Fixing the Broken Mortgage Servicing System: Critical Analysis and Recommendations

Fixing the Broken Mortgage Servicing System Professor Peter Swire Ohio State University Center for American Progress Midwinter Housing Finance Conference February 10, 2011

Overview The current system is bad for all major stakeholders: Homeowners my recent CAP report Holders of credit risk (GSEs, FHA, investors of PLS) need better workouts Holders of interest rate risk (investors in agencies) managing prepayments Servicers Basel and operational risk The public interest Thus reasons for major change, soon The transmission belt for payments from homeowners to investors is broken, and needs to be fixed A down payment on broader housing finance reform

Disclaimers Disclaimers I left White House in August. My views, not confidential government information Presenting new ideas here, so welcome your input

Homeowners Many critiques of current system from point of view of homeowners Mistakes in escrow Excessive and non-transparent fees (happened to me) Servicers prefer foreclosure, with payments to servicers from those proceeds Concerns that servicers protect second liens and so won t do mods, short sales, etc. that threaten the seconds Robo-signing, lost documents, and other back office problems

Homeowners CAP Report I propose a simple market failure story for homeowners in current servicing structure No market pressure by homeowners on servicers If homeowner is dissatisfied, can try to refinance but the same servicer quite possibly will get the new loan Concentration in servicing has climbed sharply in past decade, with little differentiation so far as consumers are concerned Usually no legal redress for homeowners In short, no apparent incentive transaction-by-transaction for servicers to address homeowner concerns I m not saying servicers don t care the point is the lack of market or legal incentives for servicers to care

Analogy to FCRA Fair Credit Reporting Act Mortgage Servicing The companies that affect consumers Credit reporting agencies Mortgage servicers The clients of those companies Lenders, insurers, etc. Investors in mortgages Protections for consumers Fair Credit Reporting Act none currently

Candidates for Homeowner Protections Substantive Homeowner Bill of Rights Single point of contact Better disclosure fees, possible conflicts of interest Penalties if prove pattern or practice of errors by servicer Better workout procedures to help homeowners and holders of credit risk (next topic) Procedural Mediation prior to foreclosure Arbitration (similar to FINRA) FCRA has modest statutory damages for private right of action Content of National Standards unclear because lack of market or existing legal remedies for homeowners Status quo, though, has been unfair and inefficient for homeowners

Holders of Credit Risk In a world with no national price falls, had modest credit risk historically, for GSEs, FHA, and PLS investors 30 straight months of housing price declines nationally by January 2009, so large embedded losses in current portfolios Credit risk likely significant going forward Flat or modest home price appreciation Lost wealth and broken credit histories for many borrowers What should servicing system do in the face of that credit risk?

Need for Good Workouts Thesis: holders of credit risk prefer +/- 80 cents to +/- 60 cents Severity in foreclosure higher than for workouts such as mods, short sales, DIL Consensus that servicers have not done well at workouts They weren t staffed for it at start of crisis Contractual limits on workouts Bair: misaligned incentives Servicers often paid more in foreclosure than alternatives Concerns about incentive effects of servicers also holding seconds

Rules for Good Workouts Bankruptcy theory & practice: Shift decision makers at time of insolvency (for homes, delinquency) Special servicers common in CRE Laurie Goodman proposal to have existing servicer & two others bid at that point Decisional flexibility to make the workout decision that maximizes value for the pool (Bair supports) Major flaw of many previous contracts has been inflexibility to get approval for value-maximizing workouts Moving forward achieve these goals for efficient workouts, with input from stakeholders on how to avoid incentives that prevent efficient workouts

Holders of Interest Rate Risk Agency and (to a lesser extent) private-label securities are enormous markets where investors take positions on future interest rates Future liquidity for housing finance requires well-aligned incentives for these investors and future servicers Biggest risk of misaligned incentives comes in prepayment speeds Recent Laurie Goodman report: Lower minimum servicing fees on performing loans Raise them on non-performing loans GSEs transfer/bid servicing at time of delinquency Much less need for advances by servicers Rules, such as no cherry-picking by servicers, to stop misaligned incentives

Servicers & Reform Servicers face problems Basel rules coming, MSRs capped as % of equity Current MSRs difficult to hedge: hard for smaller players, risky even for bigs Operational risk the costs of servicing non-performing was not prepared for, and is risky going forward given uncertainty Robo-signing, show the note and other litigation risk Political cross-fire from investors, consumers, regulators, and Congress Servicers thus at least open to change in system Surprising, quiet acceptance of need for national servicing standards, if only to get out of the cross-fire set clearer expectations for servicers

Regulators & the Public Interest Efficiency says reduce deadweight losses: Failure to get to efficient workouts Negative externalities on neighborhoods of foreclosures that could have been avoided Higher cost of capital due to greater-than-needed prepayment risk Homeowners optimal outcome not part of servicers current incentive structure Servicers face list of problems Fairness as well Lack of remedies for consumers is unfair servicers make mistakes but no redress or market pressure Question of how to more to fairer and more efficient system

Vehicles for Change FHFA & FHA current process Financial regulators and qualified residential mortgage rule Small portion of loans but could set a standard State AG consent decree ASF and new standardized securitization and servicing contracts Congress May be possible to make changes without legislation Homeowner protections maybe work better with legislation the history under TARP of voluntary programs Robo signing and bipartisan concern about mortgage servicing Perhaps can address pieces of litigation risk facing servicers, providing that incentive to come to the table Public hearings and congressional attention will maintain momentum to fix current problems Down payment on broader housing finance reform

Conclusion (Part I) When everyone dislikes the current system, have the possibility of change Nothing natural or inevitable about current system New market concentration and servicing patterns during bubble Never stress tested before Magnitude of effects on homeowners not seen when delinquent loans could be refinanced, sold at a profit in foreclosure, or covered with credit card loans Magnitude of effects from lack of a workout mechanism not seen until we needed to do so many workouts

Recap For homeowners, need some market and/or legal check against mistakes and abuse For credit risk, need good workouts For interest rate risk, need good incentives to avoid prepayment problems For servicers, need easier management of the asset and less operational risk For the public, reduce the enormous deadweight loss we ve seen since home prices turned down In short, Fix this transmission belt, so that the funds can flow in a sensible way from homeowners to investors That s a doable down payment on the bigger project of overall housing finance reform