The panel for this month’s Lending Zone round table is tailor-made for a discussion about standby servicing. The ratings agencies are well represented, as are investors, and we have a lender, Paragon Mortgages, that has successfully securitised in the past. That’s a pretty good fit when the topic for discussion is the future of the standby servicing sector.
Standby servicing, whereby a third party takes over the mortgage servicing function should the primary lender go under, is of course not a sexy subject but that could be about to change.
A recent revision in European Central Bank criteria for accessing emergency funding has effectively linked access to this cash for troubled institutions to an emerging standard for standby servicing, and the regulators’ and ratings agencies’ concerns about operational risk.
Moody’s, for example, is reassessing its ratings of 14 UK banks and building societies which could result in downgrades to their debt ratings. If their ratings fall below a certain level and their standby arrangements don’t come up to scratch, there could be a knock-on effect leading to transaction downgrades.
Moody’s says its review has been prompted because UK banks are no longer considered by the authorities to represent a zero failure system so assumptions embedded in its senior debt ratings for UK financial institutions have to be challenged.
An important issue seems to be that if a lending institution runs into trouble, investors or bondholders will want to be certain that direct debits will be collected, arrears will be chased and day-to-day operational issues will continue to be managed effectively.
Given all this, the big questions are how the changes will affect the industry and whether a firmer stance on standby servicing provision will be a force for the good or just another regulatory and financial burden on the sector.
And even if the new provisions help re-establish securitisation as a viable alternative or supplement to retail funding, do third party mortgage servicers have the resources to meet possible future demand?
THEN AND NOW
But first things first. What will be the impact of any changes on the industry? After all, haven’t standby arrangements always been a requirement?
Steve Rogers, head of securitisation services at HML, says they have, but it seems to have been a bit of a yes and no situation. It was something that had to be in place but was apparently also regarded as a box-ticking exercise when doing securitisations. But he says attitudes have changed and ratings agencies are the main drivers of this.
“The way agencies are developing their requirements, whether as published criteria or the way they are looking at operational risk within transactions, means that people are starting to have to focus on it more,” says Rogers. “There are more and more standby standards and more obligations on the standby servicer and the issuer.
“Rather than just saying that they have a standby servicer firms must prove they have looked into the process and can seamlessly transfer servicing to the standby servicer. I think the seamlessness of that transition will be the focus in the future.”
There has been a change in the market too. The non-conforming lenders that fuelled the mania for securitisation pre-credit crunch have gone but Rogers notes other firms are in need of standby servicers.
“We are seeing more deposit-taking institutions smaller building societies starting to need standby servicing, especially those with covered bond programmes,” he says. “The standby may just be on insolvency if you are looking at a trigger point when standby servicers are called on to step in, but with covered bond programmes there are ratings triggers too.
“A few institutions are getting to the point where they are close to the trigger points of either putting a standby in place if they have not got one or starting to look at transferring the servicing across.”
Rogers says this market has been growing significantly and that small and medium-sized lenders are now seeing pressure on their ratings. These are the lenders that are on the cusp of being able to issue covered bonds because of the amount of uplift they can get in their rating to issue AAA covered bonds.
“There are more firms with downward pressure on their ratings who will start to look at having a standby servicer as a requirement in their future transactions,” he says.
“Have you had to step in as a standby?” Dave Fellowes-Freeman, vice-president at JP Morgan, asks.
“No,” says Rogers.
Apparently there has never been an invocation of a standby on a residential mortgage deal in the UK. Fellowes-Freeman turns to the issue of investor confidence. He believes standby arrangements deliver more confidence from an originator’s point of view.
“There’s obviously an issue with trustees that are responsible for performance and keeping it going,” he says. “But it’s the originator the firm that puts the deal together that has its name against the deal in the market if it ever wants to originate more stuff.”
John Harvey, head of structured finance at Paragon Group, picks up the conversation from the perspective of lenders and agrees that the role of standby servicers has changed and that all firms have to have something in place. He raises the issue of the different levels of standby arrangements and invites someone to define what is meant by cold, warm and hot arrangements.
But no-one accepts the challenge and he finds himself answering his own question.
“Hot is when a standby servicer can take over the servicing within 24 hours and be up and running,” he says. “Warm is where they have done all the work to enable them to take over servicing in the event that they have to and they receive regular data feeds so they can do that.
“The invocation of a standby servicer has never happened in the UK, but there have been a couple of times where it has come close not in my own company’s case, of course.”
Brian Kane, managing director of Standard & Poor’s, knows of a Swedish mortgage originator whose servicer went bankrupt and had to be replaced.
“In this transaction I understand the originator was able to transfer to another servicing entity,” he says.
Fellowes-Freeman asks if having a standby servicer is a positive or whether it is more of a negative not to have one.
Kane says it depends how liquid the underlying assets are.
