A securitization servicer's controversial decision to sell a chunk of performing mortgages along with nonperforming ones at a loss underscores why investors want to better understand actions affecting their returns.

Last summer, SN Servicing Corp., based in Baton Rouge, La., sold an undisclosed number of loans at a loss from a real estate investment conduit created back in 2002. The company says it sold some good loans along with bad ones to get a better price for the package, mitigating the loss to investors.

But selling current loans out of a REMIC is generally considered a no-no that could jeopardize the trust's tax breaks, barring certain circumstances. Moody's Investors Service recently withdrew its ratings for the deal, saying SN Servicing failed to respond to requests for data to support the company's interpretation that the sale of the performing loans was not taxable.

As the result of the sales, the balance of current loans in the deal—Security National Mortgage Loan Trust 2002-2, dropped to $649,031 from $9.4 million and the delinquent loan balance dropped to $193,366 from $4.6 million, Moody's says. The middle-tier credit mezzanine tranche class M-1 bond lost all its outstanding principal of $5.3 million and investors in the more-senior Class A bonds lost $2.8 million or 52% of their outstanding principal.

It may be open to interpretation whether the sales were legally permissible, says Laurie Goodman, director of the Urban Institute's Housing Finance Policy Center. But the key question for investors in this case is whether the loans are coming out of the trust "at a fair price" and whether bondholders receive enough information determine that, she said.

Goodman says she's unfamiliar with the trustee reports on the 2002 deal, but that as a general matter transparency about servicing remains far shy of what investors want. This is true even on deals done since the downturn, when a lot of lip service has been paid to winning back mortgage-backed securities investors by providing them with more transparency.

While disclosure about the origination of loans has gotten better in recent securitizations, there has been relatively little improvement in information provided on the back end, when a loan goes delinquent, Goodman says. This, she says, is one of the "lost opportunity costs" of reform efforts since the financial crisis.

REMIC rules allow the sale only of loans that are in default or in danger of "imminent default," and pooling and servicing agreements generally ban anything prohibited under the Real Estate Mortgage Investment Conduit tax rules.

In the 2002 deal, however, the documents call for the servicer to refrain from "any 'prohibited transaction" under REMIC rules "and not to engage in any other action which may result in any tax under the code."

Given this wording, "A liberal reading of the PSA could suggest that the sale was permitted if it did not result in any tax under the code," Moody's said, noting that it "disagrees with this interpretation."

"We think a strict reading of the PSA forbids any prohibited transaction," the Moody's report says. 

William Fogleman, the corporate counsel for SN Servicing Corp., says the sales were permissible because they failed to generate any tax under the REMIC code. The company gave Moody's everything possible it requested that was not already available to investors in the trustee reports, he says.

"We did review the...applicable statutes [with] advice from outside counsel and found the sales were appropriate given the market at the time," Fogleman says.

The decision to sell the performing loans along with re-performing and distressed ones did "increase the recovery for the whole package," says Fogleman, noting that the original securitization was a "scratch and dent" deal. (Scratch-and-dent loans by definition have characteristics that preclude them from inclusion in more mainstream deals because they are less standardized and harder to sell.)

"There are definitely some loans that are not as attractive as others, even in today's market, with real estate coming back. We had to balance what we were going to get with what we were going to have to do. It created the greatest recovery for that particular sale," he says.

Since the downturn, servicers have been financially squeezed by the need to advance payments to investors on large volumes delinquent loans. SN in this situation, as is typical, did reimburse itself for recoverable advances on previously liquidated loans from the proceeds of the sale.

When asked if recouping advances played a role in the decision to sell the performing loans, Fogleman said, "That wasn't the main reason for the sale, but it is a concern for the recovery on any assets."

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