As special loan servicers gain market share in the subprime residential mortgage business, two competing business models have emerged - each based on the servicers' exposure to the cash flow of the portfolio.
For example, Litton Loan Servicing, through parent company C-BASS, becomes an investor and often owns a portion of the residuals or the first-loss piece in a transaction the company is servicing.
EMC Mortgage, a servicing operation of Bear Stearns, and Ocwen Financial Corp., both active in the subprime special servicer arena, also use variations of this strategy, sources said.
"The worst thing that you can do in a sub-servicing subprime deal is to structure it in a way where there's no incentive to work it," said Larry Blake Litton, Jr., senior vice president at Texas-based Litton. "If you're a B-piece holder, you're damn sure motivated to protect your investment."
However, Fairbanks Capital Corp., the company that recently acquired ContiFinancial's platform, takes the viewpoint that the servicer should have no stake in the cash flow of the transaction, and that the profitability of the servicer should be based on that business alone, said Richard A. Lee, executive vice president at Fairbanks.
Fairbanks, however, does have an equity investment in Alta Capital, a fund run by Mitch Samberg. Alta Capital invests in residential performing, scratch and dent, sub- and non-performing whole loans, and sometimes residual interests. However, Lee said, that operation is economically independent from the servicing.
Linking the servicer's profitability to the cash flow of the investment can take away from the efficiency of the servicing operation, Lee said.
"That's the problem that some of the servicing platforms get into," Lee said. "They rely on the yield off of an investment to generate income. And they don't look at the cost allocation of the servicing side. We've decided that this is what we do ... and we want to profit from our expertise. And we don't to have to subsidize that by having to buy residual interests or other assets in order to enhance the profitability of this company."
Both perspectives do agree that there should be some kind of incentive structured into the servicing transaction, such as compensation for reductions in loss frequency and loss severity, as well as marketability of the service.
Fairbanks currently services $17 billion in loans, claiming the largest share in the industry, with some of the highest ratings available in the market place, said Lee. Litton, which has also received the highest ratings available, services approximately $12 billion in loans, said a source.
Though most widely publicized in Conti's platform transfer to Fairbanks, special loan servicing companies are penetrating the subprime residential business at phenomenal rates, reflecting, if not just industry specialization, an evolution of the subprime business, said a number of market sources.
Prospectuses are just beginning to include details on the sub-servicers involved, recognizing that a value-added attitude is emerging.
Though Standard & Poor's Ratings Co. has been rating residential subprime special servicers for roughly three years, Fitch IBCA began applying ratings to the sub-servicers within the last nine months. Moody's Investors Service has yet to officially enter the game, though Moody's analyst Diane Westerback last year issued a report detailing the impacts a special servicer has on the ABS transactions.
"A few years ago, on the residential side, there weren't really special servicers," said an analyst at one the ratings agencies. "A bank used to originate and service their own product, everything from soup to nut, though now I think there's just a little more specialization out there."
Litton Loan Servicing, for example, is slated to be servicing 75,000 loans at the end of June, compared to approximately 40,000 to 50,000 loans a year ago. In addition to the loans it picks up from parent company C-BASS, Litton services loans in certain New Century Financial and First Franklin portfolios.
Interestingly, the increased business for servicers like Litton and Fairbanks reflects the large issuer's desire to diversify their products, the source said.
"It's a way for them to still produce and originate subprime product but not have to spend all the money and labor intensive efforts servicing," the analyst said. "They could keep doing the vanilla loan administration, collecting the loan payments on the other loans."
One of the anomalies of the subprime industry is that a substantial portion of the companies who were originating and securitizing loans in the mid- to late-90s, and whose bonds are currently outstanding, have long since (some not so long since) gone bankrupt.
Like with Conti and Fairbanks, a number of other platforms of troubled companies are likely to be transferred this year, sources said. Empire Funding recently filed for bankruptcy. Earlier this year, EMC was said to be moving in on the platform of United Companies.
Other companies that aren't necessarily in financial difficulty may also be looking to auction off their servicing platforms, the same way WMC Mortgage employed Fairbanks.
Potential candidates for such transfers include Advanta Corp., which recently announced it intends to sell off its mortgage-related business, and New Century Financial.
Even as the subprime residential mortgage sector may be stabilizing to some extent - meaning issuers that relied on securitization to exist have generally been replaced with well-capitalized entities - the special servicer can also, in some ways, add a level of trust/issuer remoteness to a transaction.
Take WMC and Fairbanks: if anything, a servicing transfer on a WMC trust down the line is less dependent on the solvency of WMC.
"It really does two things," said Kim Bentancourt, a director in servicing evaluation at Standards and Poor's. "It allows them to cut costs because it allows someone else to sub-service the loans, and it also gives investors a better comfort level, because whether [the issuer] is still there or not, the loans will still be serviced."
One interesting development that could further contribute to the boom in the business is the likelihood that the ratings agencies will factor the ratings scores of a servicer into the overall rating and enhancement levels on a transaction, said Jim Schneider, director of business development for C-BASS
"We are expecting to see this develop - the agencies quantifying the value of superior servicers when they structure transactions," Schneider said.
Schneider explained that, eventually, the use of a highly-rated special servicer will prompt the ratings agency to require less over collateralization.
"We actually believe that will happen this year, because we are having discussions with the agencies now," Schneider said.
According to Fairbank's Lee, in a recent securitization, the deal was already given better enhancement levels with Fairbanks as the special servicer.
"It makes sense," Schneider said. "If in fact you can demonstrate that a platform would be able to prevent delinquencies and manage loss serverities of loans that eventually do go delinquent, you're talking about substantial improvement in the overall performance of deals."