It wasn't long ago when commercial and residential mortgages were originated and serviced for life by the same entity.
When this entity borrowed funds and secured such borrowings with the loans it originated, perfecting a security interest was straightforward.
There was minimal doubt that all amounts to be paid to the originator by the ultimate borrower were pledged through an assignment of the note and mortgage, and by following procedures in the state where the property and/or originator were located.
Over the last decade, however, this process has been complicated by the growing trend among originators to separate ownership of the mortgage assets from the servicing rights. This has raised significant legal and accounting issues that must be addressed when drafting a security interest to ensure all assumed collateral is being pledged.
Before the advent of a market in which loans are frequently sold and/or securitized, originators typically serviced the loans they held for their own account, or hired an agent who performed these services for them.
Today servicing is a very valuable asset in its own right. The servicer's fee, usually expressed as a percentage of outstanding loan principal, is typically paid (before interest and principal due to the noteholder) upon receipt of monthly payments from the borrower. In the case of defaulted loans, the fee is collected from the payoff, or from proceeds of the sale of the property after foreclosure.
Loan sales are frequently structured so that the servicing rights are either received by the buyer ("servicing released") or retained by the originator. And the rights themselves can even be sold with the originator retaining the rights to the periodic repayment of loan principal and interest.
In each of these scenarios, the entity receiving or retaining the servicing establishes a "servicing right" asset category on its balance sheet. This begs the question: When does this separate servicing asset spring to life?
Did it exist as a separate asset the moment before sale, when the loan was still in the hands of the originator? If so, would it then be encumbered if the originator had pledged its whole loan receivables, its servicing rights, or both, as collateral to its creditors? This becomes a crucial issue for creditors if the originator goes out of business.
Furthermore, if a servicing asset exists only when it is intentionally created, does a failed lender have an obligation to maximize a secured or unsecured creditor's position by intentionally creating a servicing asset, or by making sure that it is not created?
Similarly, if one buys a note "servicing released," is one buying two separate assets potentially subject to the security interests of two different creditors? If the buyer's collateral pledges only cover loans receivable, are the servicing rights unencumbered and available to the unsecured creditors in the event of the buyer's subsequent failure?
Some might be skeptical about the idea that servicing is an asset apart from the loan before the originator intentionally cleaves it by selling it alone or by retaining it while selling the loan. But why should a multimillion-dollar asset be recognized as distinct upon the occurrence of a sale transaction, yet be ignored before the transaction?
Is it consistent for the seller not to recognize the sale (and before that, the ownership) of two separate assets when the loan is sold "servicing released" (to the buyer), while the servicing-retained transaction for the same note would create two assets, one in the seller's hands and one in the buyer's?
Compounding the ambiguity is the fact that a servicing-released sale, reflecting the sale of the heretofore unrecognized servicing rights, will occur at a higher price than a servicing-retained one.
In the past Statement of Financial Accounting Standards No. 65 required an institution that purchases servicing rights from another originator or servicer to recognize the purchase cost on the balance sheet as a mortgage servicing right. The same rule prohibited a financial institution that originated a mortgage and later sold or securitized the loan while retaining the servicing rights from recognizing the value of the rights on its balance sheet.
The accounting profession later developed SFAS 122, "Accounting for Mortgage Servicing Rights," and SFAS 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities," to eliminate this inconsistency in accounting treatment for virtually identical assets. These two rules require mortgage banks to recognize as separate assets the rights to service mortgage loans for others, regardless of how those rights were acquired.
These developments provided some needed consistency, but many questions remain unanswered. The rules ensure consistent accounting between purchased servicing rights and rights resulting from the originator's sale of its loan assets. However, this only recognizes servicing assets that spring to life upon an intentional separation on sale and does not address the status of these rights as potentially distinct assets upon the creation of the loan.
Yet these assets exist, arguably, from the time of loan origination. It might be argued (for legal, not accounting purposes) that during the time between origination and securitization or sale of the loan, while the originator is servicing it, there is an implicit servicing fee received as part of the interest payment.
Thus, upon the origination of a loan by a lender that intends to sell it, or upon the securitization, for legal purposes the lender will have at least two assets (a loan receivable and a servicing asset), despite there being only one recorded on the balance sheet. Such a recognition might change the respective rights of the lender's various secured (and unsecured) creditors.
We are aware of no published legal decision to date that addresses these issues. What is clear is that the traditional lender's intuition - essentially that servicing automatically "merges" into the loan receivable asset when held by the same entity - is not necessarily matched by current accounting treatment.
It is only by custom, rather than established common law or statutory regime, that loans and servicing assets are not considered separate assets until a sale.
Thus, it is incumbent upon lawyers drafting security agreements to specify clearly when a "servicing asset" is created and whether it is to be a part of the pledged note receivable.
Such explicit description would be far preferable to what we anticipate occurring soon: A judge will be confronted with deciding which secured creditor, or the unsecured creditors, gets the "servicing" asset upon the failure of a lender.
Mr. Greenspan and Mr. Nolan are partners in the business recovery services practice at PricewaterhouseCoopers.