The 800 Pound Gorrilla in the Room: Servicers Profit While Investors Face Losses

Background: Much of the attention of the housing crisis has focused on homeowners and lenders. Often, the business press uses the word “lender” to include the role of “servicer” as though the differences between them are inconsequential. These differences do in fact matter. This paper will shed light on the power of the mortgage servicing industry to determine the outcome[1] of mortgage delinquencies to the detriment of investors and homeowners. An environment of increasing delinquencies provides servicers with incentives to pursue their own self interests at the expense of investors and borrowers. Existing compensation structures, lack of oversight, informational asymmetry and consolidation of the mortgage servicing industry ensure servicers can act in their own interests with limited impunity. This paper further suggests a servicer with restructured incentives aligned with that of the investors would make the government bailout plans more effective in keeping homeowners in their homes.

What a servicer does?

The servicer manages mortgage loan portfolios and the relationship with the borrower on behalf of the investor. In exchange it receives a for a series of fees, the structure of which is ripe with the possibility of misalignment of interests. The mortgage servicer collects mortgage payments; maintains and collects escrow payments for taxes and insurance; and provides reports and distributes principal and interest payments to the investors.[2] When loans fail to perform, a special servicer manages delinquent loans.[3] The special servicer conducts negotiations and executes agreements with delinquent borrowers; initiates and manages the foreclosure process; and maintains, repairs, and manages the sale of foreclosed properties. [4]

How servicers get paid?

When loans are performing servicers generate most of their income through flat servicing fees based on the unpaid principal balance of the loans. When loans become delinquent, the lack of cash flow causes fees to be deferred until a cash-generating resolution occurs, but the opportunity to increase the fees grows more than enough to compensate for the delay. Such sources of ancillary revenue include penalty fees for late payments[5], “foreclosure fees and costs, insufficient funds charges, property inspection fees, broker price opinions or appraisals, corporate advances, post-petition fees and suspense funds.”[6] However, often times the fees charged are illegitimate. A review of over 1700 bankruptcy cases exposed the fact that most of the servicing fees charged could not be substantiated as being justifiable.[7] These fees all flow to the servicer, not the investor.[8]

Misalignment of Interests

Ancillary fees, which are profit centers for servicers, result in significant losses to investors. The servicer is ensured collection of the fees and costs[9] as they are received prior to the investor getting any proceeds.[10] Any deficiencies are covered from the securitized pool.[11] Increased fee rates on defaulted loans along with the certainty of receiving them encourages the servicer to lengthen the duration of default status,[12] further reducing the value of the mortgage pool to the investor.[13] Additionally, in a market of declining home equity, investors face greater likelihood of a loss of principal when servicers aggressively charge ancillary fees.

Servicers Have the Authority to Implement Alternatives to Foreclosure

Not only do servicers have multiple options other than foreclosure, they also have the authority to determine which option to use.[14] According to the American Securitization Forum most servicing contracts for subprime loans authorize the servicer to modify loans including forgiving principal among[15] other loss mitigation techniques.[16] Restrictions on modifications such as limits on the number of loans able to be modified without investor or rating agency approvals affect “only a minority of transactions.”[17] Servicers do not have greater legal exposure to investors simply because they conduct modifications, which include principal reductions. Servicers have an obligation to maximize net present value while minimizing investor losses.[18] In doing so, servicers are just as likely to face investor lawsuits from investors for conducting not enough modifications as well as for too many.[19] Further, “servicers are already reasonably well-protected from legal action by investors, since under typical servicing contracts they are liable only in the event of their negligence in performing their duties.”[20]

Servicers can choose the option which maximizes the net present value and is in the interests of the investors in the aggregate, not individually.[21]

Servicers utilize foreclosure or options which delay foreclosures to maximize profit at investors’ expense

Foreclosures, no actions, and repayment plans are used in 90% of the loans over 60 days in default.[22] Loan modifications are used in the remainder of the cases.[23] Repayment plans and no actions only delay foreclosure. Loan modifications, which have the potential to preserve investor interests, are used the least and used in a manner which does not provide a permanent solution. According to Professor Alan White’s study of monthly servicer remittance reports loan modifications utilized generally do not provide principal reduction, and lower monthly payments but often increase debt.[24] The modifications used, thus, “only delay, but not prevent the large numbers of foreclosures.”[25]

Loan modifications using principal reductions are in the best interests of the investors as it avoids foreclosure.

