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Finance and Economics Discussion Series: 2008-46 Screen Reader version

The Incentives of Mortgage Servicers: Myths and Realities

Larry Cordell, Karen Dynan, Andreas Lehnert, Nellie Liang, and Eileen Mauskopf*
September 8, 2008



Keywords: Mortgage, loss-mitigation, mortgage-backed-securities, mortgage-servicing, foreclosures, mortgage-servicers, subprime

Abstract:

As foreclosure initiations have soared over the past couple of years, many have questioned whether mortgage servicers have the right incentives to work out troubled subprime mortgages so that borrowers can avoid foreclosure and remain in their homes. Some critics claim that because servicers, unlike investors, do not bear the losses associated with foreclosure, they have little incentive to modify troubled loans by reducing interest rates or principal, or by extending the term. Our analysis suggests that while servicers have substantially improved borrower outreach and increased loss mitigation efforts, some foreclosures still occur where both borrower and investor would benefit if such an outcome were avoided. We discuss servicers' incentives and the obstacles to working out delinquent mortgages. We find that loss mitigation is costly for servicers, in large part because servicers currently lack adequate staff and technology; unfortunately, servicers have few financial incentives to expand capacity. Two additional factors appear to be damping workouts of nonprime loans, the group that has seen the largest increase in delinquencies. First, affordable solutions are more difficult to achieve for borrowers with these loans than for those with prime mortgages. Second, these loans are generally funded by private-label mortgage backed securities, for which investors provide little or no guidance to servicers about what modifications are appropriate. More generally, investors are wary that modifications might turn out to be unsuccessful, thus delaying and increasing ultimate losses. Given the significant deadweight losses incorporated in recent quarters' loss rates of 50 percent or more, we present options for further improving servicer performance. We discuss supporting further industry efforts to expand borrower outreach and establish servicing guidelines, educating investors, paying servicers fees for appropriate loan workouts, and improving measures of servicer performance.

JEL Codes: G21, L85, K23



The Incentives of Mortgage Servicing: Myths and Realities
Summary

1. Foreclosures, loss mitigation activity, and losses from foreclosure

Servicers have been increasing the number of workouts of delinquent or probable delinquent mortgages, but delinquencies and foreclosure starts have continued to rise rapidly. Servicers are responding to pressures from the Congress, regulators, and consumer groups and, as a result, have improved outreach and loss mitigation practices. They have increased modifications, which involve permanent changes to the mortgage contract, and have relied relatively less on repayment plans, which allow borrowers to make up missed payments in installments. Still, borrowers and housing counselors report dissatisfaction with response times and the relief offered. The available evidence suggests that some avoidable foreclosures are being initiated because of inadequate loss-mitigation servicing capacity and various practices of servicers. Given loss rates to investors from foreclosed subprime mortgages of 50 percent or more, both investors and borrowers could be better off with more effective loss mitigation.

2. Mortgage servicer revenues and costs

Consolidation in the servicing industry has created substantial economies of scale in processing payments and managing collections for performing loans. But such economies of scale are not present in loss mitigation, which generally requires more labor-intensive processes, such as assessing whether a financial setback is temporary or permanent and, in turn, determining the appropriate loss-mitigation option. Servicers of loans in private-label mortgage-backed securities (MBS) do not have strong financial incentives to invest in additional staff or technology for loss mitigation because investor guidance is limited, the prospect for future subprime servicing volume is dim, and expected recidivism rates on home retention workouts are high. Moreover, the costs of loss mitigation will be in addition to expenses incurred in any parts of a foreclosure procedure executed, because trusts generally require that foreclosure options be pursued even if loss mitigation efforts have been initiated.

3. Servicers' duties and obligations to investors

Rules are in place to protect investors' interests when a loan becomes delinquent. Servicers' duties and obligations to the investors in private-label MBS are governed by Pooling and Servicing Agreements (PSAs). These PSAs vary widely, but they generally state that the servicer is obligated to maximize the interests of the investors or certificate holders, often implemented by comparing the net present value (NPV) of a loss mitigation option to the NPV of foreclosure. However, servicers' incentives are not always aligned completely with those of the investors, and they have considerable discretion in interpreting PSA language. The housing government-sponsored enterprises (GSEs) recognize the conflict and provide explicit guidance for how servicers should deal with delinquent loans in GSE pools. The PSAs for private-label MBS do not provide much specific guidance, leaving servicers to determine what loss mitigation steps are most appropriate. In addition, some investors fear that modifications will not be successful and will ultimately cost them more by delaying a timely resolution of losses at a time when house prices continue to fall. Indeed, the investors with whom we spoke did not widely convey concern that servicers are relying too heavily on foreclosures relative to loan modifications.

