Any reader who has been with this site for a few years knows that the severity of the post-crisis housing bust was in no small measure due to the refusal of the officialdom to crack down on pervasive mortgage servicing abuses.
We are seeing a repeat of this failure with student loan servicing, via a New York Times story, A Student Loan Nightmare: The Teacher in the Wrong Payment Plan. This teacher, Jed Shafer, thought he had enrolled in a debt forgiveness program but after making ten years of payments, found he wan’t. Many people in the comments recounted their own horror stories.
Background: The Failed Servicing Model
Despite all the “You’ll be on this bus or under the bus” charts that McKinsey produced in the 1980s showing banks that securitization had fundamental cost advantages over originating loans and holding them to maturity, I was a skeptic. I couldn’t articulate well that I didn’t like the idea that this was regulatory arbitrage: that the cost savings were due to the reduction of the use of high cost bank equity. But that equity cost was meant to reflect the cost of bearing risk. Why should banks, who were the ones who evaluated the credit and would normally manage that risk over the life of the loan, not be the right party to price and manage that risk? In other words, even if investors were willing and able to take on these risks at lower costs, why should one believe that was due to some magical better capital allocation and distribution of risk to parties best able to eat it? Why was this not, instead, a story of information asymmetry and occasional bigger fools?
The fact that the US has has repeated crises in its non-government guaranteed mortgage securitizatoin sector (there was a bust in the relatively small subprime market of the 1990s) suggests this theory is not crazy.
But a second reason for skepticism is the relatively high cost and complexity of creating securitizations. Yes, investors value having a more liquid asset. But is the cost of creating that asset too high relative to what investors willing to pay for it?
The answer for years appeared to be no, that there was finance magic in turning illiquid loans into liquid securities.
But this appears to be less and less true once you look further. The dirty secret is that the donkey work of servicing, as in dealing with the borrowers, collecting, recording, and remitting payments to investors, is done poorly. That is in turn due to the fact that the securitization deals price servicing as a high-volume, low-margin commodity business. It’s also managed that way. That means when anything non-standard comes up, the servicer isn’t set up to do that, plus often has the point of view that it’s not paid to do that.
The classic example was after the crisis. More than 9 million homes were foreclosed upon. I guarantee that well over half of those could have been prevented through mortgage modifications that would have not only been better for borrowers, but for investors too. 1
But the servicers, despite their puny size, sat at an operational choke point. The securitization agreements paid them to foreclose. Servicers figured out how to do that on a high volume basis. The agreements did not pay servicers to modify mortgages, which is a high-touch, bespoke activity. So not only did they not do that, they were very clever about trying to weasel out of requirements to consider modifications even when required to do so (recall how banks would insist that borrowers fax information in, and then repeatedly say they never received it?)
There was a way to have brought the entire mortgage securitization complex to heel. As we chronicled, starting in 2003, more and more originators failed to take the steps necessary to transfer mortgages to securitization trusts. About 80% of the securitizations had elected New York law to govern the trust. New York trust law is ancient and well settled. It is also rigid. An asset has to be conveyed specifically to the trust; endorsements in blank don’t cut it. Separately, the securitizations had also required that the mortgages be transferred to the trust by a specific date for tax law reasons.
Normally, when something is screwed up in a contract, you simply write a lot of waivers and maybe someone has to pay for the waivers. But these contracts were rigid. You couldn’t write waivers to fix these problems. Instead, a mini-industry of document back-dating, forgeries, and fabrication grew up to create a paper trail covering up the original sin of the failed securitization.
That means the Obama Administration held a nuclear weapon which it refused to use. It could have called in all the servicers, the big dogs at the banks that owned them (to the extent they had banks as parents; some didn’t), and the big names among the investors, like Pimco and Blackrock. They could have sat all, say, 50 of them in a room and said,:
We know that legally, most of the securitizatons post 2003 are empty bags. The mortgages never got to the trust. And that can’t be fixed now.
So you have two choices. Either we sit back and allow or maybe even help the parties that are exposing this massive securitization failure. That will lead massive losses and litigation on a scale that will destroy a lot of wealth and almost certainly a lot of institutions.
Or you will give principal modifications to qualified borrowers. You figure it out but if you don’t do this we will blow you all up. It is not acceptable to have millions of unnecessary foreclosures because your servicers can’t be bothered to do them. You staff up and eat the costs. They are trivial compared to the alternatives.
It used to be routine for government to have chats like that (usually a bit more coded but the bottom line was clear) when businesses rode roughshod over the public interest. So don’t pretend it couldn’t have been done. The Obama Administration chose not to do it.
The Obama Administration similarly went out of its way to protect abusive student loan servicers. From a 2014 post:
As a new story by Shahien Nasiripour in the Huffington Post tells us, the Administration is now giving student loan servicers the “too big to fail” kid gloves treatment. The apparent justification is that correcting the records of borrowers who may have gone into default through not fault of their own would lead schools with bad servicers to lose access to Federal student aid, which could prove to be crippling to them.
So understand what that means: the law was set up to inflict draconian punishments on schools that used servicers that screw up and/or cheat on a regular basis, presumably because the consequences to borrowers were so serious. But rather than enforce the law, which would have such dire consequences for bad actors as to serve as a wake-up call for everyone else, the Administration has thrown its weight fully behind the education-extraction complex.
Servicing as a Big Part of the Student Loan Train Wreck
It is bad enough that student loans have turned colleges into predators. It has been widely reported that college admissions offices give unduly thin information about loan terms and also give graduate earnings forecasts that may not be at all germane to a particular student (particularly in light of the fact that many students don’t finish college).
