In structured finance transactions, servicer transition risk is ever-present. Even more so in times of high market volatility. The speed and efficiency with which a servicer is replaced can affect collateral performance as it directly affects transactions' cash flows.

Analysis by S&P Global Ratings shows potential exposure to servicer transaction risk across the Australian structured finance sector is low. About 97% of total residential mortgage-backed securities (RMBS) loans outstanding in rated trusts have back-up servicer arrangements in place or the servicing functions are done by parties with an investment-grade rating.

Across the Australian asset-backed securities (ABS) sector, all transactions rated by S&P Global Ratings have a back-up servicer in place and/or the current servicer has an investment-grade rating. A key rating assumption is that the servicer will need to be replaced, and that a willing and able replacement must be available.

To date, servicer transitions have occurred relatively seamlessly, with a number having occurred in the years following the financial crisis. This is testament to the broad market of willing participants for third-party servicing for mortgages and the solid level of servicing skill and experience across the mortgage sector, the largest structured finance asset class in Australia.

The State Of Play In The Australian Loan-Servicing Market

We consider the third-party servicer sector in Australia to be strong. Capacity within the sector is not limited to one party. It extends beyond the role of trustees as back-up servicers of last resort outlined under many transaction documents of Australian RMBS deals we rate.

Competition in the domestic third-party servicing market has grown in the wake of the 2008 financial crisis. Existing originators have expanded operations to include third-party servicing operations; existing third-party servicers retain an interest in expanding operations; and trustees active in the Australian market continue to expand and develop their own third-party servicing operations.

Many of the parties identified as potential back-up servicers have a long history of servicing experience. The performance of RMBS transactions should, therefore, derive support from an expectation of a smooth transition to a replacement servicer if a series of servicer termination events were to occur.

Scale Of Outstanding Australian RMBS Exposed To Servicer Transition Risk

The Australian RMBS sector faces minimal exposure to servicer transition risk, according to S&P Global Ratings analysis. Whether existing servicers can absorb the potential demand for replacement servicers depends on the potential scale of RMBS asset pools that may need a new servicer.

In assessing the potential scale of the issue, we have sought to identify and analyze the volumes of outstanding RMBS that could reasonably need to be transferred to a replacement servicer in the short to medium term.

After identifying issuers of outstanding RMBS least likely to face servicer transition caused by financial difficulties--in particular, investment-grade issuers--and those with back-up servicing agreements and plans in place, we believe the potential exposure decreases meaningfully (chart 1).

Based on this analysis, we estimate that about 97% of total RMBS loans outstanding in rated trusts have back-up service arrangements in place or that the servicing and origination functions are done by issuers with an investment-grade rating.

RMBS programs in which the servicer is unrated or the rating is below investment grade and have no back-up servicer arrangement are more common among some programs originated by small bank lenders and some credit unions. These lenders are all regulated by the Australian Prudential Regulation Authority.

Given the small size of many of these programs, existing servicers could absorb the potentially higher demand for replacement servicers more smoothly, with limited impact on RMBS asset performance. By small size, we mean that total outstandings across these originators is less than A$4 billion and exposure to any one originator is less than A$1 billion.

Smaller lenders are more susceptible to strong competition from Australia's more established lenders. There have been several successful servicer transition events completed in the Australian market. To date they have had no adverse effect on RMBS performance for affected portfolios.

Chart 1

Our analysis assumes that investment-grade servicers, which in our opinion are least likely to default, would be most unlikely to require a back-up servicer in the event of a corporate failure.

How Exposed Are Nonbank Originators To Servicer Disruption Risk?

Nonbanks have limited funding options beyond securitization. Consequently, prolonged market volatility and dislocation can curtail new lending and, in turn, impede business operations. In the period following the financial crisis, a small number of nonbank originators ceased mortgage originations. This resulted in several servicer transition events.

In Australia, nonbank originators issuing RMBS transactions rated by S&P Global Ratings typically all have back-up servicer arrangements with established players to mitigate servicer disruption risk (see chart 2).

