On Friday two Governors of the Federal Reserve spoke out about disincentives in the servicing industry and their impact in the foreclosure crisis.  While Governor Daniel K. Tarullo referenced the issue as an aside in a Friday address on banking reform, newly minted Governor Sarah Bloom Raskin in a separate speech took the industry head on.

Raskin, who was appointed as a Governor on October 4, told attendees at the National Consumer Law Center's Consumer Rights Litigation Conference in Boston that the foreclosure picture is grim and will probably remain so, with over four million more foreclosures expected by the end of 2012.  Now public attention has focused on alleged robo-signing of mortgage documents.  "This development is troubling on its own," she said, "but it also shines a harsh spotlight on other longstanding procedural flaws in mortgage servicing."

While many may view these flaws as trivial, technical, or inconsequential, Raskin said she sees them as part of a deeper systemic problem.  In her previous position as the former Mary Commissioner of Financial Regulation, she witnessed infractions such as padding of fees, strategic misapplication of mortgage payments to servicers' fees, and inappropriate assessment of force-placed insurance with excessively high premiums.  Some infractions threw homeowners into default and foreclosure.

Mortgage servicing in its present form is a relatively recent Raskin said, an outgrowth of widespread securitization.  This changed the old model from one where the entity that originated the loan also serviced it to one where the bulk of servicers are subsidiaries or affiliates of depository institutions or independent companies with a primary or exclusive focus on loan services.  This shift from "an originate-to-hold model to an originate-to-distribute model is one that has never been tested in a housing crisis like the one today. 

The consolidation of servicing has led to significant economies of scale in routine matters. The servicers earn money through servicing fees, other fees and float interest while maximizing profits by keeping costs down, streamlining processes, and buying servicing rights for pools that will require little work. But the model was not designed for the time-consuming, detailed loss mitigation on the scale needed today nor was the payment structure. The structural incentives that influence servicer actions, especially when they are servicing loans for a third party, now run counter to the interests of homeowners and investors.

A foreclosure almost always costs the investor money, but may bring the servicer additional fees while proactive measures to avoid foreclosure and minimize investor losses cost the servicer. Loss mitigation requires individualized case work for which costs may not be reimbursed, and even temporary forbearance usually requires the servicer to advance payments to the investor.  "Even in the case of a servicer who has every best intention of doing the right thing," the bottom-line incentives are largely misaligned with everyone else involved in the transaction, and most certainly the homeowners themselves."

Raskin said the end results for homeowners are still unknown but the standard business model for the industry "would seem to put a thumb on the scale in favor of foreclosure."  Today's needs require sufficient numbers of personnel with adequate training, tools, and judgment to deal with problems loans on a level that does not permit economies of scale.  Servicers have been pledging for several years to increase their servicing capacity, she said, and many have, but there is plenty of evidence to suggest their workforces often lack the ability to deal with the immensity of the crisis.

Recent events point to a lack of strong internal procedures. More seriously recurring issues go beyond misaligned incentives to simple bad business practices like improperly allocating mortgage payments, obtaining unwarranted fees from unfair collection practices; lost paperwork, and sloppy recordkeeping. The impact of poor business practices can linger on even after the foreclosure sale. Servicers have forced homeowners or tenants to vacate before they are legally required to do so and servicers decide whether to repair foreclosed properly based on how recoverable their advances will be.  Raskin said this influences neighborhood stabilization efforts at a time of persistent decline in home values and markets already weakened by a glut of vacant and abandoned properties.

Servicers' concerns about the Treasury's Home Affordable Modification Program (HAMP) are well-known, Raskin said, but not enough is known about how servicers are complying with HAMP requirements or how well they are doing modifications outside of HAMP where the bulk of them actually occur.

The problems grabbing headlines recently she said are neither new nor amenable to quick fixes.  Chronic problems continue to plague the industry and, because consumers cannot choose to hire or fire their servicers (other than by paying off the loan), the industry lacks the market discipline imposed in other industries.  The very structure of the loan servicing industry inevitably leads to misaligned incentives and a propensity to defer costly investments, thus a more significant re-thinking of the basic business model must be undertaken to avoid repeating prior mistakes.

Raskin pointed to some attempts to address the problems.  Although foreclosure practices are a state domain, the Federal Reserve has been expanding its expertise, first, in a review of non-bank subsidiaries in conjunction with other state and federal regulators, and a current review of loan modification practices by certain servicers. The Fed and other federal agencies initiated an in-depth review of practices at the largest mortgage servicers which focuses on foreclosure practices generally, and the breakdowns behind inaccurate affidavits and other questionable legal documents being used in the foreclosure process. The Fed has also gathered information from outside sources to help detect possible systematic problems at specific servicers or within the industry at large.

Certain firms have been directed to assess their policies and procedures for determining whether to foreclose and to examine their processes to determine if they comply with relevant federal and state laws, not just in theory but in practice.   Banking examiners will be on-site to review individual loan files, evaluate controls over the selection and management of third-party service providers, and test the assertions that the institutions make in their self-assessments. As federal examiners typically are not experts in state laws they need to coordinate with their state counterparts.  The Federal Reserve requires that the federal banks they supervise have adequate compliance risk management programs and that they are being followed.

Given the potential ramifications, it's fair to say that every relevant arm of the federal government is taking the underlying dynamics of the mortgage foreclosure crisis very seriously Raskin said.  She hopes that the multi-state work engaged in by the 50 state attorneys general will prove to be a vehicle for resolving the underlying problems. To the extent that legal settlements are structured in such a way as to generate a broader underlying reform of servicing processes, it will be more likely that we can assure consumers that they will not encounter other mortgage harms moving forward.

Raskin concluded, "Until a better business model is developed that eliminates the business incentives that can potentially harm consumers, there will be a need for close regulatory scrutiny of these issues and for appropriate enforcement action that addresses them."