4. Loss mitigation of loans in GSE pools

Fannie Mae and Freddie Mac (F/F) guarantee the timely payment of principal and interest on mortgages in their pools. Each serves as the Master Servicer for its securities and thus has the authority to represent the interest of the pools to servicers as well as maintain significant influence over the actions taken by individual servicers in working out delinquent loans. F/F oversee the entire default management process, from identification to resolution of delinquent mortgages. They provide automated tools to their servicers to aid in loan workouts, have rules for delegating authority to servicers, and generally offer a single point of contact for approving exceptions. They offer reputational and financial incentives to servicers in order to encourage more efficient resolution of delinquent loans. Their guidelines are published in their Seller/Servicer Guides that are referenced in their securities. They believe that their actions to encourage appropriate modifications have helped to keep recidivism rates relatively low.

5. Loss mitigation of loans in private-label MBS pools

Several aspects of private pools hinder successful loss mitigation. In addition to the vague PSA workout guidelines noted earlier, investors do not offer monetary incentives, and servicers see little reputational gain from performing well to attract future business because the prospects for servicing a significant volume of subprime mortgages in the future are dim. Large firms that service both GSE and private-label MBS pools may respond to the greater clarity and incentives from F/F by devoting their scarce resources to the loans in GSE pools at the expense of loans in private-label pools. Servicers also worry about legal liability from dissatisfied investors, especially in cases where a modification benefits some MBS tranches at the expense of others. However, tax and accounting issues surrounding workouts of loans in these pools have been clarified over the past year and no longer present a major hurdle. (For loans held in portfolio, regulatory accounting for troubled debt restructurings remain a potential problem).

6. Problems when there are other stakeholders--junior liens and mortgage insurers

A major impediment to refinancing and loss mitigation is the presence of junior liens, which appear to be more common among subprime than among prime mortgages. Senior lien holders generally require the holders of junior liens to affirmatively agree to substantive changes to mortgage terms. But junior lien holders are slow or reluctant to agree to changes before extracting the largest monetary concession they can because the value of their lien is often worthless in a foreclosure in today's depressed housing market. Private mortgage insurers do not appear to be an impediment for modifications, but could be for executing short sales.

7. Policy options to improve servicer performance

Loss severity rates on subprime mortgage foreclosures are steep: all told, 50 percent or more of the outstanding mortgage balance has been lost in recent foreclosures. The foreclosure process itself involves significant liquidation expenses, and foreclosed properties are typically sold at a substantial discount. These costs constitute a deadweight loss that does not benefit the borrower or the investor, but instead suggests that both could be better off with loss mitigation. Some servicers do a much better job at minimizing loss rates given default than others--Moody's (2001) reports that the difference in realized loss levels at good versus bad servicers can be as high as 20 percent. Options to improve servicer performance include supporting industry efforts to continue to improve borrower outreach and develop servicing guidelines, educating investors about loss mitigation, paying fees to servicers for completion of appropriate loss mitigation alternatives, and encouraging the development and use of an effective set of quantitative metrics of servicer performance. Servicers can be evaluated on preventing default, maximizing recoveries, and preventing re-defaults on home retention workouts. Legislative proposals to extend a safe harbor or impose blanket foreclosure moratoriums have some disadvantages.


1. Foreclosures, loss mitigation activity, and losses from foreclosure

Servicers have been increasing the number of workouts of delinquent or probable delinquent mortgages, but delinquencies and foreclosure starts have continued to rise rapidly. Servicers are responding to pressures from the Congress, regulators, and consumer groups and, as a result, have improved outreach and loss mitigation practices. They have increased modifications, which involve permanent changes to the mortgage contract, and have relied relatively less on repayment plans, which allow borrowers to make up missed payments over time. Still, borrowers and housing counselors report dissatisfaction with response times and the relief offered. The available evidence suggests that some avoidable foreclosures are being initiated because of inadequate loss-mitigation servicing capacity and various practices of servicers. Given loss rates to investors from foreclosed subprime mortgages of 50 percent or more, both investors and borrowers could be better off with more effective loss mitigation.

