Servicing costs rising for private loan pools. (Servicing).

WALL STREET'S CREATIVITY AND ITS insatiable appetite for whole loans have been a profitable blessing to secondary marketing managers. Yet they have been a costly curse to investor accounting departments. Investor accounting costs are rising sharply in many firms that sold and continued to service large groups of whole loans with scheduled interest and scheduled principal remittance requirements.

Senior executives need to fully understand the problems servicing departments face with private pools, because resolving them will require significant outlays for people and technology. The cost per loan to service private deals is likely to increase from 10 percent to 30 percent over the next year.

These costs could outstrip savings generated by greater efficiency in other areas of servicing, according to servicing and investor accounting managers interviewed for this column. On the other hand, servicing fees for loans in private pools are more than 25 basis points, and the average loan balances are higher than agency levels, Typically, sales of loans into the pools have been profitable for sellers and improved their risk position.

Over the past 24 months, most of the fieldwork the Mortgage Dynamics Inc. (MDI) Investor Accounting Center in Denver has performed involved servicers' problems with private whole loan packages. This column is based on our consulting experiences and/or interviews with 10 companies, five of which are among the 20 largest servicers.

These companies are addressing these issues as servicers, master servicers, subservicers or all three. All of the major servicing systems are represented by these servicers. All parties interviewed requested that neither their names nor company names be used.

The transactions

Whole loan sales and private securities are not new. The current problems discussed here have been building for the past few years as the volume of whole loan sales has risen dramatically and the products and servicing agreements have moved further away from Fannie Mae and Freddie Mac norms.

A major wrinkle is that resales of individual loans within pools have mushroomed. "These transactions are killing us," the head of investor accounting for a large servicer says. "We used to see maybe one trade of a subset of loans in a pool once every six months. Now we see reconstitutions within the same pool three to four times in 12 months. The servicer finds out about the sale at the last minute, or after the fact. Sometimes we find out when we send the check and report for the pool, [and] the investor tells us some of the loans have been sold to a new investor."

In some cases, securities are being called, then the loans are combined with other loans and new securities are issued. Some servicers say that their reconstitutions are five times what they were a few years ago.

Frequently, the managers are faced with late investor notification of a sale--or no notification at all, sales to the new investor at incorrect scheduled balances and servicing systems that do not handle these complex reporting and bank account reconciliation tasks. They have no choice but to do much of their work offline.

The credit levels involved in these transactions range from subprime to A-plus-quality loans. Loan products range from traditional mortgage products to inventive products such as interest-only loans, skip-payment and nonperforming loans (i.e., early pool Ginnie Mae buyouts).

"Some of the products, such as daily simple interest loans and nonperforming loans, are not well-suited to scheduled/scheduled remittances, but are being sold that way," one manager says. "Capital markets guys are moving forward with these programs, often without appropriate communication with servicing, so we don't have adequate time to prepare for these products, and our systems will not support the investor accounting functions for them." Most of the managers we interviewed have sought and obtained better communication with capital markets department staffs.

More odd products are coming into pools. They include loans where a third party makes payments when the borrower cannot. Some investors are allowing more modifications of loans in pools. Although handling them is difficult and often wipes out the servicing fee, the company retains its original purchase premium.

The problems are compounded by the fact that each investor has its own servicing agreement, usually with standards and requirements that do not match those of the agencies--particularly in the default area. Consequently, each time a loan is sold to a new party, the loan becomes subject to a different agreement. Keeping track of the servicing requirements at loan level is difficult and expensive. "Seeing that we are doing it right is a real challenge?" one manager says.

Just imagine the challenge presented by a seriously delinquent loan sold to a buyer on a scheduled/scheduled basis, then resold each of the next three months. The servicer must keep up with the amount each of the four investors is entitled to receive. Every time the loan changes hands, it is governed by a new servicing agreement, possibly with different loss-mitigation rules. Also, the servicer must keep up with who holds the recourse on each loan. If an interim investor retained the recourse and sold the loan to an agency, this affects filing the claim.

