Stepping out of the shadows

25 April 2011

Standby servicing isn’t something the mortgage industry is in the habit of talking about, but that could be about to change following a European Central Bank ruling which links bailout cash for troubled banks to an emerging standard for standby servicing.

Standby, or back-up, servicing grew out of the securitisation market and the ratings agencies’ insistence that they would only rate a portfolio of mortgages for sale by specialist lenders if arrangements were in place to take over the servicing of those mortgages should the primary servicer fail, thereby protecting any investors.

Their main concern was that a lender may run into financial difficulties a concern that has been highlighted by the credit crunch, the collapse of Lehman Brothers and, more recently, the plight of the Irish banks.

But it isn’t just the prospect of financial problems the ratings agencies want to guard against. It could be a systems failure, fire or floods if the lender’s business continuity plan doesn’t do the job it is intended to. The net effect is still the same if a lender is unable to continue servicing its mortgages it potentially puts investors at risk.

In the early days of securitisation and portfolio trading, ratings agencies made an assumption that if an institution did encounter financial difficulties, it wouldn’t collapse overnight, giving it time to put alternative serving arrangements in place.

“The credit crunch has given greater impetus to the development of standby servicing”

But the speed at which organisations like Northern Rock unravelled caused them to revisit that assumption and their attitude towards standby servicing has become more robust.

The key issue, of course, is that in the event of a lending institution hitting the buffers, investor or bondholders want to know direct debits will be collected, arrears will be chased and day-to-day operational issues will continue to be effectively managed.

Until recently, there was no common standard for standby servicing. But the ECB, which is providing financial support to the troubled Irish banks, is only willing to accept AAA-rated bonds which must be rated by two agencies.

In many instances, one of those agencies is Moody’s which has for the first time drafted a specification for standby servicing.

The arrangements are usually referred to as cold, warm or hot. A cold arrangement is one where a standby contract is signed, but no action is taken unless the arrangement needs to be invoked. The standby servicer therefore has to work from a cold start.

A warm arrangement is one where a number of preparatory activities take place as soon as the provider is appointed, such as an audit of products and processes and a review of operational procedures. A data mapping exercise may be run to make sure data can be successfully migrated from one system to another. This groundwork means a standby servicer can usually be up and running within 90 days of the contract being invoked.

A hot arrangement is one where a third party servicer could take over all servicing arrangements immediately. This means systems would need to be duplicated, with data migrated to the standby servicer on a regular basis and all operational systems would be replicated across two sites.

At the moment hot standby arrangements are theoretical and I’m not aware of any that exist in the UK or Irish markets.

In reality, nearly all standby arrangements are warm and in March this year, Moody’s published the first specification for what it considers a warm standby arrangement. In summary, they require the back-up servicer to:

• Be capable of taking over the servicing of a portfolio within 30 to 60 days from invocation. If the period is longer, additional liquidity and measures may be necessary to cover any potential negative impact on the mortgage pool performance.
• Have developed procedures for transferring the servicing from the primary to the back-up servicer.
• Conduct onsite reviews.
• Carry out an initial data mapping exercise and periodic data updates.
• Receive a sample of data so that an initial assessment can be undertaken to ensure the servicer is capable of managing the mortgages.
• Not terminate the back-up servicer arrangements unless and until a replacement servicer has been appointed.

Putting a standby arrangement in place is a detailed but straightforward process. Initially, a paper-based fact-find is completed, which requires the lender to specify how they manage their loans. It will include product specifications, details of interest charging mechanisms and lending policies and procedures.

At HML we provide the client with details of our own standard operating model, because their portfolio will be managed on our systems if the arrangement is invoked.

We also run a test to make sure our systems are compatible and highlight any issues that need attention.

Once we’re satisfied we understand the client’s products and procedures and can service their mortgages, we then carry out periodic reviews to make sure our systems remain compatible.

The rapid growth in the number of securitisation deals which happened over the past decade has of course slowed dramatically.

And while the securitisation market may not be what it once was, it hasn’t diluted the need for standby servicing. If anything, the credit crunch has given greater impetus to the development of this facility, especially among banks and building societies that have had to call on central banks for financial support.

Stronger regulations and greater interest from investors will undoubtedly encourage more financial institutions to start talking about standby servicing and put arrangements in place.

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