Foreclosures

The number of foreclosure starts rose sharply in 2006 and 2007 and continued to rise in the first half of 2008 (Table 1).

Foreclosure starts are on pace to rise by 1 million to 2.5 million this year. We expect that foreclosure starts will fall a bit next year, but remain above 2 million.

It appears that foreclosure starts have led to homeowners losing their homes about half of the time in the past. Many homeowners were able to avoid eviction by arranging a repayment plan with the servicer or lender or otherwise curing their delinquency on their own.


Table 1. Foreclosures Started and in Inventory, for Subprime and Prime Mortgages
(Thousands of loans)


Date Subprime: Foreclosures started

during period

Prime: Foreclosures started

during period

Total: Foreclosures started

during period

Subprime: Foreclosure inventory

at end of period

Prime: Foreclosure inventory

at end of period

Total: Foreclosure inventory

at end of period

2004 362 307 928 254 197 620
2005 402 293 883 243 173 539
2006 540 317 1016 342 211 654
2007 852 553 1558 603 411 1119
2007:Q1 175 110 323 374 229 701
2007:Q2 188 105 323 424 248 767
2007:Q3 232 154 429 500 337 930
2007:Q4 259 184 483 603 411 1119
2008:Q1 275 236 555 724 524 1358
2008:Q2 288 262 598 798 611 1523

Notes. Data are calculated based on foreclosure rates from the Mortgage Bankers Association National Delinquency Survey and staff estimates of the number of loans serviced. Not seasonally adjusted. Total includes FHA, VA, and loans not elsewhere classified.

Loss mitigation activity

Loss mitigation may or may not result in home retention. The term "workouts" often refers to options that help the borrower stay in their home, such as temporary forbearance, repayment plans, and loan modifications, where modifications involve a permanent change to the mortgage contract. Loss mitigation techniques that do not involve home retention include "short sales" (a sale that the lender agrees to for less than the full amount of the unpaid principal) and "deeds in lieu" of foreclosure (the voluntary transfer of the property title from the homeowner to the lender).

The number of subprime and prime mortgage home retention workouts (defined as the sum of temporary forbearance cases, repayment plans, and modifications) totaled 1.5 million in 2007 according to surveys from the Hope Now Alliance, of which nearly 1 million were for subprime mortgages.1


Table 2. Estimated Subprime and Prime Mortgage Workouts from Hope Now
(Thousands of loans during the period)

Date Subprime: Repayment plans Subprime: Modifications Subprime: Total workouts Prime: Total workouts Total subprime and prime workouts
2007 717 214 947 590 1537
2007:Q1 155 29 184 110 294
2007:Q2 167 35 202 105 307
2007:Q3 204 45 248 150 398
2007:Q4 197 103 300 174 474
2008:Q1 166 123 287 195 483
2008:Q2 161 164 325 197 522

Notes. Repayment plans are counted at initiation, modifications at successful completion (i.e. when the borrower and servicer agree to the modification). Data are from surveys of servicers in the Hope Now Alliance. Components may not sum to totals because of rounding.

There is no consensus on the relevant metric by which to judge the effort put into, and success with, loss mitigation.

What is the evidence that at least some servicers are not modifying loans quickly enough?

Servicers have substantially improved outreach efforts, but continue to report difficulties making contact with borrowers. They say some distressed borrowers may not respond to servicers' attempts to reach them because they feel nothing can help them or they expect direct contact with their servicer might accelerate the loss of their home.

Servicers are responding to continued pressure from the Congress, regulators, and consumer groups and recently have taken steps to improve communication with borrowers and establish servicing guidelines. These efforts have been largely facilitated by the Hope Now Alliance.

Losses from foreclosures

Loss severity rates on foreclosed subprime mortgages are high and involve substantial deadweight losses, suggesting that both borrowers and investors could be better off avoiding some foreclosures.


Table 3. Losses on Unpaid First-Lien balances and House Price Declines
(As a percent of unpaid first-lien balances)

House Price Decline (Percent) Initial First-Lien LTV (Percent): 80 Initial First-Lien LTV (Percent): 85 Initial First-Lien LTV (Percent): 90 Initial First-Lien LTV (Percent): 95
0 25 18 11 5
10 13 6 0 -5
20 0 -6 -11 -16
40 -25 -29 -33 -37
60 -50 -53 -56 -58

Notes. Calculations assume no appraisal bias and that negligible amounts of principal have been repaid at time of sale.


