FDIC Insurance Coverage for Securitization Servicing Accounts Leaves Some Investors in the Cold
By Anthony R.G. Nolan and Drew A. Malakoff
On October 10, 2008, the FDIC adopted an interim rule (the “Interim Rule”) that increases the standard maximum deposit insurance amount from $100,000 to $250,000, in accordance with the Emergency Economic Stabilization Act of 2008. Of particular interest to securitization investors and servicers, the Interim Rule also simplifies the deposit insurance rules as they apply to mortgage servicing accounts. By doing so, it increases certainty for investors while enhancing liquidity for servicers of mortgage assets.
Prior to the enactment of the Interim Rule, funds on deposit in mortgage servicing accounts that represented principal and interest received on the underlying loans were insurable on a pass-through basis to each investor or security holder of a securitization or fund. The theory behind this approach was that payments of principal and interest on securitized mortgages were beneficially owned by the investors in the related mortgage-backed securities. As a practical matter, however, the FDIC’s prior approach to mortgage servicing accounts created some ambiguity as to the ability of individual investors to make a claim against the FDIC for amounts in a servicing account held by a depository institution that became subject to a receivership or conservatorship, particularly as securitizations became more complicated and incorporated different tranches of bonds with varying degrees of seniority or with specific rights to sub-pools of assets.
Under the FDIC’s prior approach, in order to determine what portion of each investor’s interest in the principal and interest payments deposited into a mortgage servicing account was covered by FDIC insurance, it was necessary to determine not only which investors had not exceeded their respective deposit insurance limits, but also which investors should have been allocated the next dollar of principal or interest based on the complex paydown rules contained in the transaction documents. This complex calculus, based on a deal’s distribution waterfall and the percentage of the relevant security each investor held, made it increasingly difficult to determine which of the many investors in a securitization vehicle had the rights to each dollar of principal or interest. Moreover, given the size of many of these transactions, it was also very likely that individual investors would far exceed the applicable insurance limit.
These considerations resulted in uncertainty among securitization investors as to the extent to which their allocated portions of loan payments would be covered by deposit insurance. Consequently, investors and rating agencies require that servicers remit funds from servicing accounts to a trustee account on a daily basis (or in some cases transfer the servicing account to another institution) whenever the servicers’ creditworthiness (as measured by credit ratings) decline below certain levels. This imposed a cost to depository institutions in the form of reduced liquidity, which has become a significant threat to the stability of financial markets in the recent challenging market conditions.
The Interim Rule reconciles the needs of mortgage-backed security investors for security with the needs of depository institutions for liquidity by changing the basis for insuring accounts in mortgage servicing accounts and, in many cases, increasing the amount actually covered in each such account. Because the Interim Rule makes it easier to determine what portion of payments beneficially owned by securitization investors are covered by FDIC deposit insurance, investors and rating agencies will be more likely to permit depository institutions that maintain mortgage servicing accounts to commingle amounts received on mortgage loans for longer periods, thus enhancing their liquidity. For this reason, the Interim Rule is a welcome development for depository institutions and investors participating in the mortgage securitization market. However, the Interim Rule as currently drafted — to cover only mortgage servicing accounts — does not go far enough in that it does not address these concerns as they arise in the securitization of non-mortgage related assets.
