Why Servicers Foreclose When They Should Modify and Other Puzzles of Servicer Behavior

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As the foreclosure numbers have spiraled upwardover the last few years, policymakers and economists have come to a consensus that the national economy needs a massive reduction in the number of foreclosures, probably by modifying delinquent loans. Everyone claims to be in favor ofthis:  Congress, the President, the Federal ReserveBoard, bankers. Yet the numbers of modifications have not kept pace with the numbers of foreclosures.

At the center of the efforts to perform loanmodifications are servicers. Servicers are thecompanies that accept payments from borrowers. Servicers are distinct from the lender, the entity that originated the loan, or the current holder or investors, who stand to lose money if the loan fails. Some servicers are affiliated with the originating lender or current holder; many are not. Yet, while servicers normally have the power to modify loans, they simply are not making enough loan modifications. Why? One answer isthat the structure of servicer compensation generally biases servicers against widespread loan modifications

How servicers get paid and for what is determined in large part by an inter locking set of tax,accounting, and contract rules. These rules arethen interpreted by credit rating agencies andbond insurers. Those interpretations, more than any individual investor or government pronouncement, shape servicers’ incentives. While none of these rules or interpretations impose an absolute ban on loan modifications, as some servicers have alleged, they generally favor foreclosures over modifications, and short-term modifications over modifications substantial enough to be sustainable. Neither the formal rulemakers—Congress, the Administration, and the Securitiesand Exchange Commission—nor the market participants who set the terms of engagement—credit rating agencies and bond insurers—haveyet provided servicers with the necessary incentives—the carrots and the sticks—to reduce foreclosures and increase loan modifications.

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Servicers’ incentives ultimately are not aligned with making loan modifications in large numbers. Servicers continue to receive most of theirincome from acting as automated pass-through accounting entities, whose mechanical actions are performed off shore or by computer systems. Their entire business model is predicated on making money by lifting profits off the top of what they collect from borrowers. Servicers generally profit from: a servicing fee that takes the form of a fixed percentage of the total unpaid principal balance of the loan pool; ancillary fees charged borrowers—sometimes in connection with the borrower’s default and sometimes not; interest income on borrower payments held by the servicer until they are turned over to the investors or paid out for taxes and insurance; and affiliated business arrangements.

Servicers, despite their name, are not set up toperform or to provide services. Rather, they make their money largely through investment decisions: purchases of the right pool of mortgage servicing rights and the correct interest hedging decisions. Performing large numbers of loan modifications would cost servicers upfront money in fixed overhead costs, including staffing and physical infrastructure, plus out-of-pocketexpenses such as property valuation and credit reports as well as financing costs.

Several programs now offer servicers some compensation for performing loan modifications, most significantly the Making Home Affordable program. Fannie Mae and FreddieMac—market makers for most prime loans—have long offered some payment for loan modifications. Other investors have sometimes done likewise, and some private mortgage insurance companies make small payments if a loan in default becomes performing, as does the FHA loan program. Yet none of these incentives has been sufficient to generate much interest among servicers in loan modifications.

Post-hoc reimbursement for individual loan modifications is not enough to induce servicers to change an existing business model. This business model, of creaming funds from collections before investors are paid, has been extremely profitable. A change in the basic structure of the business model to active engagement with borrowers is unlikely to come by piecemeal tinkering with the incentive structure. Indeed, some of theattempts to adjust servicers’ incentive structure have resulted in confused and conflicting incentives, with servicers rewarded for some kinds of modifications, but not others. Most often, if servicers are encouraged to proceed with a modification at all, they are told to proceed with both a foreclosure and a modification, at the same time. Until recently, servicers received little if any explicit guidance on which modifications were appropriate and were largely left to their own devicesin determining what modifications to make.

In the face of an entrenched and successful business model and weak, inconsistent, and posthoc incentives, servicers need powerful motivation to perform significant numbers of loanmodifications. Servicers have clearly not yet received such powerful motivation

A servicer may make a little money by makinga loan modification, but it will definitely cost it something. On the other hand, failing to make aloan modification will not cost the servicer any significant amount out-of-pocket, whether the loan ends in foreclosure or cures on its own. Servicers remain largely unaccountable for their dismal performance in making loan modifications.

Until servicers face large and significant costs for failing to make loan modifications and are actually at risk of losing money if they fail to makemodifications, no incentive to make modifications will work. What is lacking in the system is not a carrot; what is lacking is a stick. Servicers must be required to make modifications, where appropriate, and the penalties for failing to do somust be certain and substantial.

A full report is available here: Loan Modifications and Why Servicers Foreclose

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