Since the foreclosure crisis began six years ago, homeowner advocates advanced two priorities: accountability for the fraud and abuse that took place, and safeguards to ensure it never happens again. There has been little if any progress on the former, but a spate of new rules from the Consumer Financial Protection Bureau represent a serious attempt at the latter. New rules governing mortgage lenders (also called mortgage originators), which create a standard 30-year “qualified mortgage” based on the borrower’s ability to pay, and use various incentives to discourage riskier loans outside the QM model, have been lauded by many analysts. A separate rule bans “steering payments” to mortgage brokers and loan officers, which were used in the bubble years as bonuses for pushing borrowers into riskier, higher-cost loans. Severing the link between mortgage originator compensation and the terms of the loans they originate really gets at the bad incentives that drove the housing bubble and led to the crisis.
But compensation does not play a role in the CFPB’s new rules on mortgage servicers. (These are, in contrast with originators, companies hired by loan owners to collect payments from borrowers and deal with loan modifications and foreclosures.) And here, the financial incentives are just as misaligned, leading to perhaps millions of unnecessary foreclosures, demonstrably harming the economic recovery. A process to alter how servicers get paid has been underway as a joint project between the Federal Housing Finance Agency (FHFA) and the Department of Housing and Urban Development (HUD), but nothing has happened on that front since the mortgage industry opposed it in the fall of 2011, and many fear it has been shelved. As a result, servicers maintain a compensation structure that values foreclosures over loan modifications.
It may sound strange that mortgage servicers make more money kicking people out of their homes than working with them to make the loan affordable. After all, a foreclosed home sells for much cheaper than a modified loan. Typically, loan owners strive to do everything they can to keep a loan “performing” with payments rolling in. But the topsy-turvy world of the modern mortgage business brings new middlemen with new incentives into the process. In almost all cases, your lender does not hold onto your mortgage, like the old days. Instead they sell it on the secondary market, and many of these loans get pooled into securities purchased by investors all over the world. In turn, the new owners hire servicers to deal with the day-to-day maintenance of the loan, collecting payments and dealing with delinquent borrowers.
In general, servicers are paid through a percentage of the unpaid principal balance on a loan. This creates problems when a borrower gets into trouble and can no longer afford their payments. There are many modifications to help a borrower in such a bind, the most sustainable, successful type being direct reductions of the principal, for obvious reasons. But forgiving principal cuts directly into servicer profits by cutting the unpaid principal balance, so most servicers shy away from it. Moreover, servicers collect structured fees – such as late fees – which make it profitable to put a borrower in default and keep him there. And foreclosures don’t hurt a servicer, because they make back their money owed, along with all fees, in a foreclosure sale, even before the investors for whom they service the loan . The investors take whatever losses result from a foreclosure; the servicer makes out just fine.
This has driven the condemnable response from servicers to the crush of delinquencies after the collapse of the housing bubble. Cash incentives to modify loans through HAMP, the Obama Administration’s foreclosure mitigation program, did not outstrip servicer compensation incentives. So with the decision to modify or foreclose completely at their discretion, servicers quickly learned to game the program. They chronically “lost” borrower’s income documents to extend the default period. They prolonged trial modifications to rack up fees, and many of the fees were not in the original lending agreement. They granted modifications that folded fees into the principal of the loan, increasing the unpaid principal balance – and thus their profit – while pushing the borrower further underwater. And they trapped borrowers by denying long-sought modifications, demanding back payments, missed interest and late fees, with the threat of foreclosure as a hammer. This often forced borrowers into ineffective “private” modifications with the servicer. At worst, it generated thousands of servicer-driven foreclosures.
Most of the CFPB’s servicer rules are procedural in nature. This includes rules requiring plain-English disclosures for borrowers, timely crediting of accounts and accurate records, as well as processes for consumers reporting servicer errors. While CFPB clearly recognizes the servicer incentive problem on modifications and foreclosures, they try to deal with it as best they can through disclosure and transparency, rather than attacking compensation directly.
Here’s an abridged version of the new loan modification rules. When a borrower misses two straight payments, servicers must intervene with specific information on loan modification options. They must provide “continuity of contact” – not a single specialist tasked with following a borrower, but a set of personnel that has access to all information, so the borrower won’t need to send multiple documents (these personnel must acknowledge receipt of an application and request any specific information they need from the borrower to complete it). Servicers must go to the investors in the loan, who have typically been shut out of the process, and clarify up-front what loss mitigation procedures they can offer, while keeping investors abreast of the decisions they ultimately make. They must offer one application that includes all potential modification plans, and consider them simultaneously, checking eligibility on the “waterfall” of options provided by the investor until they find one suitable. Critically, servicers must wait 120 days before starting the foreclosure process, ending an insidious tactic known as “dual track,” where servicers would review an application for a loan modification while simultaneously starting the foreclosure process. If the borrower slips into foreclosure, they get more limited protections from dual track, and in certain circumstances, they could pause the process by submitting a modification application. Finally, rejections of modifications must be accompanied by specific reasons, with an appeal process available to the borrower.
This all sounds good, but the rules largely don’t touch the critical compensation issue. Servicer revenue still derives from a percentage of unpaid principal balance, taking the most sustainable type of modification, principal reduction, virtually off the table. There is no cap or limitation on any fees in the rules, which encourages default over modification. Servicers can still capitalize unpaid fees by folding them into the principal balance after the modification, increasing their profits and harming homeowners. And there are no rules to automate or standardize modifications, which still would ultimately be granted at the discretion of the servicer, with no additional leverage in the hands of the borrower. CFPB opts for a second-best alternative, clarifying procedures and mandating good customer service. But if the servicer still has a financial interest in options harmful to the borrower, one suspects they’ll find a way to employ them. “The rules recognize the problem and state a desire to end the problem,” said Julia Gordon, Director of Housing Finance and Policy at the Center for American Progress. “But unless you get into the details with compensation, it’s difficult to end the problem.”
