The start of 2025 has provided no shortage of headlines. Despite the change in presidential administrations and three rate cuts from the Federal Reserve since last summer, mortgage rates have remained fairly steady into the new year. After a drop to a 52-week low in late September (6.08% for the 30-year fixed rate and 5.15% for the 15-year fixed rate), rates have hovered just below 7%.
Along with the increased interest rate environment, we have continued to see M&A activity driven by mortgage service rights. Asset volatility and regulatory and capital requirements continue to drive traditional banks away from large MSR portfolios, but non-bank servicers (like Mr. Cooper) continue to acquire MSRs and build their servicing portfolios. Mr. Cooper announced on November 1 that it closed on its acquisition of the mortgage servicing and third-party origination operations of Flagstar Bank, N.A. (the bank subsidiary of Flagstar Financial, Inc.).
We at Hunton Andrews Kurth were lucky enough to play a role in that transaction, representing Flagstar. The transaction helped Flagstar improve its CET1 capital ratio and simplify its business model. Mr. Cooper used the deal to continue to build its servicing and subservicing portfolio. This transaction is just the latest example in a trend of nonbanks building market share in mortgage servicing. Overall, MSR transfer volume in 2024 was lower than 2023 but ranked as the fourth highest year since 2015. As long as rates are elevated and origination volumes are uncertain, the servicing side of the business will continue to be a transaction driver.
We continue to get calls from all types of investors and potential buyers about acquiring a shell servicing entity or identifying the most important issues when evaluating such a transaction. We have worked on numerous shell acquisitions. Some have closed successfully and others have not. While each transaction has its own challenges, there are some common issues that arise. We are pleased to discuss a few typical issues that parties to MSR-driven M&A deals face in reaching a successful closing.
We are often asked, what makes an attractive shell entity? Certainly, it is important for the entity to have all of the necessary or desired agency tickets and state licenses. In certain cases, buyers may prefer that a shell not have, or surrender, licenses in states that have cumbersome and lengthy change of control processes. This is an issue that we have advised clients on and depending on the investment goals and states at issue, various solutions can be created to reach a timely closing while obtaining the approvals that are required to operate the business as contemplated after closing.
Other attractive characteristics of a shell servicing target include a robust and scalable (and transferable) technology platform, a strong management team, and in some cases, subservicing contracts or MSRs to provide a base level of cash flow to build from. Each of these characteristics must be understood by an acquirer or seller’s legal counsel to ensure the transaction is executed as seamlessly as possible.
On the flip side, from a legal (risk) perspective, we are also looking for the unicorn — an entity with all of the attractive features noted above and a squeaky clean track record and compliance history — no consent orders, no negative audit findings, low repurchase history, etc. Many times, shell entities are on the market as a result of a recent sale or shutdown of the entity’s origination platform. Depending on the volume or activities of that platform, the shell could have significant legacy liability that needs to be accounted for in the acquisition. We hope to come across this mythical clean shell entity, but have yet to see it! Accordingly, the key to most shell acquisitions is to find a way to allocate the risk in a way that works for both parties.
Most often, the valuation of the shell entity is not aligned with the potential legacy risk profile. For instance, a typical shell entity valued at $1 to 3 million may have legacy compliance and repurchase risk that is several multiples greater than that value depending on its historical volume or the type of origination and/or servicing that the entity participated in. In an equity acquisition (required to get the benefit of the change-of-control process for the agency and state licenses) that legacy risk can be a real concern for potential buyers.
Depending on the status of the seller, indemnification may not be a viable or sufficient solution for allocating the risk. We have used escrows and holdbacks, but the imbalance between risk and purchase price often limits the effectiveness of those protections as well. The best protection is a full due diligence process, including loan level diligence, compliance process diligence and regulatory diligence. Extensive due diligence, coupled with a creditworthy seller to back indemnification or a significant escrow or holdback, can limit the downside risk to the greatest extent possible.
However, there are no guarantees and acquiring a shell servicer brings along risk and potential successor liability. This risk needs to be balanced against the future growth and value to be captured by owning a servicing operation, including any related recapture opportunity or ability to seek outside capital looking to participate in the servicing revenues.
