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The U.S. Mortgage Market Needs Better Plumbing

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The U.S. Mortgage Market Needs Better Plumbing

(Bloomberg Opinion) -- Spare a thought for the mortgage servicer. As unsung professions go, perhaps none plays a more crucial role in the functioning of the U.S. economy. Month after month, servicers collect interest and principal payments from millions of American homeowners and pass them on to lenders and investors. They produce account statements, negotiate with borrowers who don’t pay and — if things go badly — handle foreclosures. Done well, the job facilitates lending and makes the whole housing market more resilient.

Unfortunately, it’s not being done well, for reasons partially out of servicers’ control. As a result, creditworthy borrowers, especially among low-income and minority groups, are finding it harder to get loans. And traditional banks are yielding more of the business to financial firms less bound by rules on safety and soundness. This needs to change.

For most of its existence, servicing was an obscure but lucrative business. Servicers’ fees (typically an annualized 0.25 to 0.50 percent of a loan’s balance) amply covered their costs, because they rarely encountered delinquent loans — the most labor-intensive part of the job, requiring a lot of personal contact with individual borrowers. The rights to service mortgages were a sought-after asset, completely separate from the actual loans. Large banks such as JPMorgan Chase and specialized servicers such as Ocwen Financial all got into the business.

Then the housing bust of the late 2000s pushed delinquencies to more than one in 10 loans and put servicers to the test. In principle, their goal should be to minimize losses. This entails contacting borrowers to see if there’s any hope of modifying the loan to keep the owner in the home and restart payments. If no such mutually beneficial agreement can be reached, they should foreclose quickly and competently, so the home can find a new owner before blight sets in.

That’s not what happened. Anyone who attempted a modification can attest to the chaos that ensued. In many cases, servicers had terrible incentives: Thanks to their fee structures, they were better off providing no help and eventually foreclosing. What modifications they offered gave little relief. The foreclosure process itself was a disaster. Overwhelmed employees often signed off without checking documentation — a practice known as robosigning that ultimately landed servicers in deep legal trouble. This made the housing crisis much worse than it needed to be, as unnecessary and sometimes wrongful foreclosures fed the vicious cycle of price declines, defaults and disintegrating neighborhoods.

After the crisis, regulators stepped in with a set of rules that, in their sheer obviousness, underscored how bad practices had been. Among other things, they required servicers to contact delinquent borrowers promptly, inform them of loan-modification options, acknowledge receipt of applications and have competent staff available to answer questions. State and federal settlements related to the robosigning scandal added pressure to comply.

Sensible as they were, the new rules created new problems. Most important, they made it harder to meet long-standing timing requirements set out by the Federal Housing Administration, which holds sway as the insurer of about 20 percent of all new mortgages. Specifically, the FHA imposes harsh monetary penalties on servicers that miss certain deadlines, such as initiating foreclosure proceedings within 180 days of the original default.

The conflicts have made servicing delinquent loans prohibitively expensive. A study by the Urban Institute, for example, found that servicers end up breaching the FHA’s deadlines in almost half of all cases, and that the penalties for each can be large enough to cancel out the revenues from as many as 12 performing loans. This has helped drive the annual cost of handling a non-performing loan to almost $2,500, up from less than $500 in 2008, according to the Mortgage Bankers Association. 

The daunting costs have left lenders unwilling to take on even reasonable risks, avoiding many borrowers whom government insurers would otherwise approve. The reluctance has fallen hardest on the low-income and minority groups most reliant on FHA loans. The homeownership rate among black Americans, for example, recently hit its lowest point since the 1960s, when race-based discrimination was legal. Overall, mortgage credit availability remains well below the level of the early 2000s, before the housing boom took off. 

The risks of servicing have also pushed traditional banks out of the business, leaving it to other financial companies that don’t face the same requirements for safety and soundness. This is troubling, because crises place great demands on servicers’ cash and capital: They must keep making payments to lenders and investors even when borrowers aren’t paying them, and their rising expenses undercut the value of the mortgage-servicing rights that are among their biggest assets. If they can’t handle the stress, they will leave borrowers and lenders in the lurch.

What to do? As it happens, the Urban Institute’s Housing Finance Policy Center — in consultation with banks, servicers, consumer advocates and other experts — has been studying precisely this question for years. Here are some proposals informed by their work:

Change the way servicers are paid. Under rules set by government guarantors such as Fannie Mae, Freddie Mac and the FHA, servicers receive a piece of each monthly interest payment. The income more than covers their expenses in good times, but disappears when loans go delinquent. A better approach would more closely match fees to servicers’ costs — for example, by requiring them to build reserves against delinquencies and providing incentives to reach successful modification agreements. Such a system would have an added advantage: The value of mortgage-servicing rights would become less volatile, because income would move more in sync with costs. This would relieve some of the stress on servicers in crisis times, and might encourage traditional banks to return to the market. Fix the FHA’s penalty system. The FHA’s requirements for initiating foreclosures and selling the related properties can be impossible to meet, particularly in states that require judges to get involved in the process. Fannie Mae and Freddie Mac have adjusted their timelines to better reflect reality. The FHA should do the same — and also consider allowing servicers to deliver foreclosed homes as is, to avoid time-consuming back-and-forth over the cost and quality of renovations. Give servicers the power to make modifications that work. Under FHA and Veterans’ Administration rules, borrowers can’t keep their original interest rate when they modify a loan. So if rates are relatively high, it’s harder to achieve a payment reduction that would make the loan affordable. This leaves borrowers more likely to re-default or go straight into foreclosure, further increasing costs and aggravating lenders’ losses. The remedy is simple: Give servicers more leeway to reduce payments without triggering an interest-rate reset, as Fannie Mae and Freddie Mac already do. Standardize data. Different servicers have different ways of recording and tracking all the information associated with a mortgage loan. This makes transferring servicing from one company to another extremely difficult and error-prone, weakening the system and creating costs that end up reflected in higher interest rates for borrowers. If the two largest government guarantors, Fannie Mae and Freddie Mac, insisted upon uniform data standards, the rest of the industry would follow suit. To spread out the cost of compliance, the standards could initially be applied to a core of crucial data, then expanded.

Fixing the plumbing of the mortgage market is hardly a glamorous pursuit. And not all of the work is straightforward: Some of what’s required may require congressional action. But as the suffering visited upon millions of American homeowners after the crash proved, it’s absolutely necessary to make these repairs before the system is tested again.

—Editors: Mark Whitehouse, Clive Crook

To contact the senior editor responsible for Bloomberg Opinion’s editorials: David Shipley at davidshipley@bloomberg.net, .

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