savings Bank	Irondale	AL	2009:Q3	$10	236.8%	$0	1	$10	22.1%	($0)	-1.4%
Community South Bank	Parsons	TN	2013:Q2	$9	394.2%	$9	21	$19	44.8%	($10)	-54.1%	13	$40	($31)	-77.5%
United Western Bank	Denver	CO	2010:Q4	$6	7.1%	$0	24	$27	23.1%	($21)	-79.1%
Irwin Union Bank and Trust Company	Columbus	IN	2009:Q2	$5	3.3%	$859	17	$387	66.9%	($382)	-98.6%	18	$28,429	($27,570)	-97.0%
United Commercial Bank	San Francisco	CA	2009:Q3	$5	1.9%	$275	12	$14	1.9%	($8)	-61.7%	3	$439	($164)	-37.4%
The RiverBank	Wyoming	MN	2011:Q3	$4	126.7%	$595	8	$5	13.3%	($1)	-11.0%	3	$606	($11)	-1.9%
Lydian Private Bank	Palm Beach	FL	2011:Q2	$4	14.7%	$0	13	$17	14.1%	($13)	-75.8%
Westernbank Puerto Rico	Mayaguez	PR	2010:Q1	$4	0.9%	$297	0	$4	0.9%	$0	0.0%	21	$297	($0)	0.0%
Home Savings of America	Little Falls	MN	2011:Q4	$3	Neg.	$0	0	$3	Neg.	$0	0.0%
Republic Federal Bank, National Association	Miami	FL	2009:Q3	$2	44.2%	$148	9	$6	13.7%	($4)	-65.5%	10	$427	($279)	-65.4%
Citizens First National Bank	Princeton	IL	2012:Q3	$2	10.9%	$372	5	$3	5.0%	($1)	-42.1%	3	$404	($31)	-7.8%

Note: Ranking includes only institutions that failed after 2007.

1. The failed savings associations in the ranking report zero for 1-4 Family serviced amount for the table above since Thrift Financial Reports exclude this line item. Return to table

A difficulty in evaluating the reasons for these trends is that while banks reported the amount of one- to four-family mortgages serviced for others, comparable and comprehensive data for savings associations are not readily available. Accordingly, table 1 shows this information for the banks and leaves it omitted for the savings associations. Six of the 10 banks materially reduced the volume of mortgages they serviced for others in the period before they failed. Reductions in MSA values for the banks were mostly commensurate with reductions in the volume of serviced mortgages in the years and quarters before failure, although for a few banks the MSA value reductions were proportionally more than the reductions in the volume of serviced mortgages.

Significant reduction in MSA values, volume of serviced mortgages, or both, during the time period leading to an institution's failure is a strong indicator, although not a conclusive one, that the institution experienced losses on its servicing activities. Some of the failing banks listed in table 1 had relatively high concentrations of MSAs to regulatory capital. Such institutions may have attempted to sell their MSA portfolios to meet a capital or liquidity shortfall. Data on whether such MSA sales occurred or their financial impact on the selling institutions is not readily available. An assessment of the financial impact of any sales of servicing by these institutions would require knowledge of the proceeds they received in comparison to the amount of the MSA value that was extinguished as a result of the sale, as well as the nature of any negotiated concessions or indemnifications that may have been needed to complete sales. Because such negotiated concessions and indemnifications are often agreed to in connection with sales of servicing rights, especially when there are issues or concerns with the underlying mortgages or about the ongoing creditworthiness of the selling institution, it may have been difficult for some of the troubled institutions listed in table 1 to have realized full value in sales of MSAs. The reasons sellers may need to make such concessions are described below, in the section on the FDIC's receivership experience.

Data on the volume of serviced mortgages for savings associations were not readily obtainable, ³¹ so it is not possible to isolate the effects of any MSA valuation changes compared to changes in the volume of serviced mortgages. That said, savings associations in table 1 are disproportionally represented among the institutions that reported little or no deterioration in their MSAs prior to failure. It may be that the comparative lack of downward movement of savings associations' MSAs reflected that these institutions were less likely to reduce the amount of mortgages they serviced. With the benefit of hindsight, it is also possible that some of their MSA valuations were overestimated. Indirect evidence for this possibility comes from the FDIC's experience as receiver of failed banks, which has generally been that MSAs of failing institutions either have no value or can only be sold at substantial discounts from book values. This experience and the reasons for it are described in more detail below.

