U.K. nonconforming lenders continue their exodus from the market. This has left borrowers with little option for refinancing and left lenders facing mounting arrears.
One of the only tools the mortgage industry has to rein in the losses on loans is the servicing sector, even though this area is traditionally thought of more as a back office operation.
As the market shifts to more of a loss mitigation mode, servicers have suddenly been thrust into the frontline. It's likely that the need to manage defaulting mortgages will make the servicing industry flourish during this crunch period.
A very large part of the current crisis has resulted from an over-emphasis on lending money and an under-emphasis on collecting payments on the loans.
"I think people have to start thinking realistically that many nonconforming lenders might not make it through, and how will that impact the performance of your loan?" said Mike Culhane, chairman and CEO of Oakwood Global Finance. "If the originator goes away and the special servicer goes away, that will undoubtedly impact the performance of a loan."
Servicing is Center
From a capital markets perspective, servicing is at the center of the mortgage value chain. With little deal flow at present, investors are taking a much closer look at what had long been considered a "back office" activity for originators and issuers.
"To an investor, the servicer is their front office, or at least it should be," said Toni Moss, the founder and CEO of Eurocatalyst, an advisory and market-positioning company. "That's where the loan level and overall portfolio performance statistics are generated, managed and reported on."
The greatest challenge for the sector is to reposition the role of servicing in thought and practice from a back-office operation to a front-office operation. "It is a powerful shift that, if successful, can only improve transparency, restore investor confidence and drive more investment and resources into creating faster, better, more efficient and investor-friendly servicing operations across the industry," Moss said.
Moss said the upper echelons of the mortgage industry have always viewed the servicing business with extreme distaste. "The European industry at large has generally regarded servicing professionals as the fat kid on the soccer team, and unfortunately, if treated that way for long enough, you may tend to act like it," she said.
But banks are now looking to efficiently manage arrears and support the cleanest credit and performance book possible so that they can access the cheapest funding alternatives when these options come along.
Dipesh Mehta, an analyst at Barclays Capital who recently authored a report on the sector, said that servicers are also a borrower's first point of contact if they enter financial difficulty or have an account query. Thus, the servicer can directly impact the level of arrears and losses in the wider mortgage market, and so ultimately influence securitized transactions.
"In the buoyant market of previous years and earlier this year, people were more focused on distribution and origination - everyone was conscious that in the background was the servicer but it wasn't something people really focused on," said Neil Warman, finance director at Homeloan Management, which services in excess of GBP50 billion ($99.23 billion) of mortgages with over 40 clients that range from centralized lenders to smaller traditional building societies. "Now that people don't have the liquidity to fund the front-end origination, they are looking to protect what they have, which means that we have this 180 degree turn that suddenly puts servicers in the spotlight," he said.
New Techniques
Eurocatalyst's Moss understands losses when mortgage markets go bad. She got her start in the 1990s as the former co-owner of a due diligence firm and represented investors acquiring the toxic nonperforming loan portfolios of more than 1,000 banks that failed during the savings and loan crisis in the U.S.
"At the time, the initial focus was on buying these loans for pennies on the dollar, but special servicing was nonexistent," she said. Eventually, Moss said, her firm implemented its proprietary due diligence software as the front end for a new generation of special servicing platforms.
Ten years ago, Moss relocated to Europe to advance the development of the European third-party servicing sector in her role at Stater, a company based in the Netherlands. "In 1997, professionals involved in any aspect of servicing were considered so low on the lending food chain that they couldn't even get arrested," Moss said. At that time, the only other existing third-party platform was HML in the U.K., which was entirely focused on its home market. "Cross-border servicing was unheard of and had never been attempted," she says.
"Today it remains an extremely immature sector, although Stater has made strides as a pioneer in three countries, and others, like Crown, have been scaling that same mountain," Moss said. "The only real options in Europe for third-party servicing is to either leverage phenomenal economies of scale and operate as a market utility, or specialize in a unique skill set for loan workouts and special servicing."
