The Federal Housing Finance Agency (FHFA) announced Tuesday that it has instructed Fannie Mae and Freddie Mac to study possible alternatives to the current servicing and compensation structure that they employ for their single-family mortgage loans. The initiative will seek to improve service for borrowers, reduce financial risk to servicers, and provide flexibility for guarantors to better manage non-performing loans.
The announcement is undoubtedly in response to wide-spread criticism in recent months of what has generally been termed "misaligned incentives" in the compensation structure for servicers. Compensation for servicers has traditionally been based on a small (less than ½ of 1 percent) of the unpaid principal balance of the loan, but the foreclosure crisis has exposed many problems in that model.
The criticism has come from many quarters including the FDIC Chairman, Federal Reserve Board members, consumer groups, as well as academics. Typical of the criticism were remarks last fall by Federal Reserve Governor Sarah Bloom Raskin. Raskin told a meeting of the National Consumer Law Center that mortgage servicing is an outgrowth of securitization which changed the old model from one where the lender also services a loan to a system where loans owned by many investors are consolidated and serviced by a few companies, some of which are also lenders. This consolidation has led to significant economies of scale in routine matters.
In addition to servicing fees, servicers earn money from other fees such as late fees and float interest while streamlining processes to keep costs down, but servicers have been ill-equipped to deal with their new role as loan modifiers. The structural incentives that influence servicers' actions, especially when they are servicing loans for a third party, now run counter to the interests of homeowners and investors, Raskin said. 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. Loan modification is costly and those costs may not be reimbursed; during forbearance the servicer must still 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."
Another critic, Kurt Eggert, Professor of Law, Chapman University School of Law told a hearing of the Senate Banking Committee that mortgage services appear to be plagued by conflicts of interest, "some they try to resolve, others they do not appear even to address," such as "tranche warfare," where one tranche of investors can claim they are acting to benefit one class of investors to another's detriment, a situation made worse where servicers are also originators holding an interest in the securitization.
Eggert said another problem is that the investor's main hope of repayment is from foreclosure and sale of the collateral and servicers add junk fees to the process and recoup them through foreclosure, thus taking money directly from investors or investors must depend on servicers to recoup damages from under reps and warrants and servicers are subsidiaries of the entities that would provide the putbacks. Another conflict is where servicers are subsidiaries of banks that also hold second liens are the property.
In announcing the initiative, Acting FHFA Director Edward J. DeMarco said, "As the recent problems in managing mortgage delinquencies suggest, the current servicing compensation model was not designed for current market conditions. The goal of this joint initiative is to explore alternative models for single-family mortgage servicing compensation that better address the needs of borrowers, servicers, originators, investors and guarantors."
Treasury Secretary Timothy Geithner and Secretary of Housing and Urban Development Shaun Donovan applauded the FHFA move. In a joint letter to DeMarco the two said, "It is clear that the mortgage-servicing compensation model is broken and should be fixed. Addressing this issue will help better protect homeowners, investors and taxpayers, while also increasing efficiency and competition in the market." FHFA will coordinate the intuitive over the next several months and will gather feedback from the industry, consumer groups, and investors and other regulators. The agency said it would allow sufficient lead time for those affected to adjust to changes and does not expect to have a new structure in place before summer 2012.