Retrocessions, in the realm of finance, specifically mortgage-backed securities (MBS) and other securitized products, refer to the practice of returning a portion of the servicing fees to the investor, rather than the loan servicer retaining the entire amount. It’s essentially a sharing mechanism, often influenced by the performance of the underlying loans.
Historically, the servicer of a mortgage receives a servicing fee, typically a percentage of the outstanding loan balance, for managing the loan. This covers tasks like collecting payments, managing escrow accounts for taxes and insurance, and pursuing loss mitigation strategies when borrowers face difficulties. The servicer keeps this fee regardless of the loan’s performance. However, retrocessions change this dynamic.
The concept of retrocessions arose as a way to align the interests of servicers and investors more closely, particularly when dealing with subprime mortgages and other higher-risk loans. The rationale is simple: If a loan performs well, generating consistent cash flows, the investor benefits. Conversely, if a loan defaults, leading to losses, the investor suffers. Retrocessions allow for a partial adjustment of the servicer’s compensation based on loan performance.
There are various triggers that might activate a retrocession. A common one is an increase in delinquency rates within a mortgage pool. If a certain percentage of loans become 90 days or more past due, for example, the servicer may be required to retrocede a portion of their servicing fees back to the investors. The specific retrocession rate is outlined in the securitization documents.
The benefits of retrocessions are debated. Proponents argue they incentivize servicers to more actively manage delinquent loans and pursue effective loss mitigation strategies. Knowing they will lose a portion of their fees if performance deteriorates, servicers are theoretically motivated to work harder to keep borrowers current. This ultimately benefits both the investors and the borrowers by avoiding foreclosure. Also, retrocessions provides a method of transparency of the servicing responsibilities.
However, critics argue that retrocessions can create unintended consequences. They might lead to a focus on short-term fixes rather than long-term solutions. Servicers might prioritize strategies that temporarily reduce delinquency rates to avoid retrocessions, even if those strategies are not sustainable or ultimately benefit the borrower. The complexity of retrocession calculations and the potential for disputes are also points of concern. Furthermore, the actual impact of retrocessions on servicer behavior and loan performance is difficult to isolate and quantify.
In summary, retrocessions represent an attempt to improve the alignment of interests between servicers and investors in the securitization market. While the intention is laudable, their effectiveness and potential drawbacks remain subjects of ongoing discussion within the financial industry.