A partial list of some other negative consequences of student loans, from a 2017 post:
Access to student debt keeps inflating the cost of education. This may seem obvious but it can’t be said often enough. Per the [Financial Times] article:
While the headline consumer price index is 2.7 per cent, between 2016 and 2017 published tuition and fee prices rose by 9 per cent at four-year state institutions, and 13 per cent at posher private colleges.
It wasn’t all that long ago that the cost of a year at an Ivy League college was $50,000 per year. Author Rana Foroohar was warned by high school counselors that the price tag for her daughter to attend one of them or a liberal arts college would be around $72,000 a year.
Spending increases are not going into improving education. As we’ve pointed out before, adjuncts are being squeezed into penury while the adminisphere bloat continues, as MBAs have swarmed in like locusts. Another waste of money is over-investment in plant. Again from the story:
A large chunk of the hike was due to schools hiring more administrators (who “brand build” and recruit wealthy donors) and building expensive facilities designed to lure wealthier, full-fee-paying students. This not only leads to excess borrowing on the part of universities — a number of them are caught up in dicey bond deals like the sort that sunk the city of Detroit — but higher tuition for students.
But let’s return to the focus of this post, how lousy servicing makes this sorry situation worse.
The New York Times’ story describes long form how Orgeon school teacher Jed Shafer enrolled in 2007 in a program that would allow public servants to discharge their student debt if they made ten years of on-time payments. Here is the guts of his problem:
In 2015, he discovered that he was enrolled in a particular type of ineligible payment plan and would need to start his decade of payments all over again, even though he had been paying more each month than he would have if he had been in an eligible plan. Because of his 8.25 percent interest rate, which he could not refinance due to loan rules, even those higher payments weren’t putting a dent in his principal. So the $70,000 or so that he did pay over the period amounted to nothing, and he’ll most likely pay at least that much going forward.
Mind you, Shafer made concerted efforts to do the right thing. He asked his servicer in 2007 about enrolling in the public service forgiveness program. That same servicer could have seen that Shafer was not eligible by virtue of having consolidated his loans in 2002 (why that should disqualify is another indictment of the program) and failed to advise him that he would still qualify for an income-based plan. The fact that his servicing was transferred two times (once involuntarily, once to get the loan forgiven) appears to have made matters worse.
One of many corroborations in the New York Times comments section:
I worry about this all the time. I’ve heard the horror stories!
I am a primary care physician at a marginalized clinic. I make a comfortable living, but there’s so much worry as I’m about halfway through payments, and yearly check in to see my status.
FedLoan, like most loan companies, is horrible. I’ve called multiple times about ensuring the right payment plan. They have failed to renew my payment plan in the past so there have been months where I couldn’t make payments and interest accrued. I have made multiple complaints and asked for management to intervene. I have even contacted a lawyer about their business practices.
Medical school debt is insane. I pay 1200 a month and that keeps the interest at bay. I sit on 260K of loans and if things don’t go smoothly I will have wasted ten years just like the gentleman in this piece. I can’t afford a house and even if I could, I would feel mired down in debt.
I’m not sure how we can fight school debt and these companies, but it’s become an epidemic that plagues too many.
A Consumer Financial Protection Bureau report from June describes the cost of student loan servicing failures. It found that complaints had increased 325% in a mere 12 months. It gave top billing to problems with the public service debt relief program but recommended only thin gruel remedies, like providing for “additional flexibility” so that borrowers who were given bad information about eligibility could still receive program benefits. But how is someone like Shafer going to prove what a servicer that has since exited the business told him ten years ago?
These recommendations from a Forbes story give an idea of how terrible student loan servicing is:
1. Don’t rely on your student loan servicer for all the answers
It may sound counter-intuitive, but your student loan servicer may have interests that are contrary to your best interest.
Translation: Your servicer may not just be incompetent. Assume you are his lunch.
2. Always communicate in writing
How many times have you called your student loan servicer and been assured that your request was processed, only to find out later that this was not the case?
You get the picture…..
The problem is yours truly can propose all sorts of nice-sounding solutions, like making servicers liable for the cost of bad advice, and having them bear the cost of servicing errors. Their margins are so thin that exposure like that would force them to shape up. You could give this provision even more teeth by making it permissible for borrowers to record calls to servicers without notifying them (most reps are instructed to disconnect when given a warning but some states like New York allow for recording your own calls without informing the other party. Making that legal for all interactions with servicers and financial services providers generally would be salutary). But you can expect the servicers to whinge that they can’t expect to be made responsible for actions that do more damage than their businesses are worth.
But the Democrats are determined not to touch the student loan indebtedness machine. It keeps the higher educational complex, a Democratic party stronghold, growing faster than GDP. Notice how Elizabeth Warren, who more than any other person in the US, knows that allowing student loans to be discharged in bankruptcy would make a huge difference to borrowers, both for some by being able to wipe out debt and others by having better bargaining leverage, has never once mentioned the idea? All Warren has ever proposed is rearranging-deck-chairs-on-the-Titanic-level interest relief.
So the only remedy is to make clear to the Democrats that this is unacceptable. Go full Sanders or Democratic Socialists on them. If the party is not willing to deliver concrete material benefits to its voters, most important young and even middle aged people carrying a student loan millstone, they need to pay for their negligence.
1 While servicers were far and away the big obstacle to modifications, there was often a second impediment, which was in theory that the lowest performing tranche in a subprime securitization would lost out in a mod. That is because by the post-crisis period, they were often bought by hedge funds on an interest-only basis, as in they expected that they would get no principal payments but were still getting interest payments. Without belaboring the details, principal modifications would have wiped out those tranches or at least reduced their interest payments. However, by the post-crisis period, most if not all of the original investors had bailed out of these tranches, and I don’t see any policy argument for protecting sophisticated speculators.