The U.S. housing crisis is entering its fourth year, yet Lender Processing Services says more than 2 million homes are in the process of foreclosure and another 2 million are seriously delinquent, having missed more than three monthly payments. Moreover, the average home in the process of foreclosure has been delinquent more than 16 months. How can this be? Certainly, it is in the best interests of both borrower and lender to resolve a delinquency quickly; the borrower wants to avoid eviction, while the lender wants to avoid the typical 50-percent-plus loss associated with a residential foreclosure.
The answer lies in the perverse incentives put in place by the Wall Street securitization machine; in particular, the perverse incentives facing the once-obscure entities known as “mortgage servicers.” These servicers, the largest of which are subsidiaries of the “Big Four” banks - Bank of America, Citibank, JPMorgan Chase and Wells Fargo - do the “grunt work” formerly done by mortgage-portfolio lenders. For a small fee, they collect monthly mortgage payments and distribute them to the investors who purchased the rights to mortgage cash flows in the form of residential mortgage-backed securities or “sliced and diced” derivative securities, such as collateralized debt obligations.
The perverse incentives arise because of provisions in the pooling and servicing agreements, which are the contracts that govern the mortgage-backed securities. These provisions provide for the servicers and their affiliates to extract late fees and other forms of income (foreclosure fees, forced-insurance premiums, property inspection fees, property valuation fees, etc.) from the often unwary delinquent homeowner. Moreover, these fees and income typically are paid to servicers before any payments go to the investor-lenders. Consequently, they rob equity from the homeowner and, once that equity is exhausted, rob principal and interest payments from the investor-lender. These fees include monthly late fees similar to those for a missed credit card payment; they can be quite substantial relative to the monthly mortgage payment and, cumulatively, can quickly move a delinquent homeowner from a positive- to a negative-equity position, making foreclosure all but a certainty.
Now consider how these fee incentives affect a servicer’s behavior regarding mortgage modifications. Should the delinquent mortgage be modified or refinanced successfully, or should a short sale occur, the servicer’s income stream is cut off - totally in the event of a short sale or refinancing. Faced with this loss of income, the servicer will do everything in its power to avoid permanent modifications and short sales; it will do everything it can to prolong the mortgage delinquency. These fee incentives also go a long way in explaining the abysmal performance of the Home Affordable Modification Program, (HAMP); servicers enticed borrowers into trial modifications with promises of permanent modifications, only to push the borrowers so much further underwater that they could not pass the infamous HAMP Net-Present-Value, which requires a permanent modification to be less costly than foreclosure. According to the Treasury Department’s October HAMP Report, servicers had converted 85 percent of trial offers into trial modifications but converted just 37 percent of trial modifications into permanent modifications.
Compounding these fee incentives is a more insidious conflict of interest. According to a Nov. 16 press release from the Association of Mortgage Investors, which represents the investors who actually own most delinquent mortgages but have delegated the servicing of them to subsidiaries of the Big Four banks, foreclosure-mitigation programs “have often proven unsuccessful due to servicers, who invariably are the second-lien holders, and who continue to inhibit sustainable modifications” of the delinquent mortgages. In other words, the banks that own the servicers also have extended second mortgages on the same properties that they are servicing and are pursuing their own best interests to the detriment of the investors they represent as servicers. Therefore, it is not surprising that Big Four banks converted just 78 percent of HAMP trial offers into trial modifications, and just 30 percent of trial modifications into permanent modifications, while the rest of the industry converted 99 percent of trial offers into trial modifications and 50 percent of trial modifications into permanent modifications. Incentives matter.
How can we solve this problem? Simple. Fix the perverse incentive structure facing the servicers. First, regulators, the courts and state attorneys general can limit the outrageous late fees, forced-insurance premiums and other fees charged by servicers and their affiliates. Thus far, those institutions have failed miserably in this area, but regulators are conducting on-site examinations of the largest servicers, and the attorneys general are coordinating actions against the servicers in response to the robo-signing scandal. Second, regulators or Congress can move to force the big banks to divest their mortgage-servicing subsidiaries and to “mark-to-market” their second-lien portfolios. This would remove the banks’ incentives to extend delinquencies in order to protect the value of their second liens. Third, the 27 states with statutory foreclosure rules, which have allowed servicers to run amok without meaningful legal review, should rethink adoption of judicial foreclosure rules. Were it not for the actions of defense attorneys in judicial-foreclosure states, we would not know about the pervasiveness of perjury and fraud that we now know to be commonplace in the servicing industry.
Only when we have restored sanity to loan servicing will we see successful mortgage modifications that are not only in the best interests of delinquent borrowers and the U.S. housing market in general, but also in the best interests of mortgage investors, who all too often have been made the boogeymen for the bad behavior of the servicers. Once the avalanche of foreclosures has been replaced by a wave of sustainable permanent modifications, the U.S. housing market can stabilize, and with it, the U.S. economy as a whole.
Rebel A. Cole is professor of finance and real estate at DePaul University.