The previously mundane subject of mortgage loan servicing has become the “topic du jour” among politicians, academics and the media. Barely a day goes by without some new pronouncement regarding servicing regulations or related litigation.
Most of these commentaries and news stories treat the mortgage servicing industry as a monolith, and servicers, themselves, as a homogenous group of similar companies differing perhaps only in size.
Of course nothing can be further from the truth. Within the servicing industry there are many different types of participants. Many are subsidiaries of banks with perhaps the best known being the “mega-servicers” aligned with the big banks. These, along with credit union servicing departments and community banks, typically service loans for their own book of business or those sold to Freddie Mac and Fannie Mae.
Prior to the financial crisis, many of these banks also sold loans into private-label securitizations and retained the servicing. Others are servicing arms for nonbank mortgage companies that sell their production to the GSEs. Still others are third-party, fee-based servicers — many of which are also known as subservicers. These companies do not originate loans nor hold them or their corresponding mortgage servicing rights on their balance sheet. Instead, they service loans on behalf of other entities frequently on what is known as a private-label basis, which means that the company takes on the identity of its client in its interactions with the borrower.
Then there are component servicers that typically specialize in select functions within the servicing spectrum and perform those for third parties on a contractual basis. These companies have proliferated with the advent of the financial crisis due to the explosion in nonperforming loans.
KEY DIFFERENCES
However, perhaps the most important difference among servicers lies in their expertise dealing with performing as opposed to distressed loans. A relatively small number of servicers have based their business strategy on underperforming or nonperforming loans. These servicers, typically referred to as special servicers within the industry, eschew general concepts such as economies of scale and maximum automation to bring a high-touch, more personalized approach to servicing loans where borrowers are under financial duress and in need of more individualized attention. Such companies typically service far fewer loans per employee than traditional servicers and have much higher overhead since they typically employ a greater number of highly skilled asset managers and loan counselors than a predominantly performing loan servicer would. They also tend to have much smaller loan portfolios than those of performing loan servicers.
Why is this last distinction so important? For a number of reasons, ranging from compensation to future regulatory oversight, the residential mortgage industry needs to begin to recognize the difference between performing loan servicers and default management specialists much like the commercial mortgage industry did over a decade ago. This entails creating new compensation frameworks for both types of servicers and ensuring that future private-label securitizations utilize both types of servicers to maximize returns for investors and minimize losses.
Special servicers represent a relatively new type of business model. Their model involves acquiring relatively small volumes of troubled mortgages and utilizing their own highly skilled employees to achieve the highest possible recovery on each loan. This requires a more manual approach to each account and a greater employee dollar expense per loan. As a result, the traditional compensation of 25 basis points for prime loans and 50 basis points for nonprime loans is inadequate for such a model. Any operation specializing in the administration of defaulted or underperforming loans should be paid based on the results of either successful workouts or effective liquidations.
At the same time, performing loan servicers may be overpaid for performing less manually intensive work such as employing bulk processing and economies of scale in processing payments and administering escrows for extremely high volumes of mortgage loans. Prior to the 2008 economic collapse, and as long as delinquencies remained relatively low, servicing for performing loan shops represented a healthy annuity stream of income to offset the cyclical nature of income from origination activities. However, post crisis, any contention that the current compensation scheme for residential mortgage loan servicers adequately fits the needs of servicers or borrowers is simply false. As the result of increased manually intensive workloads, servicers have incurred higher costs that are not covered in pricing of servicing rights at the time of securitization.
The problem is not limited to compensation. The industry needs to adopt a standardized template of reporting similar to that achieved in the commercial arena by the Commercial Real Estate Finance Council’s predecessor — the Commercial Mortgage Securitization Association.
In that case, a wide ranging group of industry participants came together to design a template for reporting information on a monthly basis that would satisfy the need for relevant data while protecting borrower confidentiality and in a manner that was feasible in terms of systems development and servicing cost. This standardized reporting format led to greater predictability for servicers with regard to costs as system providers modified their programming to accommodate the new data requirements that were applied to all non-GSE securitizations.
TIME FOR AN OVERHAUL
It is important that the industry seizes this opportunity while there continues to be a lull in securitization activity and moves in the direction of standardizing reporting requirements in addition to overhauling both the compensation structure and even the role for different types of servicers in future transactions. The American Securitization Forum has made some important strides toward creating a standardized reporting matrix but those efforts seem to have lost some traction.
This initiative needs to take hold to help servicers and to bring back investors who may have abandoned this industry with the lure of cleaner, more reliable and more relevant data distributed equally among all future transactions.
Likewise, future transactions need to be structured so that the performing servicing and special servicing functions are allocated to parties with the relevant skill sets and expertise for each function. Recent events have amply proven that large servicing platforms suited for mass processing of payments and administration of taxes and insurance, for example, are ill equipped to deal with distressed borrowers.
Furthermore, shops that are geared to handle nonperforming loans have no interest in processing payments for performing borrowers nor does their cost structure even make such servicing economically feasible. A transfer process similar to that employed in commercial mortgage-backed bonds where the loan is transferred at the 60th day of delinquency or earlier if default is deemed imminent may be the best solution.
However such a process is also fraught with complications for residential mortgage-backed bonds such as the regulatory notice requirements for borrowers involved in such transfers under the Real Estate Settlement Procedures Act. In addition, studies have indicated the tendency for delinquency rates to increase as residential mortgages are transferred between servicers.
Even if a workable solution to employ such a dual approach to servicing is found, care must be taken to ensure that the interests of the special servicer in a transaction are aligned with that of all investors rather than with any specific class or tranche in which it or its corporate parent may have a financial interest.
In order to counter potential conflicts of interest, the CMBS industry has begun embedding entities known as Operating Advisors into securitized transactions. The purpose of these companies is to review the work done by the special servicers to ensure the results represent the best yield for the entire trust on a net present value basis. The residential industry has employed a similar entity in the past called a credit risk manager — albeit to identify servicer error on a loan-level basis. The role of the credit risk manager could potentially be enlarged or realigned with this new goal of special servicer oversight.
These changes will not be easy to implement. Establishment of a standardized reporting regimen for mortgage-backed bonds will require cooperation from a host of constituents — many with competing interests. Likewise a serious effort to modify the current compensation structure will encounter resistance from parties that benefit from the fee schedules in place as evidenced. But without these reforms it may prove very difficult to attract investors back into the fold of private-label residential mortgage securities given the weaknesses exposed in the existing framework over the last three or more years.
