Servicers create and protect investor value by collecting payments, monitoring delinquencies, and motivating borrowers to pay. Recent vintage residential mortgage-backed securities performance is known to be significantly affected by servicer performance. In rating mortgage-backed securities, ratings agencies give significant consideration to performance variablility that can be attributed to not only origination characteristics and housing market differences across the country, but also to variability among how servicers manage “…looming interest rate resets and resulting payment shocks.” (Moody’s, “US Subprime Mortgage Market Update,” July 24, 2007 at 2).
Even the Bond Market Association and the American Securitization Forum acknowledge that valuing mortgage-backed securities involves far more than just estimating cash flows based on borrower characteristics, but involves a substantial effort in monitoring servicer effort and pricing the possibility that the servicer may reduce their efforts or otherwise change the value they bring to the loan. According to those industry sources, servicer track record is a key consideration in valuing mortgage-backed securities today. (The Bond Market Association and The American Securitization Forum, “An Analysis and Description of Pricing and Information Sources in the Securitized and Structured Finance Markets,” October 2006 at 3)
Servicer quality matters even more when loans become distressed. A defaulted borrower that re-establishes payment on their loan usually does so because of some element of trust between them and the servicer that leads to establishing a payment plan the borrower believes is advantageous to both parties. The servicer may work on the borrower’s behalf as part of that plan, assembling a program combining elements of bankruptcy, selling other assets, or consolidating other loans. If the borrower is still unable to make the payments, the servicer maintains a good relationship with the borrower through the foreclosure process to preserve the value of the home and liquidating the collateral to collect money owed to the investor. (Fitch, “Scratch & Dent: This Is Not Your Father’s MBS,” 20051213 at 8) Hence, the servicer’s workout and liquidation processes crucially affect loan recoveries.
But even more vexing to today’s valuation models, distressed loans offer far different cash flow patterns than non-distressed loans. Newly originated loans typically experience losses beginning six to twelve months after origination, after which they increase sharply and then tail off to a very low level by roughly twenty-four months. The loss pattern in distressed loans, in contrast, varies with collection patterns and the servicer’s aggressiveness. Distressed loans also prepay slower than newly originated loans, as distressed borrowers generally have fewer remaining opportunities for career advancement and less access to new sources of credit due to their severely impaired credit record, no matter how interest rates move. (Fitch, “Scratch & Dent: This Is Not Your Father’s MBS,” 20051213 at 7)
Most importantly for the modification policies announced recently, a servicer is usually not just a passive third party in a residential mortgage-backed security deal. Rather, the servicer is usually also an investor, typically owning a junior first-loss residual stake in the securitization. As a residual holder, the servicer naturally favors high levels of loan modifications, since without those modifications cash flows to the junior residuals may be cut off until the senior bonds are fully repaid. While modification may be prudent for the borrower, it is hard for investors to tell if the servicer is really acting in investors’ best interest or the servicer’s own interest. Loan modifications make it hard for investors to estimate cash flows, so investors need to be fully appraised of servicer modification policies. Furthermore, investors have to model not only defaults, but also modified loan redefaults to estimate pool cash flows.
Servicers, however, vary considerably in how they report modified loans and their subsequent performance. Some report extensively, but many report virtually nothing at all. Last, and perhaps most importantly, servicing delinquent loans in general and modification in particular are expensive, usually outstripping direct servicing fee income. Hence, investors are critically concerned with servicer financial conditions, which dictate the level of effort servicers will be able to devote to crucially adding value to even non-delinquent loan pools moving forward. (Nomura, “Sub-prime Mortgage Loan Servicing and Loss Mitigation,” Securitization & Real Estate Update 5/18/07 (informal notes from the 5/16/07 American Securitization Forum seminar titled “Subprime Mortgage Loss Mitigation Strategies – What’s Working.”) at 2)
The problem is that servicing is a lightly-regulated and highly variable segment of the mortgage industry that has already experienced more than a few difficulties. According to Elizabeth McCaul, former Superintendant of Banks for the State of New York, some areas of weakness in the servicing industry in recent years leading up the present crisis included “…a lack of focus on the strength of the [servicer] and improper analysis of the substitution of good loans for bad. We have seen re-aging policies not being properly analyzed. In fact, investment in this area has been largely driven by mathematical formulations without enough qualitative analysis of operations and financial strength. For example, we have conducted reviews of portfolios and seen residuals on balance sheets that do not reflect enough financial strength to continue operations effectively. If the shop is closed, the Trustee comes in, the re-aging practices (and other practices) are halted… delinquencies roll in, and the rest, as you know, is history.” (McCaul, Elizabeth, “What’s Ahead for the US Residential Mortgage Market Speech at ASF 2007 conference by Elizabeth McCaul of Promontory Capital, former Superintendent of Banks for the State of New York, “ February 2, 2007 at www.SIFMA.org)
Servicing is, in general, therefore, not very well understood by regulators or investors, although it is indeed a crucial aspect of value to all consumer loan securitizations and therefore securitization market stability. The problem is that servicer accountability and reporting to investors and regulators is woefully inadequate. Sufficient information to evaluate servicer quality rarely exists, and where that does it is not consistently or widely distributed. Hence, regulators can do a great service to both the industry and borrowers in today’s financial climate by insisting that servicers report information sufficient to assess not only the success of major modification initiatives, but also performance overall. The increased investor dependence on third-party servicing that has accompanied securitization necessitates substantial improvements to investor reporting in order to support appropriate administration and, where helpful, modification of consumer loans in both the private and public interest.
Improved data and reporting are key to demonstrating value in today’s servicing environment. But while some servicers want to exhibit their value demonstrably, others continue to obfuscate and manipulate their performance to squeeze the last few dollars out of the market. We owe it to borrowers and investors to systematically and comprehensively advocate a better servicer reporting environment, where typical strategies of modifying or overly-aggressively re-aging loans to mask fundamental performance are apparent and prudent uses of such strategies are rewarded.
Resolving the servicer reporting problem is straightforward. The industry has already proposed reasonable and meaningful solutions through the American Securitization Forum. There is no reason why they should not be seriously considered as the basis for industry regulation, going forward.
So we have a choice. We can watch another industry grow without adequate regulatory oversight and transparency – indeed, subsidizing that growth through current ill-documented modification policy – or we can implement meaningful servicer reporting standards now, when they can help reduce the effects of the crisis by encouraging market transparency, liquidity, and maturity.
Unfortunately, while policymakers hope for better outcomes, they continue to implement the same failed policies that caused the crisis. Wouldn’t it make sense for regulators and the industry to come together on servicer reporting standards that can help investors release servicers to undertake modifications where they make economic sense for the investor and borrower alike, without further government subsidies that continue the industry opacity? Unfortunately, it appears that while servicing can be expected to become an increasingly important and valuable part of the consumer credit industry, it may remain a woefully opaque industry, secretive about modification policies, procedures and outcomes and continuing to hinder economic growth.