[u]REQUIRED READING:[/u][/i] The relatively niched world of specialty servicing is set to explode. [/b]That is, assuming the transactions that serve as the space's foundation – the buying and selling of distressed assets – continue to pick up steam. According to professionals in the field – which, unlike prime or even subprime servicing, is wholly dedicated to default management – the amount of activity occurring between buyers and sellers of nonperforming loans is hard to quantify. While specialty servicers consider anyone holding credit risk – from private mortgage insurers to mega-servicers to credit unions – as potential clients, their expectations for growth in the sector hinge largely on the flow of distressed-loan deals. Most estimates suggest that the number of such deals, to date, has not been substantial. ‘I haven't seen a lot of activity in that space in the past year because the bid and the ask – the expectation between buyer and seller – has been too wide," says Gene Ross, president of LoanCare, a division of FNF Servicing that performs subservicing and special servicing. "Those funds that have capital are keeping their powder dry." Deal flow does, however, appear to be improving gradually, Ross adds, noting that more and more transactions have been circulated for due-diligence purposes in recent quarters. Kevin Quinn, vice president of business development and client relations for Marix Servicing, similarly observes that, while buyers and sellers have generally struggled to find middle ground, purchase activity is bound to ramp up before long. "I think it's one of those things that seems inevitable," Quinn says about the increased deal flow. "I'm not convinced it's there yet, but there's certainly more activity now than a year ago, and a year from now, I think there will be more than there is now." [b] [i]Introducing the specialty shop[/b][/i] Default servicing specialists insist their operations exist to complement traditional servicing organizations – not to compete with them. The classic loan servicing model, including fee structures, technology platforms and employee training, was built to accommodate high volumes and low delinquency rates. Special servicers, by contrast, are interested in devoting far fewer (but much higher-touch) assets to each employee. Hedge funds and private investors that acquire distressed loans are a target clientele for which special servicers compete. Private mortgage insurers, in the hope of pulling additional revenue out of a loan, will sometimes enlist specialists to work assets that have already been charged off. Community banks, credit unions and large, national banks, also reportedly shift a portion of their troubled loans to special servicers on occasion. But, as Ross points out, subservicing for credit unions and small banks – lenders that never sought high-risk loans, but whose portfolios are, nonetheless, challenged by nonperforming assets – should not be confused with special servicing. "In today's environment, what we do for a credit union or a bank is clearly higher-touch and more demanding than what it was before," he says. "In some respects, you can say that's special, but I think it's just the nature of the business, because delinquencies are so high." Specialty servicers say they are able to help investors and primary servicers sift through nonperforming loans because their business model allows for a greater time and financial investment in working with borrowers. The specifics of contacts vary, but the commonality is that the default shops are paid based on their success at restoring value to a loan. The specialty space is attempting to correct the incentive misalignment among stakeholders, which critics say discourages primary servicers from resolving more loans. For default servicing in today's environment to be economically feasible, it must be kept separate from the primary servicing process, says Steven Horne, CEO of Wingspan Portfolio Advisors, which was formed in January 2008. "Primary servicers are uniquely well positioned to keep performing loans performing," says Horne. "Once loans turn nonperforming, you don't want to, as an investor, turn default into a profit center for the primary servicer [because] you run the risk of creating more defaults." In the traditional business model, servicers are paid a flat basis-point strip that does not take into consideration the growing costs of curing a distressed loan or liquidating a real estate owned property, specialty servicers say. Default servicing has historically carried strict timelines, as well as the expectation that it be performed as cheaply as possible. No matter how strong a primary servicer is at default servicing, the process remains only an expense to the servicer, Horne explains, while all the benefit ultimately flows to the stakeholder. Another major difference between traditional servicing and specialty servicing is the degree of investor participation and reporting. For opportunity funds that buy nonperforming loans at a discount, loss mitigation options expand well beyond government-sponsored enterprise (GSE) initiatives or Treasury Department guidelines, giving servicers greater flexibility in the workouts they can offer borrowers. However, that added flexibility must be accompanied by increased transparency into servicers' actions, servicers say. Nonperforming-loan investors demand daily reports, not monthly ones, and they seek updates on a loan-by-loan basis. In the specialty sector, "high touch" does not refer to loans or borrowers alone. "The ability for a special servicer to push back information to