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Finance and Economics Discussion Series Divisions of Research & Statistics and Monetary Affairs
Federal Reserve Board, Washington, D.C.
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.
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 lossmitigation 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 havehelped 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.
Read more from the Federal Reserve
About: 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 JNellie.Liang@frb.gov.
