Although often overshadowed by topics related to origination, the more mundane servicing issues of investor reporting, loss mitigation, and payment disposition are equally important. For the residential mortgage-backed securities (RMBS) investor, these functions can have a dramatic impact on an investment's profitability. For Standard & Poor's, these third-party functions are crucial to credit analysis.
The quality of servicing of the mortgage loans backing rated certificates is an integral component to the performance of a transaction, and it has a direct effect on losses incurred in a transaction. Because servicing performance standards for the nonconforming product do not exist, measuring servicer efficiency is a critical part of credit analysis.
Standard & Poor's purpose in a transaction is to evaluate servicer capabilities and to evaluate the credit of a particular pool. These evaluations rely on the representations and warranties of the transaction documents, which include conveyance of the mortgage loans, data accuracy, and servicer and trustee covenants.
Pools of mortgages are evaluated based upon credit quality, loan-to-value (LTV) ratio, and various loan characteristics that may influence default probability and severity. Such characteristics include cash shortfalls from delinquencies and permanent losses from foreclosures.
Credit quality, reflected in the level of loss protection or overcollateralization, must be determined for each pool of collateral. It is essential that the collateral and the structure provide for the timely payment of interest and the full payment of principal.
The duties and responsibilities of the servicer and the trustee are specified in the pooling and servicing (P&S) agreement, which outlines the conveyance of mortgage loans from the originator to the trust and describes in great detail the characteristics of the asset being conveyed.
Servicer Performance Correlates To Loss Severity
Standard & Poor's measures servicers to the standards set in its credit model, and among those held by the servicers themselves. Servicer efficiency and effectiveness directly correlate with loss severity; to determine such efficiency and effectiveness, Standard & Poor's evaluates a servicer's performance in the following areas:
* Time management
* Efficient liquidation of real estate owned (REO)
* Control of third-party expenses
* Selection of the best resolution strategy on every loan
* Minimization of the incidence of foreclosure
* Most effective resolution of non-performing loans
Time management is measured by comparing a servicer's time to foreclose to the standards as set by Fannie Mae and Freddie Mac. These time-frame standards are state-specific and set by these government-sponsored enterprises (GSEs) for reimbursement limits to such servicers. Servicers that meet or exceed these standards are more able to control the amount of interest that is constantly advanced in mortgage-backed deals.
Furthermore, portfolios with concentrations in judicial states where foreclosure times are inherently longer have potentially greater loss severity, due to the longer timelines and the resulting higher interest costs. Included in time management is the speed in which REO properties are sold. The GSEs also have an average time of disposition to which servicers can be compared.
Third-party expenses include legal fees, preservation expenses, brokerage costs, taxes, and insurance. Managing these costs means having systems capable of tracking state-specific vendors and managing their work flows to ensure that the state-specific foreclosure timelines are being met.
Performance Evaluation Challenges Lie Ahead
Standard & Poor's is collecting and analyzing data to differentiate servicer performance in a quantifiable manner. This research will allow for a refined credit analysis through servicer specific loss severities.
A number of challenges lie ahead in terms of measuring servicer performance. There is a lack of data to analyze the costs and benefits of alternative loss mitigation strategies, and it is difficult to measure the impact of the jurisdiction mix of the pool. Excess spread in subprime deals is used as a credit for delinquent interest, ultimately hiding the exact loss severity of a loan.
Although a servicer may show a strong propensity to manage loss severity well, there is no guarantee that such management will continue for the life of the issue. House price appreciation can mask loss severity, and depreciation can exacerbate it. And it is not yet known to what extent the performance fees of special servicers raise the loss severity.
Standard & Poor's will continue to investigate these and many other issues relating to third-party responsibilities, as defined in the transactions' documents. Standard & Poor's also plans to work with issuers in the investment community to establish specific standards relating to these responsibilities.
This observation is part of a larger commentary article, entitled "Third-party Functions Are Crucial to RMBS Performance," available on Standard & Poor's RatingsDirect Web-based database, located at www.ratingsdirect.com.