Loan modifications with principal reduction are better for investors and borrowers but few[26] have been conducted. Federal Reserve Chairman Ben Bernake and 71 percent of economists in a New York Times survey concluded foreclosures can be avoided through reduction in principal which would allow borrowers with negative equity to refinance.[27] The American Securitization Forum stated loan modifications maximize net present value of investor proceeds through avoidance of foreclosure costs and the reduction of home values.[28] Counseling agencies and legal offices reporting to the California Reinvestment Coalition survey also overwhelmingly indicated principal write downs though necessary to maintain homeownership were rarely utilized.[29]

If principal reductions are in the best interests of the investor why aren’t the best interests of the investors as it avoids foreclosure.

Loan modifications with principal reduction are better for investors and borrowers but few[26] have been conducted. Federal Reserve Chairman Ben Bernake and 71 percent of economists in a New York Times survey concluded foreclosures can be avoided through reduction in principal which would allow borrowers with negative equity to refinance.[27] The American Securitization Forum stated loan modifications maximize net present value of investor proceeds through avoidance of foreclosure costs and the reduction of home values.[28] Counseling agencies and legal offices reporting to the California Reinvestment Coalition survey also overwhelmingly indicated principal write downs though necessary to maintain homeownership were rarely utilized.[29]

If principal reductions are in the best interests of the investor why aren’t they being implemented?

Not only do servicers have incentives to use strategies which are detrimental to investors, but the means to act with limited impunity. Lack of investor, borrower and regulatory oversight and informational asymmetry between the investor and servicer ensures servicers will act on their self interests. Additionally, the consolidation of the mortgage service industry leaves investors with few alternatives to their current servicers.

Possible private market solution.

A servicing company unencumbered by the baggage of bad practices and with structural and economic incentives for permanent re-performance on the loans would ensure the least losses to the investors. The restructured servicing company generates profits through minimizing foreclosure losses to its investors resulting in a competitive edge in servicing defaulted loans, whether owned by the government or private investors.

Conclusions

Once mortgage loans have been made, Servicers influence the outcome of the loan more than anyone else by acting as agents and fiduciaries of the investors. Increased defaults, however, expose conflicts between investor interests and that of the servicer. The servicers, faced with increasing upfront but reimbursable costs, and higher but delayed revenue, have incentives to pursue strategies that are contrary to investor interests. Servicers are ensured through the contract and market power the ability to act in their self interests to the detriment of the investors. They determine which strategy to use, have informational asymmetry with the investor, and control over the process of executing the strategy. Their senior position in the distribution of proceeds from the disposition of the defaulted loans also secures their ability to act in their own interest. One aspect of the current $700 billion bailout plan indicates the government may purchase defaulted mortgages and restructure them. Its implementation, however, is unlikely to prevent foreclosures on a significant scale without addressing the incentives and actions of the 800 pound gorilla in the room, the servicer.


[1] In 2006 paper by the Federal Reserve Bank of St. Louis demonstrated that servicers significantly impact foreclosure or REO status of loans despite “controlling for observed and unobserved loan and market characteristics.” Anthony Pennington-Cross and Giang Ho. Loan Servicer Heterogeneity and The Termination of Subprime Mortgages Working Paper. Federal Reserve Bank of St. Louis. April 2006. pp. 4, 16 and 19-20. This paper will show that increasing delinquencies and consolidation of the servicing industry provide servicers with incentives and reduce variability among servicers in favor foreclosure.

