What Constitutes a Pooling and Servicing Agreement?
Pooling and Servicing Agreements (PSA): What is it?
In the most basic sense, a pooling and servicing agreement ("PSA") is a contract between parties that sets forth the terms and conditions for the fees to be paid in connection with specified assets arising out of residential mortgage backed securities. PSAs are the backbone of the mortgage industry. They give clarity on the terms between parties involved in the secondary mortgage market. When a loan is made to a borrower, that loan is usually sold by the lender to another entity, usually a Trust. Because the Trust is not able to foreclose on a defaulted loan , or perform legal actions, the loan servicer (who works for the trust as its agent) takes over those responsibilities on behalf of the Trust. PSAs are utilized by mortgage pools of mortgages, which are held for the purpose of paying benefits of interest and principal due homeowners, "mortgage holders," under applicable laws. They are agreements among the sellers and the lender that set forth the rights and remedies of the affected parties. PSAs define the rights of the bond holders and members of a trust, usually a Mortgage Backed Securities or other interests in a pool of loans.
Essential Components of a Pooling and Servicing Agreement
Parties to a pooling and servicing agreement (PSA) typically include the depositor, the trustee, the master servicer, sub-servicers, and sometimes credit enhancers. The depositor transfers assets to the trust that are then pooled by the trustee. The trustee then oversees the distribution of cash flows to the investors from the pooling of assets. The PSA should contain covenants and agreements with respect to the duties of the parties, including: The pooling and servicing agreement will identify the different parties in the transaction, such as: sponsor/ depositor, custodian, issuing entity, trustee, indenture trustee, master servicer and subservicer.
WHO IS IN CHARGE? The PSA will set up a hierarchy of control. Generally, the master servicer will be responsible for servicing the mortgage loans and collecting, remitting, administering and otherwise handling the cash flows of the securitization. The PSA will determine the obligations and the rights of the master servicer. The PSA will also establish when the servicer will service the loans, for how long and what type of master servicer will service the loans.
SUB-SERVICERS It will also provide for the sub-servicers which will actually service the loans. The PSA will identify who the sub-servicer(s) are and their obligations to the master servicer.
DEPOSITOR/PARTY RESPONSIBLE FOR CREATING THE SECURITY The depoistior is the party or entity that acquires a pool of mortgages from another party, such as a lender, and then sells those mortgages to the issuing entity. The depositor may hold the mortgages on its own books and maintain, in its inventory, a number of mortgages acquired through its loan production originations or transactions with other lenders. Upon the creation of the security, the depositor will usually sell that pool to the issuing entity. The PSA will contain provisions to address the relationship between the depositor and the master servicer.
WILL A RATING AGENCY INSPECT THE LOANS? The PSA may also include representations and warranties made by the depositor. In other words, does the custody or operation of the loans, the pooling process, and/or the sale of the loans or on-going master servicing obligate the seller to inspections by a rating agency?
HOW WILL PAYMENTS BE DISTRIBUTED BY THE MASTER SERVICER AND THE DISTRIBUTION ACCOUNT? PSAs generally specify how principal and interest payments received from the borrowers will be allocated among the different tranches and classes of the securities. How and when funds are distributed among the various classes will be based upon the order of priority established in the deal structure. The order of payment will be determined based on possession of the funds, used to determine the amount of cash to disburse to each class, and the order in which the amounts are allocated to the classes ranging from the most senior class (the first to receive payment of principal and interest) to the most junior class (typically the last to receive payment of principal and interest).
WHAT IF THE MASTER SERVICER BECOMES UNABLE TO SERVE? The PSA will generally outline the obligations of a master servicer in the event of default. The PSA will also identify the party that will audit the servicer’s activities and the procedures for audits.
The Function of Services and Trustees
The pooling and servicing agreement identifies the trustee and the servicer of the mortgage loan assets. The trustee is the formal owner of the mortgage loan assets, while the use of sub-servicers by the servicer allows the servicer to draw mortgage payments from borrowers and pay the funds up to the trustee without the trustee ever having to receive and forward the funds from each borrower. Servicers must provide monthly reports on the collected principal and interest payments to the trustee, the certificate holders, the issuer, or other related parties named in the agreement. Servicers are also responsible for all aspects of the investor report processes, allowing them to provide extensive information to investors about their investments. Depending on the investor group, monthly, quarterly, or annual reports are sent with varying levels of detail. These reports include tax data, delinquency status, prepayment history, and other frequently requested data.
Legal Aspects of Pooling and Servicing
As a dominant aspect of the secondary mortgage market, the pooling and servicing of loans is what drives the process for buying, selling and securitizing mortgage loans. While the industry as a whole has adopted various voluntary practices to ensure the integrity of the process, the labyrinth of applicable state laws and regulations can cause complications. For example, unlike the underwriting, origination and closing of a loan, which has a relatively simple set of applicable requirements, the pooling and servicing process involves many different players in both the loan and securitization phases and contains various regulatory hurdles.