"Our capital markets group buys delinquent loans out of Ginnie Mae pools and resells them in private pools. We have to make P&I [principal and interest] advances on these loans, and many are going to foreclosure sale within the first month that we are reporting on them. Now we have to transfer the loan out into a new investor. We have to make sure it is reported correctly, and then deal with the bank reconciliation. The only way to do that is with spreadsheets [and offline] databases," says one of the managers we interviewed.

Another common situation is that the investors have moved away from the standard monthly reports available in most systems for loans serviced for others (LSFO) and now require customized reports. Some buyers, particularly those for subprime, nonperforming and alt-A products, want a great deal more loan-level information each month. Many of the companies have set up secure Web sites where investors can view information without violating customer confidentiality restrictions, Investors are becoming more active in making sure their servicers are collecting aggressively, especially on subprime loans.

Systems issues

None of the investor accounting managers we worked with or interviewed had systems that automated all of the tasks described here. In all cases, investor accountants have to do many tasks manually or on spreadsheets.

"Our systems vendor is trying to make enhancements to support us, but Wall Street is moving faster than they can keep up," one manager says.

The nonperforming loans have presented perhaps the biggest systems challenge, as frequently the last paid-to-dates are several months before the security date.

The manager who was using an in-house system had more flexibility and had hired an outside firm to help make changes to the system. Most servicers are making a lot of manual adjustments and calculations, and developing Microsoft[R] Excel and Access spreadsheets to supplement the servicing system. Many of the managers brought in consultants as advisers or workers, or they outsourced various tasks.

Bank account issues

The bank accounts related to these transactions have been difficult because of the reconstitutions and the workarounds to handle nonstandard loans, especially nonperforming ones, and the inability of servicing systems to support the reconciliations.

"It is a challenge to ensure that money makes its way into the correct bank accounts," one manager says.

It is not uncommon to have one bank account for each pool, so many of the companies have hundreds--and even thousands--of bank accounts. The bank account reconciliation method is supposed to ensure that the cash in the bank account is reconciled to the expected amount that should be in the account.

Sales made using incorrect beginning scheduled balances, delinquent loans with payments owed to several investors, and manual reporting completed offline make it hard to determine what is expected in the account. Problems have included backlogs, money in the wrong accounts and not being able to identify the loans that are causing the cash differences.

New skill sets needed

Although servicing for the agencies' accounts for the vast majority of loans and dollars in their portfolios, most of the managers interviewed say the staff structure is changing. In one case, private pools account for around 10 percent of the loans, but the private pool investor accounting staff has grown to twice the size of the agencies' staff.

Most of the companies had either hired, or were recruiting, four to six additional people for private pools. All were seeking a similar skill-set: good investor communications skills, problem-solving capability and analytical skills to work on Excel and Access spreadsheets outside the servicing system.

Strong investor accounting skills are sought, but in many cases the managers know they will have to settle for strong accounting backgrounds because so many investor accountants have left the industry. Several managers say they expect to spend considerable time explaining why they need these skills that command higher salaries than the levels reflected in the typical human resources salary surveys.

No easy solutions

Working with capital markets/secondary marketing is critical to reducing the headaches of servicing private pools. The financial realities of these transactions make it unlikely that servicing can have veto power. However, at a minimum, servicing should be involved early in each proposed deal to educate everyone to the cost/feasibility of various requirements.

"Investors are asking for so many things over and beyond those of past transactions," another manager says. "Now capital markets folks know they cannot agree to certain things without getting additional fees for them," he says.

There is also a need to consider possible legal ramifications that could result when loans move into pools with very different servicing provisions. An example would be when one sells a delinquent loan under a forbearance plan to a buyer whose loss-mitigation options are more restrictive.

Until there is more standardization in the servicing agreements and reporting for these transactions, and at least some minimum notification period for sales of loans from the pools, investor accounting costs are likely to remain high for private pools. As servicers seek interim tools, they will do their best to remind management of the financial rewards they achieved when the transactions took place.

Mary Bruce Batte is a managing director and owner of Mortgage Dynamics Inc. (MDI), McLean, Virginia. MDI is a management consulting and outsource services firm. She can be reached at [e-mail]. Melanie Smith, senior consultant, and Chris Duran, manager, both with the MDI Investor Accounting Center in Denver, contributed to this column.