[2] Anthony Pennington-Cross and Giang Ho. Loan Servicer Heterogeneity and The Termination of Subprime Mortgages Working Paper. Federal Reserve Bank of St. Louis. April 2006 p. 1-2

[3] Id. p. 2 and Yingjin Hila Gan and Christopher Mayer. Agency Conflicts, Asset Substitution, and Securitization Working Paper. National Bureau of Economic Research. July 2006. p. 2.

[4] Form 10-K Filing for Ocwen Financial Corporation to SEC for the year ending December 31, 2007. p 105.

[5] Kurt Eggert. Limiting Abuse and Opportunism by Mortgage Servicers. Housing Policy Debate Volume 15 Issue 13. Fannie Mae Foundation. 2004. p.758. Limitations on fees are regulated by state and federal law. See Katherine M. Porter Misbehavior and Mistake in Bankruptcy Mortgage Claims. College of Law, University of Iowa. November 2007. pp 24

[6] See note 117 Katherine M. Porter. Misbehavior and Mistake in Bankruptcy Mortgage Claims. College of Law, University of Iowa. November 2007. pp. 21-22.

[7] Id.

[8] Kurt Eggert. Limiting Abuse and Opportunism by Mortgage Servicers. Housing Policy Debate Volume 15 Issue 13. Fannie Mae Foundation. 2004. p.758 and Gretchen Morgenson. “Dubious Fees Borrowers in Foreclosures.” New York Times. November 6, 2007

[9] Marina Walsh. The 2007 Servicing Operations Study. Mortgage Banking September 2007. p. 5 Figure 7: 2006 Servicing Expense by Default Peer Group sourcing MBA’s 2007 Servicing Operations Study and Forum. Out of the $247 per loan of expenses, $198 were reimbursable to the servicers which had over 9% delinquencies; Out of the $187 per loan of expenses, $142 were reimbursable to the servicers which had 5-8.9%% delinquencies; and Out of the $100 per loan of expenses, $80 were reimbursable to the servicers which had under 5% delinquencies)

[10] Yingjin Hila Gan and Christopher Mayer. Agency Conflicts, Asset Substitution, and Securitization Working Paper. National Bureau of Economic Research. July 2006 p. 2. Also see Form 10-K Filing for Ocwen Financial Corporation to SEC for the year ending December 31, 2007 pp. 49 and 52

[11] Form 10-K Filing for Ocwen Financial Corporation to Securities and Exchange Commission for the date ending December 31, 2007. p 49. See also. Statement on Reimbursement of Counseling Expenses in Residential Mortgage-Backed Securitizations. American Securitization Forum. October 10, 2007. p.2.

[12] Kurt Eggert. Comment on Michael A. Stegman et al’s “Preventative Servicing Is Good for Business and Affordable Homeownership Policy”: What Prevents Loan Modifications. Housing Policy Debate. Vol. 18, No. 2, 2007 p. 287 and Written Testimony of Katherine Porter Associate Professor University of Iowa College of Law. Policing Lenders and Protecting Homeowners: Is Misconduct in Bankruptcy Fueling the Foreclosure Crisis? United States Senate Committee on the Judiciary Subcommittee on Administrative Oversight and the Courts. May 6, 2008. p.2

[13] Kurt Eggert. Limiting Abuse and Opportunism by Mortgage Servicers. Housing Policy Debate Volume 15 Issue 13. Fannie Mae Foundation. 2004. p. 771 citing Ambrose, Brent W., and Charles A. Capone Jr. Cost-Benefit Analysis of Single- Family Foreclosure Alternatives. Journal of Real Estate Finance and Economics 13(2):105–20. 996a and Capone, Charles A. Jr., and Albert Metz. Mortgage Default and Default Resolutions: Their Impact on Communities. Paper presented at the Federal Reserve Bank of Chicago Conference on Sustainable Community Development, Washington, DC. March, 27, 2003.

