Back-up service facilitation: readiness cannot be assumed

Servicing is the day-to-day administration of a loan book: collecting and recording payments and maintaining an accurate position for each borrower. A portfolio of receivables is worth only what can be collected on it, and collection depends on that record being intact. That is the risk back-up servicing arrangements exist to cover, and it is why funders require them in credit agreements and securitisation documents. 

In many transactions, the originator services the assets it has originated. Those assets sit in a ring-fenced vehicle and legally survive the originator's failure, but the function that collects on them does not, so the collateral can lose value even though title to it is unaffected.

A back-up servicer contracts to service the book itself, with services being bought at a temperature. Arrangements are broadly ‘warm’ or ‘hot’, meaning the servicer is able to step in quickly, or ‘cold’. A cold arrangement typically means a servicer only receives data quarterly and takes 60 to 90 days to migrate to a back-up platform; a warm arrangement may receive data monthly and take approximately 30 to 60 days, while ‘hot’ means a readiness to service, with access to all data within a few days. 

Investors and lenders usually choose on cost. However, this disregards a crucial point: the reality of the circumstances in which back-up servicing arrangements would actually be invoked. There are only two realistic triggers: a ratings downgrade (which every counterparty would work hard to avoid) or an insolvency. Both mean the firm is already in distress, and that the data, systems and people who understand them are least likely to be intact. 

Recent failures have reset expectations

Three high-profile failures have exposed how far servicing arrangements can fall short in practice: First Brands Group and Tricolor Holdings in the US, and Market Financial Solutions in the UK, where creditors allege double pledging and shortfalls in collateral.

Issues have included servicers arriving at invocation without complete loan and collateral data across the group they were contracted to cover, having assumed the incumbent servicer would still be functioning and cooperative when the moment came. Where several financing vehicles are involved, a service provider may not have the resource or systems to service all of them simultaneously, which is precisely what a failure at originator level demands. Issues can also arise where there is a lack of experience to deal with less standard loan types or the need to take enforcement steps. 

For example, Tricolor's deal documents were read by analysts as consistent with cold back-up servicing. Kroll Bond Rating Agency downgraded all 34 outstanding ratings across seven of its securitisation trusts, citing the potential for a missed distribution and the disruption to collections and noteholder remittances expected from the servicing transfer, and noteholders have since brought litigation against the indenture trustee and the back-up servicer, alleging failure to perform post-default obligations.

As a result, back-up arrangements are now being scrutinised by both investors and rating agencies as a condition of new deals, and existing transactions are being revisited. 

Where back-up servicing arrangements can fall short

Temperature is undefined. Many documents do not state clearly whether the arrangement is cold or warm. Invocation happens when speed matters most, usually in or around an insolvency, when books and records are incomplete or contested, staff are leaving and authority to act needs to be established before anything else can begin. A 60-to-90-day migration assumes an orderly handover from a counterparty that is no longer orderly. In our experience, a cold arrangement paired with a short invocation notice period simply cannot be delivered.

Cost is treated in isolation from value. Warmer, more responsive arrangements cost more. But cheaper, colder arrangements, where it may take 90 days to transition to loan servicing do not fully consider the risk being mitigated, or the cash flow run off that can occur in that 90-day time frame. Some rating agencies are now limiting back-up transitions to a maximum of 30 days. 

Data visibility is fragmented. Loan and collateral data can sit across originators, servicers, trustees and financing vehicles, which makes it hard for any single party to see clearly. A provider should be reconciling and confirming completeness at regular intervals so there is a known-good reference point. 

Oversight lacks independence. Where the same parties are relied on for origination data, servicing oversight and reporting, transactions lack the independent check investors and rating agencies expect.

Fee structures can work against recovery. Where remuneration is a percentage of outstanding debt, effective collection shrinks the fee base. That does not make back-up service providers act badly, but it does not push towards short default notice periods and swift enforcement either.

Too often, back-up servicing readiness has been assumed rather than tested. If arrangements are not stress-tested before they are needed, the first real test will come at the worst possible moment. 

What a back-up service facilitator can provide 

A back-up service facilitator's value sits in the work done before invocation as well as the response afterwards.

Readiness reviews: Assessing whether the nominated back-up servicer, and associated documentation, would genuinely support a fast and orderly transfer, rather than assuming that an appointment equals readiness.

Data and collateral verification: Independently checking loan-level data, collateral records and reconciliations across originators, servicers and trustees, so that gaps are found before a crisis forces the question. In recent failures, the data gaps exposing double pledging and shortfalls in collateral had been there for years.

Cost and benefit analysis: Weighing the cost of a warmer arrangement against the risk it is designed to mitigate, so the choice of temperature is a deliberate decision rather than a default position.

Scenario and transition testing: Walking through a servicing transfer before it is needed, to identify the documentation, systems or reporting that would slow implementation once triggered. 

Governance and oversight support: Acting as an independent point of co-ordination between trustees, servicers and investors, in routine monitoring as well as in an actual transition.

Stepping in on invocation: Supervising the remaining servicing team, unwinding the assets and returning funds to investors and lenders.

How we can help

Grant Thornton's Financial Services Restructuring and Insolvency team acts as an independent back-up service facilitator, testing, verifying and co-ordinating readiness, with no commercial stake in the servicing outcome.

The value we provide in mitigating risk comes from our insolvency skillset: acting quickly, identifying the key information and the key people, reconstructing books and records, engaging borrowers early, and supervising the remaining servicing team while assets are realised. 

For more information, contact Chris Laverty, Head of Financial Services Restructuring and Insolvency or Mark Birbeck, Associate Director, Financial Services Restructuring and Insolvency.