An early default clause in a mortgage loan sales agreement may require a savings association to hold capital for loans sold to a third party as if the loans were still carried on the savings association’s books, according to recently issued OTS guidance. In a memorandum to chief executive officers dated April 16, the OTS reminds savings associations that its risk-based capital regulations define recourse as a savings association’s retention of credit risk, directly or indirectly associated with assets sold, that exceeds a pro rata share of that savings association’s claim on the assets. Where there is recourse, a savings association must hold capital for the assets as if they were still held by the savings association. The memorandum notes that mortgage loan sales agreements often contain representations and warranties that meet the recourse definition, and that other provisions that confer some credit risk on the selling institution may be excluded from the definition of recourse depending upon the time period during which the savings association is at risk. The OTS guidance includes examples and diagrams of relevant timelines to illustrate the appropriate capital treatment based on the types of early default clauses contained in the mortgage loan sales agreement.
Nutter Notes: According to the OTS guidance, there is a functional exemption from the definition of recourse for certain early default provisions under the OTS’s risk-based capital regulations. An early default clause or similar warranty (such as a premium refund clause) that, for a period of not more than 120 days from the date of the sale of a mortgage loan, permits the purchaser to require the seller to repurchase the loan if the borrower defaults during that period is not in and of itself considered recourse. However, if the early default clause is actually triggered so that a loan may be returned to the savings association, then the savings association must hold risk-based capital in anticipation of the return of the loan upon notice of the triggering event, according to the guidance. If an early default clause extends beyond 120 days, the savings association must hold risk-based capital from the date of transfer of the loans until the savings association can determine that the warranty period has expired and no sold loans have defaulted. The memorandum also explains that, if a savings association is unable to track which loans it might be required to repurchase, it must hold capital against all sold loans until such time as it can make a determination about potential exposure (i.e., through the period covered by the early default provision).