[14] Statement of Principles, Recommendations and Guidelines for Modification of Securitized Subprime Residential Mortgage Loans. American Securitization Forum. June 2007 p. 3 in the section marked “II. Overview of Typical Securitization Document Modification Provisions”. p. 2

[15] Id. See also Written Testimony of Ralf Daloisio, Chairman of the American Securitization Forum, Investor Committee Hearing on H.R.5579, The Emergency Mortgage Loan Modification Act of 2008. United States House of Representatives Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises. April 15, 2008. pp. 3-4

[16] Statement of Principles, Recommendations and Guidelines for the Modification of Securitized Subprime Residential Mortgage Loans. American Securitization Forum. June 2007. pp. 2-3 in the section marked “II. Overview of Typical Securitization Document Modification Provisions”

[17] Id. p.3 See also See also Written Testimony of Ralf Daloisio, Chairman of the American Securitization Forum, Investor Committee Hearing on H.R.5579, The Emergency Mortgage Loan Modification Act of 2008. United States House of Representatives Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises. April 15, 2008. pp. 3-4

Beyond the general provisions described above [referenced in quotes sourced in earlier footnotes 15 and 16], numerous variations exist with respect to loan modification provisions. Some agreement provisions are very broad and do not have any limitations or specific types of modifications mentioned. Other provisions specify certain types of permitted modifications and/or impose certain limitations or qualifications on the ability to modify loans. For example, some agreement provisions limit the frequency with which any given loan may be modified. In some cases, there is a minimum interest rate below which a loan’s rate cannot be modified. Other agreement provisions may limit the total number of loans that may be modified to a specified percentage (typically, 5% where this provision is used) of the initial pool aggregate balance. For agreements that have this provision: i) in most cases the 5% cap can be waived if consent of the NIM insurer (or other credit enhancer) is obtained, ii) in a few cases the 5% cap can be waived with the consent ofthe rating agencies, and iii) in all other cases, in order to waive the 5% cap, consent of the rating agencies and/or investors would be required. It appears that these types of restrictions appear only in a minority of transactions. It does not appear that any securitization requires investor consent to a loan modification that is otherwise authorized under the operative documents.Statement of Principles, Recommendations and Guidelines for the Modification of Securitized Subprime Residential Mortgage Loans. American Securitization Forum. June 2007. p. 3 in the section marked “II. Overview of Typical Securitization Document Modification Provisions”

[18] Written Testimony of Ralf Daloisio, Chairman of the American Securitization Forum, Investor Committee Hearing on H.R.5579, The Emergency Mortgage Loan Modification Act of 2008. United States House of Representatives Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises. April 15, 2008. p. 2

[19] Id. p. 5

[20] Id.

“The underlying premise of the legislation [H.R. 5579, The Emergency Mortgage Loan Modification Act of 2008] appears to be that servicers of securitized mortgage loans are not sufficiently engaging in loan modification and workout activity due to fear of investor lawsuits and related legal exposure. However, it is worth noting that servicers today face potential legal exposure from overly conservative, as well as overly aggressive, loss mitigation activity, to the extent that a servicer may be accused of not fulfilling its obligations to maximize recoveries on mortgage loans. In addition, servicers are already reasonably well-protected from legal action by investors, since under typical servicing contracts they are liable only in the event of their negligence in performing their duties. Thus, we question the need to give servicers additional protection, as well as the premise that doing so will stimulate a significant expansion of the number and/or type of loan modifications taking place.” Id

[21] Statement of Principles, Recommendations and Guidelines for a Streamlined Foreclosure and Loss Avoidance Framework for Securitized Subprime Adjustable Rate Mortgage Loans. American Securitization Forum July 8, 200. 8 p. 10