Several state laws and regulations are meant to be complied with, including mortgage lender licensing requirements and prohibitions against discriminatory loan pricing, lending to individuals who lack the ability to repay, and "overreaching" loan stipulations. Traditionally, most developers of pooling and servicing agreements have not sought explicit regulatory approval. Since the mid-1980s, The Office of Thrift Supervision (OTC) has indicated that mortgage-backed securities involving qualified thrifts may be sold without agency approval. However, many government-sponsored entities (GSE) such as Freddie Mac, with their purchase of 96 percent of all subprime bonds, have made meeting GSE guidelines more complicated.
Securitization of loans has also given rise to legal issues involving antitrust law (risk-sharing among lenders and concern about potential market power by bank-originated securities) and potential liability under federal securities laws (governmental immunity from liability for governmental agencies that issue bonds in "good faith"). The current crisis also threatens to bring up issues relating to preemption of state antitrust law, the scope of which has grown over the years through litigation. Also, with the advent of globalization, pooling and servicing transactions have begun to involve foreign investors, alleviating international concerns over choice of law for contracts. With the passage of the Securities Act amendments, the SEC has stated that pooling and servicing transactions that are regulated by the 1933 Act are no longer subject to the SEC’s exclusive jurisdiction. Because of the complexities of this constantly evolving area, it is essential for companies and individuals involved in pooling and servicing to work closely with counsel who are well-versed in this subject.
Benefits and Risks to Consider
Pooling and Servicing Agreements can be highly beneficial to financial institutions and investors. First and foremost, pooling and servicing agreements provide the structure and framework for transactions. Pooling and servicing agreements can provide comfort to investors and financial institutions or parties in the common securitization currently under consideration by the SEC. Because pooling and servicing agreements are standardized contracts that have a fair amount of precedent and history, relying on the precedent history saves time, lowers the cost of due diligence and allows the parties to focus on the nuances of the particular deal . Additionally, pooling and servicing agreements provide the ability to add and move on receipts; determine the priority of payments; modify forms of purchase and servicing remedies; set criteria for mixing portfolios and sharing the risk of credit performance; create a mechanism for the winding up of the deal; provide a basis for the structuring and information to be provided through the disclosure process; and provide a liquid market for distressed deals. This liquidity benefits both regular and distressed investors, including banks.
However, pooling and servicing agreements can create a number of risks. Oftentimes, pooling and servicing agreements will have replication revisions that can create risk for the parties. In addition, pooling and servicing agreements contain a number of representations, warranties and covenants that can also create risk. If those representations, warranties or covenants are not true, or if there is a problem, the affected party may be liable to the other parties under the particular pooling and servicing agreement.
Impact on Mortgage-Backed Securities
The pooling and servicing agreement has significant influence on the resulting structure and performance of the mortgage-backed securities. For example, the deal may incorporate senior/subordinated tranches, so one tranche provides credit support to another. Additionally, the deal may include overcollateralization or, as is often the case with auto ABS, excess spread credit enhancement.
In addition, pooling and servicing agreements also include yield and interest rate protection. To address the risk that prevailing interest rates in the marketplace may decrease, for example, the PSA often imposes a cap on the total reinvestment in UMBS or UBG securities, and if that’s breached, there are additional restrictions established so the servicer must hold the cash. This is referred to as the first flush bucket. So, the first flush may go to a reserve to be reinvested in a stripped coupon to help the servicer reduce its capital costs in providing credit enhancement, or to pay down the bonds. The purpose is to create a yield protection vehicle for the cashed out through the liquidity of the UMBS market.
The PSA may also have the party who is at risk to take some cash reserves by taking cash that would otherwise go to investors and put it into government bonds. So if something breaches a certain trigger amount, you stop paying principal and interest to other investors and that cash is used to fund the remittance for the liquidity of the UMBS.
The pooling and servicing agreement also obligates the servicers to take certain actions, monitor the credit quality of the loans and their compliance with certain limits – such as the loan limits, loan size limits and interest rate limits.
In a transaction where one servicer is offering the servicing of three different types of mortgage loans, there may be a requirement that the servicer sets up several different subservicing arrangements for each group of loans, and if those subservicing arrangements are household balance sheets, then you may be using a master mortgage loan servicing agreement that requires the servicer to do some additional documentation for those three different servicers.
Pooling and servicing agreements also may include required reports that are intended for disclosure to the investors about the performance of the loans. So it’s important for both the rating agency and an investor to understand that the deal may include reports that are not intended for disclosure to the investors. Consequently, you need to read all the terms of the pooling and servicing agreement, including those so-called confidential reports, because some of those reports may only be disclosed to the rating agencies while others are disclosed to investors.
Recent Developments and Trends
The financial crisis has resulted in a closer examination of the representations and warranties made in pool and servicing agreements. Reps and warranties have been re-examined by underwriters and investors to express greater specificity, and the disclosure of exceptions to the knowledge standard have been considered for inclusion in the PSAs. The significance of any exception must in turn be determined in light of the overall volume of the loans being underwritten and the nature of the exception . Based upon experience, we do not believe that investors would necessarily consider it a deal killer if there are a multitude of exceptions for a given PSA. However, in the current environment the longer there is a pattern of exceptions for a single deal, the more likely it is that investors will collectively be less willing to forbear other areas where exceptions arise. When an exception is disclosed to a specific representation or warranty, investors will frequently seek to determine whether the same or similar exception arises in other transactions or due diligence, and what, if anything, is done to correct it.
