It’s more than a tad ironic that Senator Carl Levin released a strongly-worded report on Wall Street’s role in the financial crisis, focusing on abuses and failures of oversight in the residential mortgage and CDO markets, when the officialdom is engaged in yet another whitewash of further crisis fallout, that of servicing and foreclosure related abuses.
One effort at pushback comes via a bill proposed today by Senator Sherrod Brown and Representative Brad Miller, the Foreclosure Fraud and Homeowner Abuse Prevention Act of 2011. While some provisions need further work, it’s an ambitious and badly needed effort that targets many servicer abuses.
Unlike other efforts at servicing reform, this one considers the needs of investors as well as of borrower. That matters because investors are treated badly by servicers and currently face obstacles to disciplining them. Many of the bill’s requirements are sound, such as eliminating the exemption that MBS trustees now have from the Trust Indenture Act, limiting some of the banks’ avenues for “extend and pretend”, ending dual track, improving disclosure of fees and charges, and allowing borrowers to challenge foreclosures if the bank has not considered a loan modification, with an obligation to offer a principal mod when it makes sense for investors.
There are some efforts to improve servicer incentives that I am less certain will work. Servicers would be construed to have a fiduciary duty to investors. That could only be prospective. Servicers won’t work under those conditions; the business isn’t that profitable even in the best of times.
The bill also would have delinquent borrowers be serviced by special servicers. That makes sense since most servicing platforms were built around the idea of basic processing at a time when delinquency, foreclosures and losses were low.
Having an independent party manage all defaults (not just cherry picked ones) is a good idea. But the big question is who will these independent servicers be? They don’t really exist now and that’s because it is an expensive business with large liquidity demands via hedging.
Historically, in deals where the investors were worried about the strength or quality of the servicer (ie the bank wanted the deal to have a weak servicer, and the investors wanted a stronger one), the investors would require that a special servicer be appointed on day one and written directly into the pooling and servicing agreement. While the loans were performing, the special servicer would get a small “retainer” fee (3-5 basis points per annum) but would get to step up to the full fee when they took control of servicing of the loans in default. It was a structure that worked pretty well – it helped keep the basic servicer honest, knowing that they could have the entire servicing business taken away and given to a special servicer if the loans performed poorly.
However, offering new, real modifications is really like underwriting a new loan. If the special servicer is unaffiliated with a major bank, it would not have an underwriting department. Nor would it have the ability to fund refinances of performing loans. And it seems unrealistic to expect a special servicer to enter the new loan underwriting business.
It’s not clear how the fees provided for (100 basis points “untranched”) would actually be collected and held, and what the formula would be for paying them to the special servicer, and how and when they would be reversed back to the investors if the deal performed well and there wasn’t much need for special servicing.
The bill also prohibits servicers or their affiliates from owning seconds may not be workable. However, if the servicing is split out between basic collections and special servicing, the solution might be to permit parties who lend and perform basic servicing to own seconds, but bar the special servicers.
The bill intended to reduce conflicts and increase investor ability to discipline servicers but missed some key issues. It does have a provision that would limit so-called “tranche warfare” but the bigger barrier to investors taking action against trustees (who would then deal with the servicer) is that it has become the standard in the industry to require investors to waive their rights to sue unless 25% of the investors sign up. That clearly has to go.
Finally, many servicers are reluctant to allow deep principal modifications because they would mean that the servicer could not get reimbursed for their advances of principal and interest. This is a real source of conflict in the transactions. The bill seeks to limit the amount of principal and interest that the servicer advances, but that reduces the severity of the tension rather than eliminating it.
Overall this is a promising effort, but there are still some thorny issues that need to be resolved. I hope the sponsors can iron them out.