Hedge Funds are Purchasing or Launching Mortgage Servicers to Take Advantage of Increased Opportunities in Distressed Residential Mortgages
Hedge Fund Law Report
Despite accounting rules that generally permit banks to carry residential mortgages at cost and thus serve as a disincentive to sell, banks have begun unloading residential mortgages for two primary reasons: pressure from regulators (especially the Federal Deposit Insurance Corporation (FDIC)) and improvements in other operating or investment areas that can offset loan losses. Hedge funds have been buyers, to a degree, but hedge funds’ appetite for whole residential mortgages (as opposed to mortgage-backed securities) is limited by a dearth of servicers who are willing or able to modify mortgages in a manner that will serve the hedge funds’ investment goals. Since a significant amount of value in mortgage investing may be captured via modification, the limited field and ability of existing servicers has constrained purchases by hedge funds from banks of residential mortgages. In response, various hedge fund managers are launching or buying servicers. As noted by Paul Watterson, a Partner at Schulte Roth & Zabel LLP: “Some institutional investors feel like they are not getting enough attention from these mortgage servicers, particularly for scratch and dent loans, and so they are launching or buying servicers so the loans get the attention they seemingly deserve.” (“Scratch and dent loans” generally refers to non-performing, or sub-performing mortgages. The phrase can also apply to re-performing mortgages – mortgages that have been modified so they are performing again but still may fall back into default.) Owning a servicer offers the opportunity to create value in mortgages, but it also can expose a hedge fund manager to liability for, to name just a few items, predatory lending claims or misrepresentation, to the extent the manager is involved in or controls modification decisions. At worst, the manager may be exposed to a buy back obligation. However, hedge funds that purchase or start servicers can structure transactions to mitigate liability concerns. As a practical matter, managers contemplating ownership of servicers also face a “buy or build” question, and have to contend with various barriers to entry (practical and regulatory) into a non-core business. We analyze these and other issues involved in ownership by hedge fund managers of mortgage servicers.