2. Mortgage servicer revenues and costs

Consolidation in the servicing industry has created substantial economies of scale in processing payments and managing collections for performing loans. But such economies of scale are not present in loss mitigation, which generally requires more labor-intensive processes, such as assessing whether a financial setback is temporary or permanent and, in turn, determining the appropriate loss-mitigation option. Servicers of loans in private-label MBS do not have strong financial incentives to invest in additional staff or technology for loss mitigation because investor guidance is limited, the prospect for future subprime servicing volume is dim, and expected recidivism rates on home retention workouts are high. Moreover, the costs of loss mitigation will be in addition to expenses incurred in any parts of a foreclosure procedure executed, because trusts generally require that foreclosure options be pursued even if loss-mitigation efforts have been initiated.

Industry structure

The mortgage servicing industry has consolidated substantially over the past 20 years.

Consolidation of Mortgage Servicing.  Chart shows in bar graphs the percentage share of mortgage loans serviced by the top 5 and 25 servicers for selected years between 1989 and 2007, as well as the dollar volume of total servicing in that year.  In 2007, the chart also shows the share of mortgage servicing assuming the Countrywide/Bank of America merger had occurred at the end of 2007 instead of when it actually occurred in July 2008.   The chart shows a monotonic increase in the concentration in this industry.  For example, in 1989, the 5 firms that handled the largest dollar volume of mortgage servicing accounted for only 7 percent of total mortgage servicing; this share had grown to 46 percent by 2007.  Taking account of the Countrywide/Bank of America merger, the top 5 share accounted for 51 percent in 2007.  A similar pattern of increasing concentration in this industry is evident from the share of the market serviced by the top 25 firms in the industry.  The chart also provides the total value of 1-4 family mortgage debt outstanding, in billions of dollars.


Table 4. Large Servicer Holdings of High-Risk Mortgages
(Holdings at Year-End 2007)

Rank Servicer Parent Primary Product Types Volume (All Loans) Mkt. Share (All Loans) Mkt. Share (Subprime) Mkt. Share (Alt A) Mkt. Share (Option ARM) Mkt. Share (FHA/VA)
1 Bank of America/Countrywide Comm. Bk All Products $1,993 18% 12% 18% 22% 14%
2 Wells Fargo & Company, IA Comm. Bk All Products $1,473 13% 5% 7% 0% 30%
3 CitiMortgage Inc., MO Comm. Bk All Products $838 8% 7% 1% 0% 10%
4 Chase Home Finance, NJ Comm. Bk All Products $776 7% 8% 2% 0% 10%
5 Washington Mutual, WA Thrift All Products $623 6% 5% 8% 21% 0%
6 Residential Capital LLC, NY (GMAC) Nonbank All Products $410 4% 4% 9% 10% 5%
7 IndyMac, CA Thrift Alt A/GSE $198 2% 1% 12% 12% 0%
8 HSBC North America, IL Comm. Bk Subpr/Prime $161 1% 9% 0% 0% 0%
9 Aurora Loan Services, CO (Lehman Bros.) Inv. Bk. Alt A/GSE $113 1% 0% 9% 0% 0%
10 EMC Mortgage Corp, TX (Bear Stearns) Inv. Bk. Alt A/Subpr $89 1% 2% 8% 10% 0%
11 Merrill Lynch B&T FSB, NY Inv. Bk. Subprime $65 1% 7% 0% 0% 0%
12 Ocwen Financial Corporation, FL Nonbank Subprime $53 0% 6% 0% 0% 0%
13 Option One Mortgage, CA (WL Ross & Co.) Pr. Equity Subprime $48 0% 6% 0% 0% 0%
14 HomEq Servicing Corporation, CA (Barclay's) Inv. Bk. Subprime $47 0% 5% 0% 0% 0%
15 Litton Loan Servicing, TX (Goldman Sachs) Inv. Bk. Subprime $46 0% 4% 0% 0% 0%
16 Saxon Mortgage (Morgan Stanley) Inv. Bk. Subprime $37 0% 5% 0% 0% 0%
17 American Home Mortgage Corp. (WL Ross & Co.) Pr. Equity Alt A $30 0% 0% 6% 14% 0%
18 Select Portfolio Servicing, UT (CSFB) Inv. Bk. Alt A/Subpr $29 0% 2% 2% 0% 0%
  Totals/Shares by Product Type     $7,000 63% 88% 81% 89% 69%

Notes:

- Total, Subprime and FHA/VA figures are from Inside Mortgage Finance, except for IndyMac Subprime, which came from financial statements.