their client is absolutely critical – some will say that's the most important thing," says Quinn, who describes Marix as willing to do a lot of "investor hand-holding" to build its specialty book of business. The company currently has four specialty servicing clients, and Quinn says it will consider any deal, regardless of the extra attention that some investors might require. Marix's investor portal allows investors to recommend workout treatments for individual loans and cull data from more than 5,000 fields of information. Ross similarly notes that LoanCare's specialty clients want access into its servicing systems and that multiple investor phone calls a day is not uncommon. "The bar has raised substantially" in terms of investor reporting, he says. "Default specialist" is a popular nomenclature that casts a wide net, sometimes including companies that are not end-to-end default loan servicers, but rather vendor shops that focus on one particular form of loan resolution, such as a short sale or loan modification. The competition among true specialty servicers is hard to assess. Some shops actively engage in buying distressed loans, while others focus exclusively on third-party business. Charlotte, N.C.-headquartered RoundPoint Mortgage Co. is an example of the former type of specialty operation. The company, which launched in 2007, recently won a bid to split an equity interest with the Federal Deposit Insurance Corp. on a $490.7 million pool of loans that emanated from 19 failed-bank receiverships. RoundPoint expanded its platform and services to third parties after successfully working out a portion of a severely challenged – 99% delinquent – portfolio, explains Vickie Lester, president of servicing. Investor demands vary when it comes to loan treatment options. Some of RoundPoint's clients request that the company push loans through the Home Affordable Modification Program (HAMP), for which RoundPoint has signed a participation agreement. Other clients choose not to go the HAMP route. "Some people want loss mit; others just want very heavy collections," Lester explains. "But what everybody wants to know is, is there going to be any cashflow. That's the one thing all of our customers have in common." Few specialty shops appear to focus exclusively on the end-to-end servicing of defaulted loans. Many organizations launched their platforms in the last two to three years, hoping to capitalize on high levels of distressed-asset deals that have yet to materialize. Several outfits that did not hedge their bets with complementary service offerings have fallen by the wayside. "It's the best of times and the worst of times for specialty servicing, and it depends on how you came into the business and what your model was going forward," says Horne. Wingspan, like several of its competitors, offers business process outsourcing and component servicing in addition to specialty servicing. "It's basically packaging that same core skill set in a number of different ways," he explains. Regulatory action at the Treasury and GSE level, as it turns out, might be a saving grace for specialty servicers, at least while they bide their time waiting for distressed-loan deals to gain momentum. Less nimble, large-scale primary servicers have clearly been challenged by federal and state anti-foreclosure programs – a scenario that equals business opportunity for specialty servicers, says Amy Brandt, CEO of Acqura Loan Servicing's parent company, Vantium Capital. "Specialty servicers that will succeed in this space will do so by helping traditional servicers meet these specific requirements," she says. "The flip side of that is that much of that business will be component-based – not wingtip to wingtip – so adaptation by the specialty shops will be needed also." But while federal programs – namely the Making Home Affordable suite – have provided opportunity to specialty servicers in terms of component servicing, Brandt notes that mega-servicers have been so determined to implement the programs themselves that they haven't moved to an approach of sending out an asset for end-to-end specialty servicing. "I think they should consider it, because specialty servicers will put the staff ratio and full bag of potential tools to force on these assets, which is needed," she states. "I think sometimes these other programs are narrow in focus and don't get the borrower all the way to a resolution." Most of the specialty services interviewed for this article say they have discussed potential specialty outsourcing arrangements with mega-servicers that are facing bandwidth constraints. For the most part, the industry's largest players appear reluctant, which Lester chalks up to what she calls the "intimidation factor." In a sense, large, primary servicers that are handling high default volumes in addition to the normal ebb and flow of performing-loan servicing are no different from creditworthy borrowers who have fallen behind on their payments for the first time – they are in an unfamiliar situation and may be unwilling to show a sign of weakness, she says. "I see the same thing happening in the very large shops where they don't want to admit they have a problem, so they're not going to partner with someone or ask for help," Lester says. "And if they do, it's going to be very hush-hush. "The unfortunate thing is, people are staffed appropriately to take care of millions of loans up front, and they're staffed inappropriately to take care of what are now thousands and thousands of workout files," she adds. "It's an unintentional problem, but it's a problem that needs to be dealt w
