With mortgage servies losing loans from their portfolios at a high rate, the demand for new rights to replace the runoff is unusually high.

As the mortgage industry prepares for a brisk market in servicing rights, lenders should be aware of the issues involved in contracts to buy or sell.

Perhaps the important aspect of any loan servicing agreement aside from the price is the effective date of the transfer.

In any transaction, the buyer and seller must recognize the importance of each of three dates: the agreement date, the sale date, and the transfer date.

The interaction of these three dates effects the accounting for gain, the purchase price, and the liabilities of the parties.

The contract must define each date and the rights and liabilities that occur between them.

A seller who is not concerned about what quarter or year the gain from a sale will be booked will typically allow the sale date to coincide with the actual physical transfer of the servicing.

Seller Bears the Risk

In such cases, the seller retains the servicing fee income and incurs the costs of servicing in the interim. In other words, the seller bears the risk of prepayments and foreclosure losses.

On the other hand, if a sale must take place by a given date in order for the seller to book the gain on the transaction, the purchase price must be paid and ownership should transfer to the purchaser on the sale date even though the purchaser may not begin servicing for several months.

In such a deal, the purchaser becomes involved with the seller's accountants, who will have to bless the booking of the gain and may require that the contract shift the risk of prepayments and losses in the interim onto the purchaser.

Risks for Purchaser, Too

The purchaser faces additional risks as well. The seller will look to pay only a portion of the purchase price (as little as 20% may satisfy his accountants) and offer a note for the difference.

The note could be properly secured by the servicing itself, but is this enough to secure payment and transfer?

In the area, business needs sometimes require innovative legal techniques as the interplay between agency approvals, servicing cash flows, and the value of the note.

The purchaser's lawyer needs to understand the pricing of the note and the interim servicing agreement during the period from the sale of the transfer in order to understand the income risks involved as well as the performance risks.

Closing adjustments will need to be made on the otherwise uneventful sale date as well as the transfer date.

Host of Potential Evils

Even without an intervening sale date, the purchaser needs to protect itself against a host of potential evils when the transfer date will occur substantially after the date of the agreemtn.

After signing the agreement, the seller may not give as much attention to the soon-to-be discarded servicing.

This can negatively affect delinquency rates, foreclosure time frames, and ancillary-income levels.

Floors and Ceiling Helpful

Provisions that establish floors and ceilings for such items can serve as

meaningful tools for binding performance by the seller during this interim period.

Remedies can include step adjustments to the purchase price or increased holdbacks if the levels exceed the standards set.

Issues of performance and indemnity will also arise as a transaction is being negotiated. They will be examined in a future article.

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