Contractual loan modification provisions in securitizations typically also require that the modifications be in the best interests of the security holders or not materially adverse to the interests of the security holders, and that the modifications not result in a violation of the REMIC status of the securitization trust. ASF and market participants generally interpret the standards “in the best interest of” or “not materially adverse to the interests of” investors or security holders in a securitization to refer to investors in that securitization in the aggregate, without regard to the specific impact on any class of investors or any class of securities.[emphasis added].” Testimony of Ralf Daloisio, Chairman of the American Securitization Forum, Investor Committee Before the Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises of the United States House of Representatives’ Hearing on H.R.5579, The Emergency Mortgage Loan Modification Act of 2008. April 15, 2008. p.3

See also Statement of Principles, Recommendations and Guidelines for the Modification of Securitized Subprime Residential Mortgage Loans. American Securitization Forum. June 2007 p. 5

7. Any loan modification that reduces otherwise lawful, contractually required payments of principal or interest must be understood to be a financial concession by the securitization investors. There is no basis for requiring such concessions from investors unless the modification is determined to be in the best interests of the investors collectively. Loan modifications should seek to preserve the originally required contractual payments as far as possible. 8. Reasonable determinations made by servicers with respect to loan modifications, where made in good faith and in accordance with generally applicable servicing standards and the applicable securitization operative documents, should not expose the servicer to liability to investors and should not be subject to regulatory or enforcement actions. Statement of Principles, Recommendations and Guidelines for Modification of Securitized Subprime Residential Mortgage Loans. American Securitization Forum. June 2007 page 3-4. in section marked “III. Loan Modification Principles”

[ 22] HOPE NOW data which covers 66% of the industry of servicers not just subprime http://www.hopenow.com/site_tools/data.php Appendix Mortgage Loss Mitigation Statistics Industry Extrapolations (Monthly for July-December 2007 and January-May 2008 page 7 of 8

[ 23] Id.

[ 24] Alan M. White. Rewriting Contracts, Wholesale: Data on Voluntary Mortgage Modifications from 2007 and 2008 Remittance Reports. Valparaiso University School of Law. August 2008. p. 1 Electronic copy available at: http://ssrn.com/abstract=1259538.

Professor Alan White of Valparaiso University School of Law, in analyzing servicer remittance reports from July 2007 through June 2008, concluded the following:

[W]hile the number of modification rose rapidly during the crisis, mortgage modifications in the aggregate are not reducing subprime mortgage debt. Mortgage modifications rarely if ever reduced principal debt, and in many cases increased the debt. Nor are modification agreements uniformly reducing payment burdens on households. About half of all loan modification resulted in a reduced monthly payment, while many modifications actually increased the monthly payment..

and

A few loans did have their principal balance reduced, but only 62 (1.4%) of the 4342 modifications reduced the principal balance by more than 1%, and only 40 (0.92%) reduced principal by more than 10%. Some of these large principal reductions may have resulted from litigation. Ibid p. 20

[ 25] Id. p. 1

[26] Alan M. White. Rewriting Contracts, Wholesale: Data on Voluntary Mortgage Modifications from 2007 and 2008 Remittance Reports. Valparaiso University School of Law. August 2008. p. 11. Electronic copy available at: http://ssrn.com/abstract=1259538

[27] Written Testimony by Julia Gordon Center for Responsible Lending . A Review of Mortgage Servicing Practices and Foreclosure Mitigation . U.S. House of Representatives Committee on Financial Services. July 25, 2008. in footnote 19 citing Housing Market Has Further to Fall by Phil Izzo. The Wall Street Journal. March 13, 2008.

[28] Statement of Principles, Recommendations and Guidelines for a Streamlined Foreclosure and Loss Avoidance Framework for Securitized Subprime Adjustable Rate Mortgage Loans. American Securitization Forum. July 8, 2008. pp. 1-2 and 10.