- Alt A and Option ARM security volumes are from Loan Performance. Only non-missing values were included in calculations.

- Figures are year-end 2007. Bank of America and Countrywide figures were combined.

Servicer revenues and costs

The main revenue source for servicers is a fixed fee, expressed as a percent of the outstanding balance of the loan, and is paid out of monthly principal and interest (P&I) payments collected by the servicer.

Loan defaults raise servicing costs and reduce revenues

Loan loss mitigation is labor intensive and thus raises servicing costs, which in turn make it more likely that a servicer would forego loss mitigation and pursue foreclosure even if the investor would be better off if foreclosure were avoided.


3. Servicers' duties and obligations to investors--the net present value calculation for determining whether to engage in loss mitigation

Rules are in place to protect investors' interests when a loan becomes delinquent. Servicers' duties and obligations to the investors of private-label MBS are governed by Pooling and Servicing Agreements (PSAs). These PSAs vary widely but generally state that the servicer is obligated to maximize the interests of the investors or certificate holders, often implemented by comparing the net present value (NPV) of a loss mitigation option to the NPV of foreclosure. However, servicers' incentives are not always aligned completely with those of the investors, and they have considerable discretion in interpreting PSA language. The GSEs recognize the conflict and provide explicit guidance for how servicers should deal with delinquent loans in GSE pools. The PSAs for private-label MBS do not provide much specific guidance, leaving servicers to determine what loss mitigation steps are most appropriate. Indeed, some investors fear that modifications will not be successful and will ultimately cost them more by delaying a timely resolution of losses at a time when house prices continue to fall. That said, the investors with whom we spoke did not widely convey concern that servicers are relying too heavily on foreclosures relative to loan modifications.

Servicers typically are required by the PSAs to pursue loss mitigation on a delinquent loan if the net present value (NPV) to the investors is higher than that realized under foreclosure. The operating procedure is for the servicer to calculate the NPV of a proposed loss mitigation option relative to foreclosure, and implement the option if it has a higher NPV to the investor.

While PSAs generally obligate servicers to follow customary and usual standards of prudent mortgage servicing, it does not appear that investors generally question servicers of private-label MBS about the practices they follow. Thus, in practice, servicers can exercise discretion in their choice of parameters when calculating the NPV of different options. This is less true in the case of GSE pools, because the GSEs prescribe specific actions for servicers to take at different points in delinquency, provide software to servicers that compute the NPV of different options, and monitor servicer practices quite closely.

Incentives of servicers are not completely aligned with those of investors. Servicers often are not part of the same organization that originated the loan and they often do not have any ownership stake. Primarily, servicers will favor alternatives that are less labor intensive, and hence less costly, or for which out-of-pocket expenses will be reimbursed or payments from the GSEs will be greatest.

Servicer discretion may be exercised in various ways, including the choice of various parameters important to the NPV calculation: (1) the house price likely to be obtained in a foreclosure, (2) the discount rate used to discount payments streams under workout options, and (3) the expected recidivism probability. A higher sales price, discount rate, or recidivism rate would increase the NPV of a foreclosure relative to a modification. These parameters, especially in the current environment of high delinquencies and falling house prices, are highly uncertain and thus a sizable amount of subjectivity may be introduced into these calculations.

While investors seem somewhat concerned about servicer capacity, they do not convey widespread concern that servicers are relying overmuch on foreclosures relative to modifications. Investors may be more comfortable with foreclosures because that process is more transparent. Investors also may fear modifications will be unsuccessful and, in an environment of declining house prices, would rather take losses sooner than later (the reasoning behind the maxim "the first loss is the best loss").


4. Loss mitigation for loans in agency pools

Fannie Mae and Freddie Mac (F/F) guarantee the timely payment of principal and interest on mortgages in their pools. Each serves as the Master Servicer for its securities and thus has the authority to represent the interest of pools to servicers and significant influence over the actions taken by individual servicers in working out delinquent loans. They oversee the entire default management process, from identification to resolution, of delinquent mortgages. They provide automated tools to their servicers to aid in loan workouts, have rules for delegating authority to servicers, and generally offer a single point of contact for approving exceptions. They offer reputational and financial incentives to servicers in order to encourage more efficient resolution of delinquent loans. Their guidelines are published in their Seller/Servicer Guides that are referenced in their securities. They believe that their actions to encourage appropriate modifications have helped to keep recidivism rates relatively low.

