Understanding how the day-to-day servicing (including the back-up servicing) of a loan portfolio will work operationally is key to successful loan origination and management.
If a third party servicer is chosen to provide this function, the agreement governing the servicing of the loan portfolio should be drafted with input from the teams who will be living with the terms of the agreement for the life of the servicing contract (importantly, including the parties’ compliance and risk functions). It is also worth considering that a properly devised servicing agreement can not only act as a portfolio management tool, but also reflect the quality of the servicing of the loans which can enhance the profile of the parties in the eyes of investors and rating agencies.
Based on our experience, here are the top five issues which benefit from special focus during negotiations – whether from the perspective of servicers or originators / lenders of record.
1. Fees and expenses
The level of fees and expenses is obviously a key commercial term. However, in order to make the arrangements workable on a day-to-day basis, the parties also need to focus on how and when the fees and expenses are actually paid and by whom. The cash flows and payment mechanics of a deal are critical to ensure cash is available to the lender to make the necessary payments to the servicer.
In addition, borrowers may pay direct fees to the servicer for certain tasks undertaken, and there needs to be flexibility around the level of these fees from time to time. Robust systems for fee reviews are important generally, and without them a servicing agreement can become obsolete over time, giving rise to additional costs to renegotiate or replace it.
2. Scope of services
The detail of what the servicer can and will be doing for the lender is often left open, with a promise to work on a client operations manual (which usually includes the service level agreements) once the loan servicing is up and running.
From experience, we cannot over-emphasise how important the client operations manual is to both lender and servicer. The earlier the key personnel on both sides get talking, the quicker the operations manual will be drafted leading to much more effective servicing. Operations teams on both sides should, ideally, be engaging simultaneously on the manual whilst the actual servicing agreement is in negotiation.
3. Risk of regulatory change
One important driver for the outsourcing of loan servicing is the benefit of a servicer’s regulatory permissions that allow it to fully service the loan book. The risk of the regulatory environment changing in a way that materially impacts on the servicer’s ability to deliver the regulatory function is commonly discussed in terms of change management processes. This usually involves a high level of engagement and coordination among the compliance teams at the lender and the servicer.
4. Business continuity
Disaster recovery and business continuity are areas where servicers and lenders spend time thinking about the ‘what ifs’. Technology is at the heart of loan servicing and therefore data risk is of great importance. The risk and compliance teams of both the lender and the servicer are key stakeholders in agreeing the final form of any loan servicing agreement in this regard.
5. Reputational risk / white labelling
Lenders who engage servicers to provide start to end loan origination and/or servicing may wish for the servicer to act as an extension of their business rather than a separate entity. This, in practice, means “white labelling” the servicer’s systems and technology and tailored training of designated servicer personnel. From a contractual perspective, how white labelling is controlled needs to be negotiated thoroughly, and it is important to agree on a balanced approach that achieves the aims of outsourcing without losing value in either party’s business.