WORD ON THE STREET: The weaknesses that have been identified in mortgage servicing practices during the mortgage crisis are a by-product of both rapid growth in the number of problem loans and a compensation structure that is not well designed to deal with these loans.
As recently as 2005, when average U.S. homes prices were still rising rapidly, fewer than 800,000 mortgage loans entered foreclosure on an annual basis. By 2009, the annual total had more than tripled to over 2.8 million, and foreclosures through the first three quarters of this year are running at an annualized pace of more than 2.5 million.
Moreover, the proportion of foreclosure proceedings actually resulting in the repossession and sale of collateral appears to have increased even more rapidly over this period in some of the hardest-hit markets. Data published by the Federal Housing Finance Agency show that the percentage of total home sales in California resulting from foreclosure-related distressed sales increased more than eight-fold, to over 40% of all sales, between 2006 and 2008.
The share of U.S. mortgage loans held or securitized by the government-sponsored enterprises (GSEs) and private issuers of asset-backed securities has doubled over the past 25 years to represent a full two-thirds of the value of all mortgages currently outstanding. One effect of this growth in securitization has been parallel growth in third-party mortgage servicing under pooling and servicing agreements (PSAs). By definition, a large portion of the mortgages sold or securitized end up serviced under PSAs.
The traditional structure of third-party mortgage servicing fees, which was put in place well before this crisis, has created perverse incentives to automate critical servicing activities and cut costs at the expense of the accuracy, reliability and currency of loan documents and information.
Prior to the 1980s, the typical GSE mortgage pool paid a servicing fee of 37.5 basis points (bps) annually, or 0.375% of the outstanding principal balance of the mortgage pool. Since the 1980s, the typical servicing fee for prime loans has been 25 bps. When Alt-A and subprime mortgages began to be securitized by private issuers in the late 1990s, the standard servicing fees for those loans were set higher, typically at 37.5 bps for Alt-A loans and 50 bps for subprime loans.
While this fee structure provided a steady profit stream for servicers when the number of defaulted loans remained low, costs rose dramatically with the rise in mortgage defaults in the latter half of the last decade. As a result, some mortgage servicers began running operating losses on their servicing portfolios.
One result of a compensation structure that did not account for the rise in problem loans was a built-in financial incentive to minimize the investment in back-office processes necessary to support both foreclosure and modification. The other result was consolidation in the servicing industry. The market share of the top five mortgage servicers has nearly doubled since 2000, from 32% to almost 60%. The purpose and effect of consolidation are to cut costs and achieve economies of scale, but also to increase automation.
Most PSAs allow for both foreclosure and modification as a remedy to default. But servicers have continuously been behind the curve in pursuing modification as an alternative to foreclosure. A survey of 13 mortgage servicers conducted by the State Foreclosure Prevention Working Group shows that the annual percentage of all past-due mortgages that are being modified has risen from just over 2% in late 2007 to a level just under 10% as of late 2009. At the same time, the percentage of past-due loans entering foreclosure each year has also risen steadily over this same time period, from 21% to 32%.
One example of the lack of focus on loss mitigation strategies is the uncoordinated manner in which many servicers have pursued modification and foreclosure at the same time. Under such a ‘dual-track’ process, borrowers may be attempting to file the documentation needed to establish their qualifications for modification and waiting for a favorable response from the servicer, even while that servicer is simultaneously executing the paperwork necessary to foreclose on the property.
While, in some cases, it may be reasonable to begin conducting preliminary filings for seriously past-due loans in states with long foreclosure timelines, it is vitally important that the modification process be brought to conclusion before a foreclosure sale is scheduled.
Failure to coordinate the foreclosure process with the modification process risks confusing and frustrating homeowners and could result in unnecessary foreclosures. We recommend that servicers establish a single point of contact that can work with every distressed borrower and coordinate all activities taken by the servicer with regard to that particular case.
Since the early stages of the mortgage crisis, the Federal Deposit Insurance Corp. (FDIC) has made a concerted effort to promote the early modification of problem mortgages as a first alternative that can spare investors the high losses associated with foreclosure, assist families experiencing acute financial distress, and help to stabilize housing markets where distressed sales have resulted in a lowering of home prices in a self-reinforcing cycle.