F/F empower servicers with sophisticated automated tools.

F/F use reputational and financial incentives to improve servicer performance.

For example, Freddie uses quantitative metrics, with the best performing servicers earning recognition as Tier One Servicers and financial rewards. Some servicers have said that such recognition is important, largely because it enhances their prospects for future business with F/F.

F/F explicitly pay fees to servicers for approved and properly executed workouts and short sales.

Servicers report that they find it "far easier" to work with loans in F/F pools. Each pool has a single set of guidelines that make it easier to apply rules and approve exceptions.

F/F pools are created subject to REMIC and FAS140 rules, just as the private-label MBS pools are, so the parties to the pool are required to act in a "brain dead" manner. But, because F/F have (up to now) removed most loans from the pool before they are modified, their actions appear to be less constrained by the "passive" notion of the pool. Taking the loan out of the pool results in F/F having to take an immediate fair value writedown and hold the loan on its books until it terminates; this speeds up the recognition of losses.


5. Loss mitigation for loans in private-label MBS pools

Several aspects of private pools hinder successful loss mitigation. In addition to the vague PSA guidelines discussed earlier, investors do not offer monetary incentives, and servicers see little reputational gain from performing well to attract future business because the prospects for servicing a significant volume of subprime mortgages in the future are dim. Large firms that service both GSE and private-label pools may respond to the greater clarity and incentives by devoting their scarce resources to the loans in GSE pools at the expense of loans in private-label MBS pools. Servicers also worry about legal liability from dissatisfied investors, especially in cases where a modification benefits some MBS tranches at the expense of others. However, tax and accounting issues surrounding workouts of loans in these pools have been clarified over the past year and no longer present a major hurdle. (For loans held in portfolio, regulatory accounting for troubled debt restructurings remain a potential problem.)

Several key features of private-label MBS pools distinguish them from GSE pools and bear importantly on what workouts are feasible and optimal:

Many other factors appear to represent important impediments to servicer modifications of loans in private-label MBS pools:


6. Problems when there are other stakeholders

A major impediment to refinancing and loss mitigation is the presence of junior liens, which appear to be more common among subprime than among prime mortgages. Senior lien holders generally require the holders of junior liens to affirmatively agree to substantive changes to mortgage terms. But junior lien holders are slow or reluctant to agree to changes before extracting the largest monetary concession they can because the value of their lien is often worthless in a foreclosure in today's depressed housing market. Private mortgage insurers do not appear to be an impediment for modifications, but could be for executing short sales.

Junior liens

In contrast with past housing downturns, delinquent borrowers today often have at least one junior lien.


Table 5. Subprime Mortgages Originated with an Associated Junior Lien
(Percent)

Type of subprime mortgage Origination year: 2002 Origination year: 2003 Origination year: 2004 Origination year: 2005 Origination year: 2006 Origination year: 2007
2/28 2.3 10.0 18.6 30.5 35.4 19.9
Fixed-rate 1.0 3.1 6.0 10.4 13.6 5.4

Notes. Data from First American LoanPerformance ABS data and reflect subprime 2/28 loans only. A "2/28" is a mortgage with a fixed initial interest rate for two years which then converts to an adjustable-rate mortgage.


Table 6. Delinquency Status and Presence of Junior Lien at Origination, May 2008

Delinquency status Has a second lien: No Has a second lien : Yes All Percent with a second lien
Current / 30 or 60 days delinquent 2,105,787 507,742 2,613,529 19
Seriously delinquent 459,593 201,544 661,137 31
All 2,565,380 709,286 3,274,666 22
Memo:

Serious delinquency rate

18% 28% 20%  

Notes. Data are from First American LoanPerformance ABS and reflect subprime loans only. Junior liens are only recorded if originated at the same time as the associated senior lien. Data do not contain open-ended liens such as HELOCs.

