National Mortgage Servicing Standards?

Earlier this week, a group of 50 pundits, academics and other “experts” fired off a letter to the Fed, FDIC, SEC and any other Government Agency they could think of to make their case for following through on Dodd-Frank to push through a national standard for first-lien residential mortgage servicing (at least we assume they only meant first-lien residential mortgage servicing because there was no mention of autos, credit cards, commercial real estate, business loans, other personal loans, etc).

Now, we completely understand the foundation for this group taking up the cause at this time but please excuse us if a smidgen of sarcasm seeps into our reactions and comments here.  We “get it” that most folks didn’t know that the word “servicer” even existed before 2 or 3 years ago (they all thought that the bank (many may have believed the actual branch) where they borrowed the money “serviced” their loan).  On that basis, it’s not hard to understand that they have been working hard for the last 2 years cooking up a fix to the US mortgage industry.  Thank goodness that they took the time to write their letter.

As you might be able to tell by now, we fall decidedly on the side of the argument that suggests that everyone should take a timeout and go to their respective corners before we screw this market up even more.

We thought that best way to address the topic might be to provide commentary to several sections in the letter.  In doing so, we have provided a few comments in a few key sections.  While we could have commented in several other places, we don’t feel it’s necessary.  We think we make our points.

So here’s that letter and our comments:

Re: National Standards for Loan Servicing

 Dear Colleagues:  

We the undersigned write to you regarding the urgent need to develop national standards for originating, selling and servicing mortgage loans.  The private residential mortgage securitization market is frozen as to new issuance.  The housing market is suffering from a dearth of credit, which is causing a serious lack of confidence among potential homebuyers. [SM: Two pretty powerful statements about the state of the securitization market and the general availability of credit.  We would note here that not a single securitization investor (or a firm that issues securitized debt) has signed onto this letter.  If they had, certainly they would agree that there is a dearth of new issuance but not that it is due to a lack of cohesiveness in servicing standards; in fact it has nothing at all to do with that.  All investors care about is their ability to enforce the contracts (terms of their bonds) and that is their right to do so.  The dearth of issuance is not due to any lack of confidence in new homebuyers, it is due to a lack of confidence by institutional investors in the mortgage-backed markets and whether the terms of their bonds will be enforceable.  Quite honestly, they could care less if a servicer is abusing a homeowner via an overly aggressive foreclosure process.  Not trying to sound cruel but that’s not their concern particularly when you consider that the investor in question may be a local pension fund trying to make timely distributions to their retired members.  In an ugly twist of fate, those bond payments may actually be used to make a mortgage payment (imagine that!!).]

 Widely reported servicer fraud, whether in the foreclosure process or in the systematic assessment of illegal fees against homeowners, is also a serious problem.  It’s bad for investors, it’s bad for homeowners, and it’s ultimately bad for a sustainable residential mortgage securitization market and the U.S economy.  Fraud is also a symptom of the disease affecting our broader financial system, namely the lack of accountability in the loan servicing industry and the resulting impairment of the value of securities sold to investors.  [SM:  Now wait a  minute….. either there needs to be more laws and regulations to curtail abuses or there doesn’t.  We would agree that it would appear that at least some servicers have engaged in some illegal activities, at the expense of homeowners.  However, to say that it has already been determined that some of these activities are “illegal” would suggest that laws are already on the books (a view we would agree with; in fact there are plenty of laws) and that the problem is a lack of application or enforcement (a view we would also agree with).  This is not a case where more laws and regs are the answer.  Let’s start with an application of what’s already in place.  This is not a new position for us to take.  In fact we have been making this point to any and all who would listen for more than 3 years.  We have always believed that a more vigorous (in fact even just a moderate) regulatory regime back in 2000, 2002, and 2004 would have gone a long way to eliminate the systematic abuses in the mortgage industry.  However, it is always at times like this that the “rumbling herd” will call for more regs and more laws as the solution.  We obviously differ with this point of view.]

 To that end, new securitization standards should be adopted now.  The rules under the Dodd-Frank Act relating to disclosure and risk retention for securitization, which apply to all market participants, are the place to start.  We suggest, therefore, that the agencies concerned, led by FDIC and SEC, undertake a coordinated rule making effort now to start the process and then also report to Congress.  

 As part of your duties under Section 941 of the Dodd-Frank Act, your agencies must develop new standards for the secondary market in mortgage loans.  These standards must promote a sustainable securitization market and, in particular, maintain additional “skin in the game” for sellers of loans so the excesses and abuses of the past are not repeated.  As part of this effort, you will be defining the criteria for the highest quality residential mortgages, those which do not need risk retention.  This new definition for what constitutes a qualified residential mortgage should be the gold standard in all areas of mortgage origination, securitization packaging and servicing, and disclosure.  [SM:  We absolutely love how these new buzzwords, such as “skin in the game”, work their way into industry parlance.  Lately, this particular phrase has us thinking about the Coors Lite TV commercial where former NFL Coach Jim Mora responds to a questioner with the phrase  “PLAYOFFS??……. PLAYOFFS????……. PLAYOFFS????????.  Don’t folks get it?  Don’t they understand just how much SKIN the average lender or issuer of securitized debt already has IN THE GAME?  All forcing them to hold 5% of the pools does is add cost to their structure.  It doesn’t add any discipline.  Accountability and risk take on many forms.  Just ask the big conduit issuers in the market in 2007, including Countrywide, Bear Stearns and others, if they didn’t already have too much skin in their game?  Oh that’s right, they aren’t around to ask!] 