In 2007, when the dimensions of the subprime mortgage problem were just becoming widely known, I advocated in speeches, testimony and opinion articles that servicers not only had the right to carry out modifications that would protect subprime borrowers from unaffordable interest-rate resets, but that doing so would often benefit investors by enabling them to avoid foreclosure costs that could run as high as 40% or more of the value of the collateral.
In addition, the FDIC, along with other federal regulators, jointly hosted a series of roundtables on the issues surrounding subprime mortgage securitizations to facilitate a better understanding of problems and identify workable solutions for rising delinquencies and defaults, including alternatives to foreclosure.
More recently, the FDIC has been actively involved both in investigating and addressing robo-signing and documentation issues at insured depository institutions and their affiliates, ensuring that its own loss-share partners are employing best practices in their servicing operations and implementing reforms that will better align the financial incentives of servicers in future securitization deals.
The FDIC is exercising both its primary and backup authorities to actively address the issues that have emerged regarding banks' foreclosure and robo-signing practices. The FDIC is the primary federal supervisor for nearly 5,000 state-chartered insured institutions, where we monitor compliance with safety and soundness and consumer- protection requirements and pursue enforcement actions to address violations of law.
Although the FDIC is not the primary federal regulator for the major loan servicers, our examiners are working on-site under our backup authority as part of an inter-agency horizontal review team at 12 of the 14 major mortgage servicers, along with their primary federal regulators. This inter-agency review is also evaluating the roles played by MERS and Lender Processing Services, a large data processor used by many mortgage servicers.
The FDIC is committed to active participation in horizontal reviews and other inter-agency efforts so we are able to have a comprehensive picture of the underlying causes of these problems and the lessons to be learned. The on-site reviews are finding that mortgage servicers display varying degrees of performance and quality control.
Program and operational deficiencies may be correctable in the normal course of business for some, while others may need more rigorous system changes. The level and adequacy of documentation also varies widely among servicers. Where chain of title is not sufficiently documented, servicers are being required to make changes to their processes and procedures. In addition, some servicers need to strengthen audit, third-party arrangements and loss mitigation programs to cure lapses in operations.
However, we do not believe that servicers should wait for the conclusion of the inter-agency effort to begin addressing known weaknesses in internal controls and risk management. Corrective actions on problems identified during a servicer's own review or the examiner's review should be addressed as soon as possible.
We expect each servicer to properly review loan documents prior to initiating or conducting any foreclosure proceedings, to adhere to applicable laws and regulations, and to maintain appropriate policies, procedures and documentation. If necessary, the FDIC will encourage the use of formal or informal corrective programs to ensure timely action is taken.
Actions taken as receiver
In addition to our supervisory efforts, the FDIC is looking at the servicing practices of institutions acquiring failed institutions under loss-share agreements. To date, there are $159.8 billion in loans and securities involved in FDIC loss-share agreements, of which $56.7 billion (36%) are single-family loans.
However, the proportion of mortgage loans held by acquiring institutions that are covered by loss-share agreements is, in some cases, very small. For example, at One West Bank, the successor to Indy Mac, only 8% of mortgages serviced fall under the FDIC loss-share agreement.
An institution that acquires a single-family loss-share portfolio is required to implement a loan modification program, and is also required to consider borrowers for a loan modification and other loss mitigation alternatives prior to initiating foreclosure. These requirements minimize the FDIC's loss-share costs.
The FDIC monitors the loss-share agreements through monthly and quarterly reporting by acquiring bank and semi-annual reviews of the acquiring bank. The FDIC has the right to deny or recover any loss-share claim where the acquiring institution is unable to verify that a qualifying borrower was considered for a loan modification and that the least-costly loss mitigation alternative was pursued.
In connection with the recent foreclosure robo-signing revelations, the FDIC contacted all of its loss-share partners. All partners certified that they currently comply with all state and federal foreclosure requirements.
We are in the process of conducting a loan servicing oversight audit of all loss-share partners with high volumes of single-family residential mortgage loans and foreclosures. The FDIC will deny any loss-share payments or seek reimbursement for any foreclosures not compliant with state laws or not fully remediated, including noncompliance with the loss-share agreements and loan modification requirements.
