Consumer Law

Paying (but not overpaying) the Servicers

By Alan White

By Alan White

Why are foreclosures continuing, when each foreclosure results in an average loss of $100,000 and frustrated homeowners and counselors are trying to get reasonable loan workouts?  One of the many answers to this complex question is how mortgage servicers get paid (or don?t). 

    Subprime securitization agreements were set up so that servicers make money, but also advance money to investors, in the following ways.  First, they receive the part of the interest paid each month representing 0.5% (annually) of outstanding balances.  Thus, if a homeowner with a 10% interest rate makes a monthly payment of $1,100, and $100 is properly applied to principal, $1,000 represents interest, of which the servicer pays itself $50.  The servicer does not get a servicing fee for interest that is not actually paid.

    In fact, the servicer must advance to the investors the interest (but not the scheduled principal portion) for homeowners who did not make their monthly payment.  So if the same homeowner does not make her monthly payment, the servicer in the above example would pay $1,000 to the investors, and then accrue an advance in the same amount to be recovered later.  Recovered how? If the homeowner eventually catches up on payments, the servicer reimburses itself.  If the home is foreclosed and sold, the servicer is entitled to recover its advances before paying the principal due to investors.

     What if the loan is modified?  Then things get murky.  If the modification includes a waiver of unpaid past-due interest, there is no clear mechanism for the servicer to recover losses, which rightly should fall on investors.  If the modification simply adds unpaid interest to the principal, or to a balloon payment, the servicer may have to wait until the loan is paid in full to recover its advances.  At current prepayment rates that could be five to ten years or more.

    The second way servicers get paid is that they usually keep 100% of late fees paid by borrowers.  They also impose a variety of other fees (for payoff statements, for sending faxes, etc.) which they keep.

    Modifications and foreclosures both cost money.  Servicers and their lawyers have to hire staff to perform these tasks.  In the case of foreclosures, however, servicers usually pay a law firm to perform the work.  The payment becomes a servicer advance, i.e. the servicer writes a check to the law firm, that the servicer does not recover until the property is foreclosed and sold.  Then the foreclosure fees are taken off the top, out of the investors? recovery, and the resulting loss, appropriately, is borne by the investors (rather than the servicers.)  In the case of a modification, there is no clear way to charge investors for the cost of additional work, so the servicer has to make do with the general 0.5% fee income from the mortgage pool.

    Three consequences flow from all this:  servicers do not get paid to modify loans, they don?t recover their advances at the time of a modification, and in the case of a foreclosure they don?t recover advances until the sale is completed.  This means servicers and their lawyers are in a hurry to get to the finish line, i.e. a completed foreclosure sale, so they can get paid for work they have already done and costs they have laid out.

    As I speak to housing counselors and legal services attorneys, I am hearing that there is also a big issue from the standpoint of the borrowers.  When loans are modified, servicers are taking every opportunity to impose the foreclosure and modification costs on the borrower as soon as possible.  Many modifications are conditioned on the borrower making an up-front cash payment for foreclosure fees and costs, and servicers are also charging completely unregulated modification fees.  Moreover, advocates feel that many excessive and unjustified fees are being included, to be paid by homeowners either at the time of the modification agreement or over the remaining mortgage term.  Katie Porter?s study on excessive servicer fees in bankruptcy filings lends credence to this complaint.

    What can be done about all this?  The government (FHFA, FDIC, and Treasury) as direct or indirect investor in many mortgages could pay servicers for good work and try to reduce incentives for uneconomic foreclosures.  Fannie and Freddie have programs to pay servicers up to $800 For each completed workout.  This could be expanded and improved by paying servicers a reasonable amount to be negotiated with the industry, both for modifications individually and also based on monthly metrics of foreclosure prevention, which would include credit for numbers of mods, redefault rates on mods, and demerits for REO growth and losses.  Fannie and Freddie and their new FHFA bosses should set comprehensive standards for allowable foreclosure and modification fees, and how they should be recovered and accounted to investors.

    A second step is to change the way payments are applied and accounted for, so that servicers can pay themselves back for advances at the time of modification, or after a modification has performed successfully for a reasonable period, instead of having to wait for prepayment or foreclosure sale.  This is tricky because it would involve some legislation and some altering of securitization contracts, but at this point in the crisis we need to consider all options.  Investors are better off if servicers modify loans successfully, even if they have to give up some cash flow now to better compensate servicers.  To put it another way, servicers are now being forced to maintain cash flows to investors artificially, and this allows investors to remain in denial about the real losses inherent in these mortgage pools, while the same incentives are making the long-term losses much worse through irrational foreclosures.
HT to Irwin T. for insights on how things really work.

Full post as published by CL&P Blog on November 17, 2008 (boomark / email).