Chart 2

Lenders with back-up servicing arrangements have an added degree of protection from a business continuity perspective and can mitigate potential rating caps that may apply if servicer risk is moderate.

Portability Risk Is Low For The Australian RMBS Sector

Our operational risk analysis includes portability risk, or the likelihood that the key transaction party such as a servicer could be replaced if needed. We base portability risk on a review of the following five primary risk factors (see "Global Framework For Assessing Operational Risk In Structured Finance Transactions," Oct. 9, 2014):

• The market depth of qualified replacement key transaction parties, given the asset class and region.
• The fee incentive for a replacement key transaction party.
• The degree to which the key transaction party's systems and business practices would be compatible with those of a potential replacement.
• The issuer's right to terminate a key transaction party when its performance is materially disrupted.
• Whether a control party (e.g., the trustee or master servicer) is responsible for appointing a replacement key transaction party in the event the initial key transaction party needs to be replaced.

For mortgage servicers in the Australian RMBS sector we make the following assessments: there is a broad market of willing participants for third-party servicing functions; a solid level of servicing skill and experience in managing such a transition; and that the servicers could be replaced by a third party. The relative homogeneity of most mortgage products also contributes to the lower portability risk for the sector.

Further mitigating the transition risk is the prevalence of direct-debit loan payments in the Australian market. This facilitates management of payments following a servicer transition.

In addition, in many of the servicers most at risk, loans are originated in the name of a trustee. This makes the servicer transition a more straightforward issue of counterparty replacement rather than replacement and the added overhead of completing assignment and transfer formalities to perfect title in the assigned assets.

Servicer Transitions: Relatively Seamless So Far

To date, servicing transitions have been well managed in the Australian RMBS sector. There has been no material impact on arrears or rating performance for affected transactions. Experience to date has shown that servicer transition can improve the performance of a pool.

As originators/servicers face their own financial challenges, RMBS loan pool performance can weaken due to financial and resource constraints at a servicer. Similarly, loan management outcomes can improve by moving to an alternate servicer with more resources.

How Exposed Is The Australian ABS Sector To Servicer Transition Risk?

The Australian asset-backed securities (ABS) sector has a low exposure to servicer disruption risk. The sector rated by S&P Global Ratings comprises about 20 transactions across a range of asset classes, including autos, equipment receivables, credit card receivables, and buy now, pay later receivables. Of these transactions, about 81% have a back-up servicer arrangement in place; the remainder have servicers with investment-grade ratings (chart 3).

ABS Replacement Risk Exposure

Chart 3

For more esoteric asset classes, portability risk can be higher, given the bespoke nature of the assets or lack of market depth of replacement service providers. In this case, the performance of the assets starts to link to the credit strength of the servicer, and rating caps could apply.

Chart 4

Cyber Attacks And Servicer Disruption Risk

In the event of a cyber attack, a servicer typically poses the largest potential for payment disruption in a securitization, in our view. This is because the performance of the receivables, which are the primary source of cash flow to repay the rated notes, could be directly affected by a cyber event at the servicer.

Many of the structural features already in place to ensure operational continuity in structured finance transactions have positive spill-over effects on cyber readiness. These include cash reserves to address liquidity risks, performance triggers that may change the priority of payments, and replacement provisions for key transaction parties that may become materially affected by a cyber event (see "How Could Cyber Risks Affect Structured Finance Transactions," Sept. 8, 2021).

Australian Structured Finance Sector Well Placed To Weather Any Servicer Transition Events

Despite the heightened market volatility, we believe the Australian structured finance sector is well placed to manage any servicing transition events due to market forces. Underpinning this resilience are the contingency plans already in place, including back-up servicing arrangements, and the depth of potential third-party mortgage servicing providers with suitable experience and skill.

In the case of RMBS, the relative homogeneity of most mortgages also helps to ensure any potential servicer transitions should be relatively seamless, as demonstrated historically.

Editor: Lex Hall

Related Research

• How Could Cyber Risks Affect Structured Finance Transactions, Sept. 8, 2021
• Global Framework For Assessing Operational Risk In Structured Finance Transactions, Oct. 9, 2014