Significant changes to the senior lien may result in the revised lien being treated as a new lien; that is, modified loans can be treated like a refinancing. In such cases, in principle, unless the junior lien holder agrees to re-subordinate its lien, it becomes the senior lien holder. The actual extent to which senior lien holders are treated as subordinate when they modify loans without the junior lien holders' consent is unknown, but seems fairly rare. Indeed, the practice of subordinating modified senior liens appears related to state legal traditions and the applicable local case law. It may be the case that senior lien holders are overestimating the risk that courts will consider them as subordinate following a modification.

Nonetheless, given the legal uncertainties surrounding modifications, senior lien holders generally require the junior lien holder to affirmatively agree to subordinate their claim to the modified senior lien before agreeing to the modification.

Junior lien holders have been slow and reluctant to agree to re-subordinate in this episode and have held up refinancings, modifications, and short sales.

The Hope Now servicer guidelines issued in June 2008 include an automatic re-subordination of second liens "when the second lien holder's position is not worsened as a result of a refinance or loan modification."

Private mortgage insurance

Loan-level mortgage insurance may be used for GSE loans as a credit enhancement when there is less than a 20 percent down payment. It is less commonly found on non-agency subprime loans.

Mortgage insurers (MIs) pay claims to lenders if a loan defaults and the recovery value falls short of the unpaid loan balance.

Mortgage insurers do not appear to have an incentive to stand in the way of modifications, but may have an incentive to block short sales.

MIs and junior lien holders seem to have similar incentives, but incentives actually differ.


7. How can servicer performance be improved?

Loss severity rates on subprime mortgage foreclosures are steep: all told, 50 percent or more of the outstanding mortgage balance has been lost in recent foreclosures. The foreclosure process itself involves significant liquidation expenses and foreclosed properties are typically sold at a substantial discount. These costs constitute a deadweight loss that does not benefit the borrower or the investor, but instead suggests that both could be better off with loss mitigation. Some servicers do a much better job at minimizing loss rates given default than others--Moody's (2001) reports that the difference in realized loss levels at good versus bad servicers can be as high as 20 percent. Options to improve servicer performance include supporting industry efforts to continue to improve borrower outreach and develop servicing guidelines, educating investors about loss mitigation, paying fees to servicers for completion of appropriate loss mitigation alternatives, and encouraging the development and use of an effective set of quantitative metrics of servicer performance. Servicers can be evaluated on preventing default, maximizing recoveries, and preventing re-defaults on home retention workouts. Legislative proposals to extend a safe harbor or impose blanket foreclosure moratoriums have some disadvantages.

Two goals of better servicer performance are to:

Policy options to promote better servicer performance are:

1. Continue to work with the servicing industry to develop best practices, including more expansive borrower outreach and standardization, to streamline the workout process, to lower the costs of workouts.

2. Educate more investors about loss mitigation.

3. Pay servicers for completion of appropriate loss mitigation alternatives.

4. Encourage investors to develop and use an effective set of quantitative metrics of servicer performance.

5. Legislation to provide a safe harbor or impose foreclosure moratoriums.

1. Continue to work with the servicing industry to develop industry best practices so servicers can effectively and efficiently provide workouts

2. Educate investors about loss mitigation

3. Pay servicers for completion of appropriate loss mitigation alternatives

4. Encourage investors to develop and use an effective set of quantitative metrics of servicer performance

Measures of success at preventing default:

Measures of success at maximizing recoveries:

Measures of successful foreclosure alternatives and successful loan modifications

5. Two proposals that would require legislation that could have some short term benefits, but significant long term costs

References

Brinkmann, Jay. 2008. "An Examination of Mortgage Foreclosures, Modifications, Repayment Plans and Other Loss Mitigation Activities in the Third Quarter of 2007." Mortgage Bankers Association (January).

Capone, Charles. 1996. "Providing Alternatives to Foreclosure: A Report to Congress." U.S. Department of Housing and Urban Development (May).

Conference of State Bank Supervisors. 2008. "Analysis of Subprime Mortgage Servicing Performance." (April 22).

Credit Suisse. 2007. "The Day After Tomorrow: Payment Shock and Loan Modifications." Fixed Income Research Report (April 5).

Credit Suisse. 2008a. "Subprime HEAT Update." (June 17).

Credit Suisse. 2008b. "Deep Dive into Subprime Mortgage Severity." Fixed Income Research Report (June 19).

Cutts, Amy Crews and Richard K. Green. 2005. "Innovative Servicing Technology: Smart Enough to Keep People in their Houses?" In Building Assets, Building Credit: Creating Wealth in Low-Income Communities, Nicolas P. Retsinas and Eric S. Belsky, eds. Washington, DC: JCHS/Brookings Press.

