Backup servicing refers to when a backup servicer takes over the servicing responsibilities for a pool of loans or mortgages if the initial servicer is unable to continue servicing them. This usually happens if the initial servicer goes bankrupt, defaults on its obligations, or fails to meet certain performance metrics outlined in the servicing agreement.
A backup servicer is essentially an insurance policy (or a contingency plan) for investors in securities backed by pools of loans. Having an established backup servicer in place ensures that the loans will continue to be serviced properly even if the initial servicer runs into financial or operational difficulties. This helps maintain the value of the loan pool and minimizes losses for investors.
Why is Backup Servicing Needed?
There are a few key reasons why backup servicing arrangements are commonly established:
Protect against servicer disruption
As mentioned, if the initial servicer fails, the backup servicer can step in and take over servicing without much disruption to borrowers or investors. This prevents late payments, defaults, and other issues that would decrease the value of the loan pool.
Investor confidence
Investors have more confidence that their investment will be preserved if an established backup servicer is in place in case issues arise with the initial servicer. This makes the securities more attractive to potential investors.
Compliance with rating agency requirements
If you are looking to get a portfolio securitized, rating agencies like S&P and Moody’s often require a backup servicing arrangement in order to assign high credit ratings to securities based on loans or mortgages. The presence of a backup servicer reduces the risk for investors.
Regulatory requirements
Certain regulations require establishing a backup servicer for some types of loan pools. For example, the Dodd-Frank Act has backup servicing requirements for some asset-backed securities.
Responsibilities of a Backup Servicer
The responsibilities of a backup servicer include:
Maintaining current data on the loan pool
The backup servicer will regularly update information on all the loans/mortgages in the pool, including balances owed, borrower payment histories, tax and insurance details, and more. This ensures the backup servicer has all the information required to smoothly take over servicing if needed.
Operational readiness
Reputable backup servicers conduct trial runs of taking over servicing so they can guarantee a quick transition if needed. This includes having capacity to take on new servicing volume, adequate staffing, and strong processes and controls around areas like payment processing and customer service.
Reporting to stakeholders
The backup servicer keeps investors, bond trustees, rating agencies, and other stakeholders informed on the status of loans in the pool as needed.
Types of Backup Servicing
There are three main levels of backup servicing for financial technology companies (fintechs): cold, warm, and hot. These refer to how quickly a backup servicer can take over the servicing duties from the primary servicer in case of an outage or transition of responsibilities. It also reflects how frequently the backup servicer updates its own customer data and loan records to ensure accuracy and readiness.
Cold Backup Servicing
A cold backup servicer has fairly infrequent updates to its borrower data and portfolio. This means if responsibility needs to be transitioned, it could take several weeks (generally 30 days). This is a lower end option that some startups select for cost savings.
Warm Backup Servicing
Fintechs that want a slightly more robust backup capability often select a warm backup servicer. Here, the backup systems are updated more regularly which allows a transition period of 1-2 weeks if required. The added data currency comes with an incremental cost increase compared to the most basic cold option.
Hot Backup Servicing
Companies requiring the highest degree of resiliency and data availability utilize a hot backup servicer. This entails frequent data synchronization, enabling the backup service team to take over loan servicing within 1 day. This option is the most expensive.
Backup Servicing Costs
There are several categories of costs associated with having a backup servicer in place:
Retainer fees
The backup servicer often charges an annual retainer fee that gives them the “right of first refusal” to take over servicing if needed. This can range from 1-10 basis points of the outstanding loan principal per year depending on the size of the loan pool and other factors.
Setup fees
If the backup servicer needs to actively step in and start servicing, they often charge a one-time setup fee. This is usually around 5-10 basis points of loan balances. It compensates them for the staffing and operational changes required for the transition.
Ongoing fees
Once the backup servicer takes over active servicing, they get paid an ongoing monthly servicing fee. This is usually similar to what the initial servicer was earning – 25 basis points per year is typical for conventional mortgages and 100 basis points per year for unsecured consumer loans.
Activity fees
Fees for specific servicing activities may also apply after the transition, like processing mortgage payments or handling delinquent accounts. These fees are earned on top of the ongoing servicing fee percentage.
Other expenses
Out-of-pocket expenses for things like mailing statements, tax tracking services, foreclosure fees, or appraisal costs may also be billed back to the mortgage pool by the backup servicer after they take over.
The specific fee structure and percentages vary widely based on the size of the loan pool, type of loans, servicing requirements, and operational scale/capabilities of the backup servicer. But in general, the all-in costs typically equate to between 5-20 basis points per year.
For a $1 billion pool of conventional mortgages, having an active backup servicer in place would therefore cost roughly $5-20 million per year. Much of this is usually funded by deductions from borrower interest payments that get passed on to investors earning income from the loans.
Transition Process
So what happens when a backup servicer needs to actively step in and start servicing? The transition process usually involves:
Stage 1: Initial Notice
The backup servicer receives notice from the trustee that servicing must transition, often due to financial strain on the original servicer. The backup servicer acknowledges the notice and mobilizes resources.
Stage 2: Data Transfer
The original servicer provides all necessary loan-level data to the backup servicer, including payment histories, escrow balances, contact info, documentation, and more. Data integrity testing occurs.
Stage 3: Borrower Notices
Borrower notices go out informing them that servicing is moving to the new servicer. This includes the specifics on where to submit future payments.
Stage 4: Licensing & Approvals
The new servicer works quickly to establish all the state licenses, GSE approvals, HUD certifications and other regulatory needs vital for actively handling the loan pool.
Stage 5: Initial Transition Testing
The backup servicer does some initial servicing operations testing on a small portion of the loans to ensure they can handle all aspects like payment processing accurately.
Stage 6: Full Portfolio Transition
Finally, on a specified date, the backup servicer systems fully take over servicing responsibilities for the entire loan pool. They handle borrower calls, process payments, manage escrow accounts and all other duties from that point onward.
The transition can happen very quickly – often in under 60 days – if an advanced backup servicer arrangement is already in place. The specific processes can vary based on the regulatory and pooling requirements applicable to the loans involved. But in general, an experienced backup servicer makes the transition smooth for both borrowers and investors.
Conclusion
Backup servicing is a critical risk mitigation function to preserve value for investors in loans that are pooled and securitized. It ensures continuity of servicing even if the initial servicer fails. With trillions worth of mortgages, consumer credit, auto loans and commercial debt securitized, strong backup servicing arrangements protect against downside shocks. They facilitate smooth transitions to prevent systemic market disruptions when unforeseen servicer distress events arise.