CFPB may not have had a good choice here. Existing contracts between investors and servicers determine compensation, and multiple parties, in the private sector and on the regulatory side, have overlapping interests and jurisdictions in that area. It’s not clear whether CFPB would have legal authority on servicer compensation rules. They did have that authority on steering payments to loan officers because the Dodd-Frank law explicitly granted it to them.
There is another possibility to address servicer compensation. The Federal Housing Finance Agency (the conservator for mortgage giants Fannie Mae and Freddie Mac, also called GSEs, short for “government sponsored enterprises”) and HUD have begun work on a joint project to address servicer compensation. It makes sense to house this project at FHFA, because Fannie and Freddie own a substantial chunk of all extant mortgages, so their behavior as investors can drive an industry-wide transformation. And under most servicing contracts, the GSEs have the right to terminate servicers at any time for failure to comply with any servicing standards.
However, the FHFA/HUD servicer compensation process is showing few signs of life. They announced the initiative two years ago, and released a discussion paper in September 2011, inviting public comment on a couple broadly rendered alternatives, including a “fee for service” model where servicers would get paid a flat rate for performing loans, presumably encouraging them to keep the loans current. As is typical for these regulations, practically all of the public input on the discussion draft came from the mortgage industry. They objected to changing the system before they had new requirements in place, like the 2012 National Mortgage Settlement and the CFPB servicing standards. In addition, they made the usual complaints about undermining the market and increasing costs for borrowers.
Perhaps as a result, basically nothing has been done on servicer compensation since the fall of 2011. Officially, HUD spokesman Brian Sullivan calls the joint project a “work in progress.” An FHFA spokesman told me that “consideration of the servicing compensation issue will continue as FHFA moves forward with the Build portion of the Strategic Plan for the Conservatorships of Fannie Mae and Freddie Mac.” And in a speech last December, FHFA Acting Director Ed DeMarco remarked that they “have already completed a substantial amount of groundwork on this subject,” and that “it remains for me an important part of the work ahead.”
It’s certainly possible that, with CFPB’s rules out of the way, FHFA and HUD will get back to work. But nobody expects anything anytime soon – the Strategic Plan has been around since 2010 without completion – and there’s a sense among many close to the situation that the project has been shelved. More importantly, between the new CFPB rules, consolidation in the industry, and new types of servicer models, FHFA and HUD would basically have to start over from where they left off in 2011.
Pieces of servicer compensation concepts have been folded into other rules from the GSEs, with certain penalties based on processing foreclosures. And there are additional opportunities for an inter-agency group of bank regulators, including CFPB and the Federal Reserve, to forward guidance to the servicing industry. But staff attorney Alys Cohen of the National Consumer Law Center says that these guidances in the past have been completely meaningless. Prior to the financial crisis , “they did more than one inter-agency guidance on subprime lending,” says Cohen. Needless to say, that didn’t reform the market.
For CFPB’s rules to work, they must accompany vigorous supervision and enforcement from their examiners. For the first time ever, these rules include supervision of non-bank financial institutions, meaning they will actually cover the entire servicing industry. But the problem is that many of the new rules align with previous iterations, from Fannie and Freddie, from HAMP, even from the National Mortgage Settlement with the largest servicers over fraudulent practices, which mandated various servicing standards. And the servicers continue to fail to comply, as reports by officials monitoring the mortgage settlement have confirmed. In announcing the new rules, CFPB Director Richard Cordray acknowledged that their Office of Consumer Response received 47,000 complaints in the second half of 2012 from borrowers, the large majority of them about servicing. Servicers appear to fear the loss of the profit centers in their business model more than any penalties or sanctions.
“There’s clearly broad non-compliance right now,” Alys Cohen said. “It’s clear that there’s a robust supervision process at CFPB. But it’s not possible to adequately police a market in real time.” Some CFPB rules include a private right of action, where homeowners can sue for noncompliance, but not all of them. Investors have contractual rights they can employ if the servicers aren’t effectuating their explicit wishes on modifications. The new standards on communication between servicers and investors are critical in this regard. But we’re six years into the foreclosure crisis, and investors haven’t really borne this burden so far. Plus, investors are a disparate bunch – there could be hundreds on any individual pool of mortgages – and it’s therefore difficult to get them to make uniform decisions. “Maybe after years of supervision and enforcement, servicers will fall in line,” Cohen said. “But it’s cold comfort to a homeowner that loses their home to get a cash payout in a few years.”
What’s worse, a recent DC Circuit Court ruling throws this entire discussion into doubt. The decision declared the practice of inter-session presidential recess appointments effectively unconstitutional, which could invalidate all actions by recess-appointed officials. Since CFPB head Richard Cordray was so appointed, these new mortgage rules are under a cloud of legal uncertainty until the appeals process is worked out.
The best thing that can be said about the CFPB’s rules is that restrictions on mortgage origination could significantly slow the rush of delinquencies we saw during the housing bubble collapse. This would considerably reduce the threat of servicer mischief. “It’s definitely easier to prevent the problem than to solve the problem,” said Julia Gordon of CAP. Still, the inability to crack the compensation angle and fully harmonize the incentives between servicers and investors means that borrowers may still face hardship if they get into trouble. CFPB obviously recognizes the value of using compensation terms to encourage better practices; it’s what they did on the origination side, after all. But their well-meaning servicer rules, built around transparency, disclosure and timeliness, won’t go far enough if the servicer still sees their best interest as a foreclosure instead of a loan modification.