“If you have super-prime mortgages at a good margin you will always find somebody to take them on,” he says. “But if you have highly impaired, non-performing assets you may have to divert interest payments or even some principal redemptions to incentivise another servicer to take them on.”
In a market like the UK, he doesn’t think the ratings agencies are going to insist on always needing a standby servicer for every transaction.
“There are certain transactions where you may need one,” he adds, citing more risky underwriting criteria and higher leverage or possibly non-standard products as examples.
But Kane doesn’t like that idea as following the financial crisis a large amount of lending got lumped into the sub-prime bin and non-conforming doesn’t always mean sub-prime.
He maintains that a lot of the assets that may have been perceived to be non-conforming and non-standard have actually performed well buy-to-let mortgages being a case in point.
Mark Wilder, associate director at Fitch Ratings, observes that standby servicers exist to replace an existing servicer, which may also be the originator in the event of a servicer default which includes, but is not limited to, bankruptcy.
Ideally, the back-up servicer would be able to step in relatively quickly although the effectiveness of the transfer process to the backup servicer is directly linked to the type of standby servicing arrangement.
“That could be done on a cold basis,” he says. “From our definition that’s estimated at between 60 and 120 days, but we are reviewing these timelines and in extreme situations, where the cold back-up has no working knowledge of the portfolio, the transfer process could take much longer.”
PRACTICALITIES OF TAKING OVER THE BUSINESS
“You’d need someone who is almost side by side on a daily basis,” says Harvey, an observation that leads to an exploration of what happens when a company goes bust and how a standby servicer might move in to run the mortgage servicing operation.
“When you talk about invocation of the standby servicing contract, what it meant 20 years ago was that HML, for example, would send Rogers to our Solihull office to say it now works for him and that he is controlling the servicer,” Harvey explains.
“In due course, together with his management team, he would decide whether they wanted to keep that platform where it was or move it somewhere else. Some ratings agencies have the misconception that the standby servicer would be based in our office and ask for the disks and then run back to Skipton and plug them into their machine. Fortunately, we’ve moved on from that.
“Under the warm arrangement the standby servicer receives monthly data feeds and understands how the systems work,” he adds.
“More importantly, its IT people are put next to our IT people they understand how the whole thing works. I don’t believe any of that changes what would happen at invocation. Rogers will still come in and say that they all work for him now.”
Rogers suggests that you are not going to have the Lehman Brothers scenario here, where investment bankers who see their bonus pot disappearing into the ether pack up their possessions in boxes and march out the door on a Friday night never to be seen again.
He suggests that at a servicing operation level when there have been scare stories going out overnight you’ll still see people going to work the next day.
“They might be wondering if they’ll get paid at the end of the month,” he says. “But I don’t think you’ll have the mass run for the door that we saw at Lehmans.”
“Lehman’s servicer, Capstone, encountered a similar problem itself although the company was able to continue operating and staff turnover rates remained relatively consistent with the market average throughout the crisis,” he says.
Capstone, now Acenden, is an interesting example of how the servicer kept working while the investment bank which owned it went bust, but how close was the call for invocation given that the company was the in-house servicing operation for Lehmans in the UK with three different lending platforms?
Fellowes-Freeman says one might have expected the trustees to have called in the standby servicer, but what if they had? Apparently it would have been a case of HML to the rescue.
“The HML team would have turned up saying it’s business as usual as much as possible,” says Rogers.
But would it have worked? Julian Wells, marketing director at HML, says that his company stress tests its standby exposures at least bi-annually, adding that it would be interesting to know how worried ratings agencies are about invocation now.
“I know that when we had our annual servicer review two years ago it was high on the agenda to see how prepared we were for an invocation and what we were going to do if there was one,” he says.
According to Kane this is a key component of Standard & Poor’s analysis.
“From a Fitch perspective HML’s back-up arrangements and its business continuity plan are areas that we always focussed on,” says Wilder.
“We go into that in great detail at the annual review. It’s not just its ability to take over a third party portfolio which is a concern, but also its governance and controls around it.”
STANDBYS AND REBUILDING CONFIDENCES IN THE SECURITISATION MARKET
Rogers says that HML has had a few conversations in the last year or so with issuers looking to do single investor trades.
“We’re finding they’re keen to have standbys in place,” he says. “Some may be happy looking at the standard criteria that you would see from the rating agencies on other transactions, but a lot of the time they have their own requirements and they can be more stringent.
“I suppose if single investors have several billion pounds invested in a single transaction they want a lot of security in there. I think that will drive the market as well.”
Kane believes this is good news for securitisation. “It is positive in a period of credit dislocation that single named investors will come in and take up a large volume of bonds,” he says. “They will often use this leverage to tighten up the deal, in many respects beyond what a credit rating agency would require.
“At these times when there is additional risk in the market the ball is essentially in the court of the investors. They can drive triggers and can insist on the different structural features they require, depending on which particular tranche they are interested in. Originators will respond by adhering to their wishes because they are picking up a significant amount of the transaction.
