“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 FCRAFair 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