When executives of FirstCity Capital Corp. launched their company a year ago, they faced all of the challenges of a company just starting out.
One of the most crucial for FirstCity was how to service the home equity loans they were about to begin purchasing. Did they want to service the loans in house or outsource them to a servicer? And if FirstCity did decide to contract out the servicing, what company would be entrusted with the job?
FirstCity first decided to outsource and then, following an intensive review, chose an outsourcing vendor.
A year later, FirstCity is confident it made the right decision.
FirstCity's experience is a common one in the subprime lending industry, according to Sam Tabet, senior vice president with Lehman Brothers Asset Backed Securities Group in New York. There are a host of reasons why originators, especially companies just starting up, need to consider outsourcing servicing to a third party before they tackle it themselves, Mr. Tabet says.
"When you consider the capital investment it requires to establish a credible servicing platform-from erecting the technological infrastructure to hiring the expertise to run it-it's clear that partnering with a well- known third party servicer is advantageous and it is a strategy we recommend, especially for the first 12 or 24 months," Mr. Tabet says.
And outsourcing isn't just for new originators. Mr. Tabet says major companies that service their own loans should consider outsourcing if they reach or exceed capacity or acquire a new product with which they have limited experience.
"For example, if an originator specializes in second mortgages and adds a home equity line of credit product, they will probably save a lot of time, money, and headaches by outsourcing the servicing because lines of credit are a different breed and require a different style of servicing," Mr. Tabet says.
Also, when selecting a third-party servicer, it is crucial that originators pick from a very short list of servicers that Wall Street considers credible and able to do the job properly, Mr. Tabet says.
"Because many of these loans are securitized and the originators are looking at accessing the capital markets, the quality of the servicer is right up there in importance with the quality of the collateral," Mr. Tabet says. "It's extremely important to retain the expertise of a servicer who has been in the business and is known to investors, the bond insurers, and the rating agencies."
That decision not only can have an impact on bond ratings and the credit terms the originator can arrange, but whether the deal gets done at all.
"In financing these kinds of assets, an originator will always get more favorable terms if an established company like Advanta is servicing their loans as opposed to some small xyz company which may be just starting out," Mr. Tabet says. "In fact, in certain instances, the rating agencies will require a backup servicer if they feel the servicer selected is too weak."
In FirstCity's case, Advanta Mortgage was the choice. More than two dozen originators have turned to Advanta for help since it began offering third-party subprime loan servicing in 1992. In the six years since, the servicing unit has grown rapidly to servicing more than 225,000 loans worth $14 billion.
I believe a key factors contributing to the ongoing boom in third-party loan servicing is cost. Outsourcing takes an organization's fixed cost associated with servicing its own loans and turns it into a variable cost, and there is no cost at all until the first loan is placed. Why should somebody spend a fortune to erect a complicated infrastructure to service their own loans when an outsourcer can do it for them cheaper?
In fact, most of the time Advanta, for one, can do it for half the cost they can do it for internally. That frees up capital that can be invested in what their company does best, which is loan production or acquisition.
Chris Morrissey, FirstCity's president and chief operating officer, offered a critical criterion in choosing its outsourcer. "When we use the capital markets as a source of financing, it's important that the servicing end of the deal get good marks," he said.
In the world of subprime lending, with its enhanced risk attributes, those who master the efficient collection, integration and analysis of information are going to win. It is that simple. Data is king. "At Advanta, we use it to establish and maintain a close relationship with borrowers and to clearly understand their ability or inability to make loan payments. On behalf of our clients, it helps us predict delinquency, benchmark overall portfolio performance, enhance investor reporting, and assist in planning future securitizations.
Critical to an outsourcing vendor's ability to stay on top of technology, I believe, is designing and operate its own systems rather than outsourcing them. This helps maintain high levels of responsiveness for clients, including being able to accept a servicing conversion within weeks of a client request.
Almost as critical is the selection of system software. Vendors need a system that allows them to easily add on a host of specific services and products to help increase overall services to clients.
Our own choice at Advanta, LSAMS, has helped us achieve seamless electronic data interchange with our clients."
'Both flow and bulk acquisition methods can be supported through our electronic data interchange."
A couple of years ago, when clients came on board, they had to first create a hard-copy servicing file, which took two or three days at the copier. They then put it in the mail to Advanta where it had to be keyed into the system manually. The net effect was an interruption in the servicing activity in the critical early days.
Today, it is virtually effortless and instantaneous, which is important in the subprime business, where the pace is much quicker than in the conforming world. Every client gets a data dictionary that tells them how to format their loan files so that with a push of a button, the information zips electronically into our system.
We believe technology is so crucial to its success that we continues to invest heavily in new systems. One example is an enhanced delinquency predictor model using both proprietary data and Fico scores to help determine the queuing and decision-making that needs to occur in collecting an account.
We are uncertain how long we and our clients can ride the expansion wave simply because no one knows how long the surge in subprime lending will last. But we sees opportunities for growth in the special servicing arena.
Some of the loan pools have seasoned 18 and 24 months and those who were involved in servicing such loans have discovered that they were dealing with an entirely different risk profile than the conforming world, with a lot more work and problems than they anticipated. We think our specialized competencies provide an aftermarket opportunity in special servicing pools that need extra attention.