“These features may become standard for a while and then as more investors come into the market the weight shifts to that of the originators, and they will generally then make some amendments that are more in their favour,” he adds. “The agencies are comfortable with both, because both will adhere to a minimum standard that would be appropriate for the ratings.”
A GLIMMER OF LIGHT AT THE END OF THE TUNNEL
Rogers points to the growing number of single investors driving the market and taking a large proportion of the deals. So can we be optimistic about these developments?
“A few years ago, when you had 50 to 60 investors in a trade with none of them taking more than 5% to 10% of the transaction, their power to start driving the structure of the transaction was limited,” he says.
“But that’s changed and the single investors are now calling the tune. These days they not only stipulate that they need a standby, but say how the standby will be set up, what the trigger points will be and how quickly an invocation will happen. “As more and more investors start getting into transactions, I think the power will probably swing back towards the issuer, but the goalposts will have moved from where we were three or four years ago, and they’ll have moved in favour of the investors with the ratings agencies exercising real influence on the terms,” he adds.
SHIFT IN THE MARKET
Moving on, Kane observes that there has been a large change in how the market is made up.
“The decision by the Bank of England to create the portfolio discount window facility that is, to give banks and lenders some liquidity for these portfolios is interesting,” he says. “If you look at what happens in a securitisation or a covered bond there is a market value component in terms of the potential liquidation of a given mortgage portfolio.
“At the point that a covered bond originator defaults they go through certain triggers and you may have to sell the portfolio to repay the bonds. There is a similar situation where originators have been unable to call a securitisation because they may not have been able to sell or refinance the portfolio for a high enough amount to redeem the bonds.
“I think we may see a link between servicers and standby servicers and the discount whole loan facilities the Bank is providing,” he adds.
“In this situation they may act as conduit between the institution and the Bank in terms of data and documentation consistency that could open additional avenues for alternate financing options.”
So could this be an answer to the refinancing crisis facing the industry in the coming year?
Kane thinks so.
“The Bank doesn’t necessarily want to make smaller lenders or possibly any lender have to go through some of the pain and administrative struggles around putting the securitisation together,” he says.
“Often they view the risks attendant to securitisations such as swaps and bank accounts as additional financial risks. They may discount some of these when they look at the bonds they are providing financing for. I think this new initiative is an effort to go back to basics and say we will deal with plain credit risk associated with the loans and provide funding on a discounted basis against those loans.
“At the moment the funding is intended to be short term, so as it is currently structured it would not provide a full take out,” he adds. “But it does provide some form of benchmark liquidity and the Bank does take a legal charge over those assets.”
As the whole-loan sales market re-emerges, and more private equity comes back into the market, then hopefully there will be other participants that could potentially buy the portfolio at a time when you are trying to repay a covered bond or to call a securitisation.
WHAT IF THE MARKET RETURNED TO 2007 LEVELS?
This is a sort of stress test for the future but if the mortgage market recovered could the standby service providers deliver in a market the size it was in 2007?
Julian Wells, marketing director at HML, says they could.
“It is down to the people taking up the standby contract with the servicer,” he says. “HML, for example, has £43bn of assets under management and around £20bn of standby contracts. In theory, if they were all invoked tomorrow, we’d have to increase the business by 50% to deal with the situation but that’s not a likely scenario.”
Rogers agrees up to a point. The question begs another if the market returned to 2007 levels would there be enough credible standby counterparties out there that could start looking at this volume of transactions?
“If we went back to 2007 issuance levels, but with requirements for standbys across the board, then in terms of assets under management versus standby we’re comfortable with that kind of ratio,” says Rogers.
“But some servicing operations only have £4bn or £5bn of assets under management,” he adds. “Could the market expect them to absorb £3bn, £4bn, £5bn worth of standby?”
Wells wonders if there might be a European solution with a primary servicer in the UK and a standby servicer in Germany or Holland. But Rogers thinks it would only work with the Dutch being a standby to the English because they can speak the language so well.
“If we had the English trying to be standby to the Dutch, I think we might have issues there,” he admits.
WHEN ARE AGREEMENTS TRIGGERED?
The issue of when standby arrangements are triggered is an interesting one. For example, do trustees have much control when things start to unwind or is invocation written into the standby contract in a black and white fashion?
Steve Rogers, head of securitisation services at HML, says that most of the standby contracts HML sees are focussed around insolvency.
“There aren’t many that have a ratings trigger,” he says, though he knows of a ratings agency that is considering implementing a binary decision below a certain rating.
According to David Fellowes-Freeman, vice-president at JP Morgan, one of the problems when it comes to invocation is that the issuers are small-scale companies who have few finance people to make a decision.
“That’s possibly why you see the standby contracts in place being so binary in terms of ’this is the invocation point’,” he says. “There’s no leeway because, as you say, the issuer is not really in a position to be making that decision.”