Regulatory actions to reform securitization
We are also taking steps to restore market discipline to our mortgage finance system by doing what we can to reform the securitization process. In July, the FDIC sponsored its own securitization of $471 million of single-family mortgages. In our transaction, we addressed many of the deficiencies in existing securitizations.
First, we ensured that the servicer will make every effort to work with borrowers in default, or where default is reasonably foreseeable. Second, the servicing arrangements in these structured loan transactions have been designed to address shortcomings in the traditional flat-rate structures for mortgage servicing fees. Our securitization pays a base dollar amount per loan per year, regardless of changes in the outstanding balance of that loan.
In addition, the servicing fee is increased in the event the loan becomes more complex to service by falling past due or entering modification or foreclosure. This fee structure is much less likely to create incentives to slash costs and rely excessively on automated or substandard processes to wring a profit out of a troubled servicing portfolio.
Third, we provided for independent, third-party oversight by a master servicer. The master servicer monitors the servicer's overall performance and evaluates the effectiveness of the servicer's modification and loss mitigation strategies.
And, fourth, we provided for the ability of the FDIC, as transaction sponsor, the servicer and the master servicer to agree on adapting the servicing guidelines and protocols to unanticipated and significant changes in future market conditions.
The FDIC has also recently taken the initiative to establish standards for risk retention and other securitization practices by updating its rules for safe-harbor protection with regard to the sale treatment of securitized assets in failed bank receiverships.
Our final rule, approved in September, establishes standards for disclosure, loan quality, loan documentation and the oversight of servicers. It will create a comprehensive set of incentives to ensure that loans are made and managed in a way that achieves sustainable lending and maximizes value for all investors. In addition, the rule is fully consistent with the mandate under the Dodd-Frank Act to apply a 5% risk-retention requirement on all but the most conservatively underwritten loans when they are securitized.
We are currently working, on an inter-agency basis, to develop the Dodd-Frank Act standards for risk retention across several asset classes, including requirements for low-risk Qualifying Residential Mortgages (QRMs) that will be exempt from risk retention. These rules allow us to establish a gold standard for securitization to encourage high-quality mortgages that are sustainable for the long term. This rulemaking process also provides a unique opportunity to better align the incentives of servicers with those of mortgage pool investors.
We believe that the QRM rules should authorize servicers to use best practices in mitigating losses through modification, require compensation structures that promote modifications and direct servicers to act for the benefit of all investors. We also believe that the QRM rules should require servicers to disclose any ownership interest in other whole loans secured by the same real property, and to have in place processes to deal with any potential conflicts.
Some conflicts arise from so-called ‘tranche warfare’ that reflects the differing financial interests among the holders of various mortgage bond tranches. For example, an investor holding the residual tranche typically stands to benefit from a loan modification that prevents default. Conversely, the higher-rated tranches might be better off if a servicer foreclosed on the property, forcing losses to be realized at the expense of the residual tranche.
A second type of conflict potentially arises when a single company services a first mortgage for an investor pool and the second mortgage for a different party, or for itself. Serious conflicts such as this must be addressed if we are to achieve meaningful long-term reform of the securitization process.
Therefore, the FDIC believes it would be extremely helpful if the definition of a QRM were to include servicing requirements that, among other things:
- Grant servicers the authority and provide servicers compensation incentives to mitigate losses on residential mortgages by taking appropriate action to maximize the net present value of the mortgages for the benefit of all investors rather than the benefit of any particular class of investors;
- Establish a pre-defined process to address any subordinate lien owned by the servicer or any affiliate of the servicer; and
- Require disclosure by the servicer of any ownership interest of the servicer or any affiliate of the servicer in other whole loans secured by the same real property that secures a loan included in the pool.
Risk-retention rules under the Dodd-Frank Act should also create financial incentives that promote effective loan servicing. The best way to accomplish this is to require issuers – particularly those who also are servicers – to retain an interest in the mortgage pool that is directly proportional to the value of the pool as a whole.
Frequently referred to as a ‘vertical slice,’ this form of risk retention would take the form of a small, proportional share of every senior and subordinate tranche in the securitization, creating a combined financial interest that is not unduly tilted toward either senior or subordinate bond holders.
Sheila Bair is chairwoman of the FDIC. This article is adapted from a speech given before the Committee on Banking, Housing and Urban Affairs on Dec. 1.