Why is there such urgency?  Because of the ongoing litany of revelations pertaining to inadequate servicing, lost loan modification documents, and improper foreclosures which reveal significant problems in the mortgage servicing industry.  Problems of this magnitude are a threat not only to the economic recovery, but to the safety and soundness of all insured depository institutions.  Banks rely upon a functioning secondary market in home mortgages for liquidity management purposes.  The chaotic situation in the mortgage market today demands immediate action to ensure all parties are treated fairly and to restore the confidence needed to support a recovery in real estate markets and the entire U.S. economy.

 Servicing standards need not be overly complex, but they must address the misaligned incentives and ‘tranche warfare’ issues that have bedeviled mortgage servicing throughout this crisis.  We also believe it is of critical importance to eliminate existing discontinuities in servicing practices with regard to loans held in whole-loan form by banks, versus those in securitization vehicles.  Your agencies must address loan servicing as part of the lending process so that the new Dodd-Frank risk retention rules meet the goals set by Congress. [SM:  We are also just a little fatigued by this “securitization made me do it” argument.  Why can’t there be different servicing standards for loans that are securitized vs. those that are not?  We continue to see this overly liberal linkage of securitization to mortgage servicing standards and home borrower rights.  We believe, without reservation, that homeowners are protected by law from illegal servicing activities.  On the other hand, how a servicer handles a portfolio “after” and even in some cases “before” a servicer ensures that the homeowner regs are followed, should not be a concern of the homeowner.  Last we checked, we live in a “mostly” free market economy.  As such, investors and the banks that sell them securities should be able to negotiate terms which are most beneficial to the structure of their bond issue.  Let the appropriate authorities and regulators look after the homeowners and we assure you that investors will look after their rights.  At the end of the day, it is the issuer or bank that will have to negotiate with both.  That’s called running a business!]

To protect borrowers and investors alike, the standards generally should require lenders and servicers to:

 * Credit monthly loan payments promptly and correct any misapplication of such funds in a timely manner.

* Engage in loan modifications, including reductions in the payment amount and principal balance, consistent with state law, to address reasonably foreseeable default when a homeowner can make a reasonable payment and it is economically feasible to do so.  When existing or future loans are more than 90+ days delinquent, federal regulations should mandate that the credit be assigned to a special servicer.   [SM:  We can only guess that no one on this list of 50 experts has actually been through an asset management process.  We’d like to hear their ideas for the business model.  Most large issuers of mortgage-backed debt (certainly the large private conduits) prefer to service their own loans.  The “logic” is very sound…. who knows the loan better than the party that originated the loan or has serviced the loan in good times?  Sure, let’s turn the file over to a disinterested third-party when things get rough!  That wouldn’t be our vote.]

 * Prohibit the commingling of homeowners’ monthly mortgage payments with servicers assets except for the time necessary to clear the payments received, but generally not more than two (2) business days.  [SM:  We’re not sure we understand the rationale for this but, once again, we assume that they are referring to loans pledged to a securitization.  The bond trustees will surely like this measure but the income still has to go somewhere.  This is all about economics and not safety.]

* Be accountable for lost paperwork on loan modifications and/or for failing to suspend  the foreclosure process when a homeowner is actively engaged in the loan modification process.  [SM:  Is the group suggesting that the servicer is not currently accountable?] 

* Create incentivized compensation structures tied to effectiveness in managing the long-run performance risk of the assets in a securitization. [SM:  We assume that they mean incentives for the issuer/servicer.  These incentives are already in place.  They are called bond ratings and interest rates (cost of funding).  Do people actually think that investors haven’t thought about this stuff for the past 25 years?]

 * Mitigate losses on residential mortgages by taking appropriate action to maximize  the net present value of the mortgages for the benefit of all investors in a securitization rather than the benefit of any particular class of investors.  [SM:  See last comment above] 

* Make servicer advances to a securitization vehicle a required reporting item.  Prohibit the servicer from advancing delinquent payments of principal and interest by mortgagors for more than three (3) payment periods unless financing or reimbursement facilities to fund or reimburse the primary servicers are available. [SM:  Let’s leave the bond structuring to the pros, shall we?  If they agree to something different, so be it.]

* Disclose 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 a given pool of mortgages used in a securitization.  

 * Eliminate the regulatory incentives that motivate banks to keep troubled portfolio loans in “limbo,” without permanent modification or remediation, merely because the bank is successful in obtaining a marginal payment that avoids classifying a loan as non-accrual.

* Establish a pre-defined process to address any subordinate lien owned by the servicer or any affiliate of the servicer, if the first mortgage is seriously delinquent (i.e., 90 days or more past due) to eliminate any potential conflicts of interest.

* Attest annually in writing under penalty of a fine or legal action that a bank or non-bank servicers’ foreclosure process complies with applicable laws.  

During a December 1, 2010 hearing, Federal Reserve Board Governor Daniel Tarullo acknowledged that “it seems reasonable at least to consider whether a national set of standards for mortgage servicers may be warranted.”  We agree with Governor Tarullo.  The time to act is now.  

Recent discussion among regulators as to the need for new legislation to address the servicing issue are misplaced, in our view.  We cannot wait for uncertain future legislation to accomplish something that is clearly appropriate under the Section 941 risk retention rules of Dodd-Frank and current law, namely a national standard for loan servicing.     

 The agencies currently involved in developing the standards for residential mortgages have an opportunity to address this critical issue now.  The responsible servicing standards described above would be applicable to all issuers of securitizations and will prevent the problems we are seeing today in the secondary market for mortgage loans. [SM:  By now, we think you know where we stand……..]

Yours sincerely,


About markferraris
Managing Principal Orchard Street Partners LLC

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