[29] The Continuing Chasm Between Words and Deeds III. Survey by CRC (California Reinvestment Coalition. July 2, 2008. p. 5 Also see Chair Ben S. Bernanke, “Reducing Preventable Mortgage Foreclosures” (March 4, 2008), http://www.federalreserve.gov/newsevents/speech/bernanke20080304a.htm and see Written Testimony by Julia Gordon Center for Responsible Lending . A Review of Mortgage Servicing Practices and Foreclosure Mitigation . U.S. House of Representatives Committee on Financial Services. July 25, 2008. p. 7.

8 Responses to "The 800 Pound Gorrilla in the Room: Servicers Profit While Investors Face Losses"

  1. London Banker   November 4, 2008 at 8:49 am

    A very useful, practical overview of one of the key misalignments in the US mortgage finance mess. Sadly, investors in the MBS products appear to have too little knowledge and too little collective organisation to change the model as you suggest.

  2. Anonymous   November 4, 2008 at 9:26 am

    Excellent discussion of why loan modifications are not occurring: the mortgage servicers make more money when a mortgage defaults and goes into foreclosure. How to stop this scam?

  3. Dan Herkes   November 4, 2008 at 11:28 am

    Nicely explained. I always feel illuminated after one of the technical explanations.

  4. Pablo Cruise   November 4, 2008 at 6:58 pm

    While the mortgage service providers can extract substantial fees in the process of foreclosure, there doesn’t seem to be any incentive for a bank or financial institution to take title to “another unoccupied” piece of property. With Bank of America’s takeover of Countrywide, and Wells Fargo takeover of Wachovia and other consolidation in the industry, these banks may reap more of these mortgage service-providing fees but, again it is not in the interests of anyone to foreclose on homes in today’s climate. I would also expect greater government agency regulation and self-regulation by the new larger banks. Stand alone mortgage service providers, along with their legal friends, should see less business in the near future and possibly none in the not too distant future – provided we are serious about stemming housing problems.

  5. Mike McCarthy   November 7, 2008 at 11:30 am

    Now I know why servicers build operational fire-walls between their loss-mitigation staffs and front-end call center staff, why they make you talk to a different person each time, fail to respond to your mail, lose your faxes, and are non-responsive to solid well-designed work-out proposals.Unless insurers, lenders, and trustees for MBSs take action to reform their contracts with servicers and sue to recover unjustified profits, this will continue.

  6. Richard Davet   November 14, 2008 at 11:34 am

    “misalignment” or actually conflicted? The “GSE Business Model” is fraught with conflicting roles of the various players. Most or all are prohibited by the FNMA Guidelines to which most are contractually bound. Problem is……………no one is auditing for complaince of the Guides. The lack of accountability places the burden on “the taxpayers”.

  7. Archana Sivadasan   November 14, 2008 at 11:50 am

    Richard DavetI would like to know more about the “conflicting roles” of the various players in the GSE Business Model. Please feel free to contact me at as@pylonprop.com

  8. George Harter   January 18, 2009 at 4:34 am

    Beautifully researched study. I read too few articles of this caliber (it is not an article, this is real research).If Mortgage Servicers can profit from their present activities we, as a nation, must realize that, #1 They will not leave the playing field voluntarily and #2 They will continue on, unchanged because few have the intelligence, knowledge, courage or SELF INTEREST to police them properly.I devoutly wish this death spiral could be wound down. But, my conclusions are rather dull and pedestrian: THIS SITUATION WILL CONTINUE INDEFINATELY because profit to the servicers is REAL money and AMERICA still has a deep seated belief that raw greed is an acceptable motive for almost any activity.As a simple minded Biologist and a long time American, my thoughts are that there will not be a top down solution. Most initiatives will be state and local and may not be fully legal(but servicers aren’t playing by any rules either!)That is if they have solidarity. But, this is not the America of the 1930’s. Likely most citizens will avoid these issues as being unpleasant and also hope that disaster strikes their neighbors.In sum, foreclosures will explode in numbers, to levels unthought of today. The tea leaves look bad for Mr,/Mrs.Average but portend a fat future for the Vultures in Mortgage Servicing! (Hey, a bright spot in the service sector!)