Oakwood's Culhane said that, over the past four years, his group has built a dedicated in-house team that collects on loans once they begin to underperform. The firm has developed some new techniques and technologies, such as remodeling the basic work flow of arrears collection. "Investors are much more interested in following how loans start to pay, particularly in the nonperforming category, and what we have now is a situation where borrowers who, in the past, may have refinanced themselves out of trouble no longer have that option."
Euro Loan Mods
Europe is seeing more U.S. style servicing initiatives aimed at managing default risk. One such initiative is in the area of loan modifications, where the terms of the mortgage are altered to enable the borrower to continue making payments and remain in their home.
In January 2008, Capstone - a wholly owned subsidiary of Lehman Brothers that services loans for Southern Pacific Mortgage Loans (SPML) and Preferred Mortgage Loans (PML) - announced that it would make loan modifications on a case-by-case basis to minimize borrower arrears and losses if foreclosure was expected (ASR, 1/21/08). The servicing strategy has been developed by expertise gained from Capstone and Lehman's recent U.S. deals and specifically targets borrowers that might suffer difficulties with upcoming rate resets. Capstone believes that this special servicing strategy is in the best interests of the borrower, and therefore should ensure performance for securitized transactions.
"It is important to make sure the framework doesn't override the contractual obligations of the servicer to the investors," Warman said. "What is less clear is whether this will have any impact on the secondary market - we will probably find that any benefit from reducing defaults through such arrangements, is offset in declining excess spread."
Another initiative is servicer advancing where, for each interest payment date, the servicer advances to the securitization special purpose vehicle (SPV) the shortfall between the full amount of money due from the borrowers and what is collected. The servicer must determine whether the money is recoverable before it advances the funds to the SPV.
Typically, the servicer is able to borrow the money from the arranging bank to fund the advances and makes a turn on what is charged by the bank versus what it is paid by the SPV. This structure is beneficial to senior investors as it pushes losses further down the credit spectrum. Although the market is dislocated, where even senior funding is proving difficult, such structures could aid in the execution of deals.
Warman believes that servicer advancing is likely to become more popular in the U.K. as more servicers look to leverage their experience and infrastructure and increase remuneration from the performance of the portfolios. "One thing that emerges from recent developments is that the role of the servicer, having already been important, is increasingly critical," he said.
It's likely that lenders will begin to see the numerous benefits of outsourcing administration, given the current market conditions. "An outsourced model enables the lender to remove large overheads from its business that cannot be supported by lower origination volumes," said Warman. "We can provide a variable cost base that enables the lender to quickly scale up its origination levels when the market returns."
The main concern is that because these are traditional back-office operations, the necessary skills and resources aren't in place to meet these bigger responsibilities brought on by current choppy market conditions." There are more issues that you have to consider - for instance, who is servicing the loan?" explained Jenna Collins, an asset manager at Cairn Capital. "Is it a small company? Can they sustain employment and the stress that they will be put under given the current market conditions? You need to make sure that your servicer is a viable business, and at the moment there are not many people who are good at that."
Culhane said that the U.S. has a very transferable, commoditized model, which is not the case in the U.K. and Europe. It takes enormous effort to transfer or trade servicing rights because it's not simple to get around the legal and technical issues. Culhane believes that special servicing will take on a more important role, because it's easier to take on a special servicing component from other people.
However, he also said that the Financial Services Authority requires servicers collecting on a book to have the appropriate license if they also hold the legal title of the loan, which will be a structural impediment and may limit entrants into the special servicer market.
"There is lots of overhang loan supply sitting on balance sheets, and for the market to reignite you'll have to clean up this backlog," Culhane said. "We have interesting ideas on how to do it. We are prepared to assume big chunks of risk as long as we can assume the servicing capabilities. We are ready to invest and hope to purchase pools from sellers over the next few weeks."
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