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Material Loss Review Reports

In accordance with section 38(k) of the Federal Deposit Insurance Act (FDI Act), when the Deposit Insurance Fund incurs a material loss with respect to an insured depository institution, the inspector general of the appropriate federal banking agency shall make a written report to that agency reviewing the agency's supervision of the institution (including the agency's implementation of prompt corrective action provisions of section 38), which shall ascertain why the institution's problems resulted in a material loss to the Deposit Insurance Fund and make recommendations for preventing any such loss in the future.³² Under the FDI Act, a loss was material if it exceeded the greater of $25 million or 2 percent of an institution's total assets at the time the FDIC was appointed receiver.³³

The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) amended section 38(k) of the FDI Act by increasing the MLR threshold from $25 million to $200 million for losses that occur for the period January 1, 2010, through December 31, 2011, to $150 million from January 1, 2012, through December 31, 2013, and to $50 million for losses on or after January 1, 2014.³⁴

A review of the MLRs found several instances in which a bank's mortgage servicing activities were a contributing factor in the bank's failure:

• The bank failed, in part, because of its aggressive growth strategy in MSAs and insufficient capital relative to the risk level of its servicing portfolio, as well as inadequate controls to develop and execute MSA hedging strategies. The deterioration of the bank's servicing portfolio resulted in significant losses, which diminished earnings and capital and, ultimately, led to the bank's failure.³⁵
• The bank's servicing activities contributed to volatility in earnings and capital levels. The bank ultimately recorded an impairment charge related to its MSAs, as the asset's fair value was lower than its amortized cost.³⁶
• The bank did not follow supervisory recommendations to implement controls for its servicing activities, including developing an understanding of the MSA market and MSA hedging. The bank ultimately incurred net losses in its servicing activities and subsequently sold its MSAs to reduce future earnings volatility.³⁷
• The bank did not hedge effectively the market risk associated with its MSAs, which decreased the bank's net income. The bank ultimately sold its MSA portfolio, resulting in net losses.³⁸

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FDIC's Experience with MSAs in Its Capacity as the Receiver of Failed Banks

The FDIC's process of disposing of MSAs from failed or failing institutions can be complicated by various factors that erode the value of MSAs. Specifically, a buyer's uncertainties about exposure to contingent recourse liability for a selling bank's origination and servicing defects can materially impair the marketability of MSAs, making it difficult for a receiver to sell MSAs at a price that is consistent with its book value.

As noted, investors (i.e., the owners of the mortgage loans) have consent rights to servicing sales and transfers. As a condition to providing the consent, investors have historically required that the buyer of the MSAs assume direct recourse liability for origination and servicing defects, regardless of whether that buyer, as the new servicer, originated the loan or caused the servicing defect. The buyer is typically protected from incurring losses as a result of its assumption of the seller's recourse liability by an indemnification provided by the seller. This structure, however, creates counterparty risk as the value of the MSAs is, in part, dependent on the value of the indemnification that the seller provides to the buyer and on the perceived quality of the seller's underwriting, origination, and servicing. As a result, a failing bank could have difficulty in realizing the value of its MSAs in a market sale if a buyer views the failing bank as not creditworthy or questions the quality of the origination, underwriting, or servicing of the failed bank.

In connection with the resolution of failed banks, the FDIC's recovery of value from MSAs has been negatively affected by two main factors. First, the contingent recourse liability impairs the value of MSAs. Second, most of the failed banks had very small MSA portfolios and the relatively fixed transaction costs associated with a sale frequently exceeded the value of these MSAs.

The FDIC determines and executes the resolution strategy that maximizes the value of each pool of MSAs at a failed bank. Prior to August 2010, most MSA pool acquisitions were done through whole-bank purchase and assumption transactions. In such transactions, the acquiring bank submits a single bid to the FDIC for all the assets of the failed bank. As a result, asset-level purchase prices are not provided by the acquiring bank in a whole-bank purchase and assumption transaction. During this time, MSAs from four failed banks were sold outside the purchase and assumption transaction, and it became clear that the purchase and assumption bidders were increasingly disinterested in acquiring the MSAs along with the failed bank's recourse liabilities.

As a result, in August 2010, the FDIC changed its practice and began marketing the assets and liabilities of a failed bank without the MSAs. Since that time, MSAs have been evaluated to determine whether the FDIC can recover value from a separate sale of the MSAs. In doing so, the FDIC considers both the transaction costs and either (1) the amount charged by the investor for a release of the FDIC and the buyer from all of the recourse liability related to the failed bank's actions, or (2) the amount the FDIC would expect to spend if it provided an indemnification for all losses incurred by the buyer resulting from its assumption of the failed bank's recourse liability.

If the FDIC determines that an MSA pool likely has no net value in a market sale transaction, it will surrender the MSAs to the investor.³⁹ Of the 32 banks that had MSAs and failed after August 2010, only one bank had MSA pools with net value to the FDIC in an MSA sale.

If the FDIC determines that it can likely recover value from a pool of MSAs, it pursues a competitive market sale transaction. Since 2008, the FDIC has sold one or more MSA pools from each of five failed banks. Data on these sales are available on the FDIC's website.⁴⁰ These data reflect that the aggregate gross proceeds from these sales was 29 percent of the book value of the MSAs (as reported by the failed bank prior to failure). The size of this discount is indirect evidence that the value of some MSA pools was overestimated by some banks. Even this substantial discount from book value overstates the value recovered by the FDIC. The FDIC's gross proceeds were reduced by transaction costs and either the cost to obtain a release from the failed bank's recourse liabilities or the out-of-pocket amounts paid by the FDIC in accordance with its indemnification obligations to the buyer. As noted, open banks attempting to sell MSAs, especially open banks in a troubled condition, may face similar issues of needing to indemnify or otherwise compensate MSA buyers or investors for recourse liabilities, and this may detract from their ability to realize the full book value when selling MSAs.

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References

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