Cutts, Amy Crews and William A. Merrill. 2008. "Interventions in Mortgage Default: Policies and Practices to Prevent Home Loss and Lower Costs." Freddie Mac Working Paper #08-01 (March).

Eggert, Kurt. 2007. "Comment: What Prevents Loan Modifications?" Housing Policy Debate Vol. 18 no. 2 (March).

Freddie Mac. 2008. "Single-Family Seller/Servicer Guide Bulletin." (July 31).

Hagerty, James R. 2008. "Fannie, Freddie Do More to Prevent Foreclosures." Wall Street Journal (August 4): p. A3.

Hope Now Alliance. 2008. "HOPE NOW Mortgage Servicing Guidelines." (June 9).

Mason, Joseph R. 2007. "Mortgage Loan Modification: Promises and Pitfalls," SSRN Working Paper: http://ssrn.com/abstract=1027470. (October).

Moody's Investors Service. 2001. "Moody's Approach to Rating Residential Mortgage Servicers." (January 19).

Moody's Investors Service. 2008a. "2007 Review and a Look Ahead to 2008: U.S. Mortgage Servicer Ratings." (February 8).

Moody's Investors Service. 2008b. "Moody's Subprime ARM Loan Modification Update," (July 14).

UBS Investor Research. 2008. "Mortgage Strategist." (August 12).



Footnotes

* Cordell is from the Federal Reserve Bank of Philadelphia. Dynan, Lehnert, Liang, and Mauskopf are from the Board of Governors of the Federal Reserve System. We thank David Buchholz, Richard Buttimer, Philip Comeau, Amy Crews Cutts, Kieran Fallon, Jack Guttentag, Madeline Henry, Paul Mondor, Michael Palumbo, Karen Pence, Edward Prescott, Peter Sack, David Wilcox, staff at Neighborworks America, and many market participants from servicers, investors, Freddie Mac, mortgage insurance companies, rating agencies, and legal and tax counsel for helpful discussions and comments. We are also grateful to Erik Hembre and Christina Pinkston for excellent research assistance. The views expressed in this paper are those of the authors and do not necessarily represent the views of the Federal Reserve Board, the Federal Reserve Bank of Philadelphia, or their staffs. Contact author: Nellie Liang at [email protected]. Return to Text
1. The Hope Now Alliance is a private-sector group of lenders, servicers, mortgage counselors, and investors that were brought together by the government to address problems of servicing mortgages and helping homeowners. President Bush asked HUD and Treasury to launch a new foreclosure avoidance initiative in August 2007, and Treasury Secretary Paulsen announced the creation of Hope Now on October 10, 2007. Return to Text
2. Brinkmann (2008). Return to Text
3. Conference of State Bank Supervisors (2008). Return to Text
4. Moody's Investors Service (2008b). Return to Text
5. Hope Now Alliance (2008).

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6. UBS Investment Research (2008). Return to Text
7. Credit Suisse (2008b). Return to Text
8. Mason reports that the cost of a typical foreclosure has been estimated to be about $60,000, about 20 to 25 percent of the loan balance. Capone estimates a loss severity rate of 30 percent for an eight-month period between the date of last payment and property disposition. Return to Text
9. Based on 2007 servicing volumes, the merger of Bank of America and Countrywide completed in July 2008 should have pushed the top-five share to above 50 percent. Return to Text
10. Cutts and Merrill (2008) note that in Freddie Mac's portfolio only around half of the borrowers who lost their home through a foreclosure sale had a contact with the servicer. Return to Text
11. See Freddie Mac (2008) and Hagerty (2008). Return to Text
12. Credit Suisse (2007). Return to Text
13. The exception is Fannie Mae's new Homesaver Advanced modification program described above that makes all changes to the loan part of a separate promissory note Fannie puts on its own portfolio. Return to Text
14. Credit Suisse (2008a). Return to Text
15. For example, legislation reported out by the House Financial Services Committee on April 23, 2007 (H.R. 5579) would provide a safe harbor to servicers that modify residential, owner-occupied loans consistent with maximizing the net present value if, among other things, the modification does not result in negative amortization or require the borrower to pay additional points or fees. This legislation also would clarify that a servicer owes a duty to act in the best interests of all investors in the aggregate, not any particular party or group of parties. Return to Text

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