Mortgage Modification Programs Are Failing Because Mortgage Servicers Are Not Paid to Have Them Succeed

By Andrew Toth-Fejel, Bankruptcy Litigation Support for Attorneys, Andy@BLSforAttorneys.com

Following up on the Bankruptcy Bulletin on this website of January 7 entitled Mortgage Modification Programs Have Been Ineffective. Why?, in that Bulletin I referred to "one of the most important and least recognized reasons for so few modifications" being that "the incentive structure for mortgage servicers in most cases greatly favors foreclosures over modifications." This Bulletin explores this incentive structure and how it is stymieing mortgage modifications.

The Role of Mortgage Servicers
As succinctly stated in an article by Katherine Porter, associate professor at the University of Iowa law school (and former associate at Stoel Rives LLP in Portland, Oregon):

The communication problems in today's securitized mortgage market are very different than during past real estate downturns, such as the Midwest farm crisis of the 1980s or the wave of foreclosures in the 1930s. Why? Because of the widespread use of mortgage servicers, third-party agents who collect payments from borrowers and remit them to the mortgage note holders (usually investors, often via a trust). Mortgage servicers are responsible for enforcing defaults, including pursuing foreclosures, and for engaging in loss mitigation. Gone are the days of sitting down with the bank that originated your loan and negotiating a new deal. . . . . I am concerned that policymakers, including legislators, judges, and regulators still do not understand the barrier that loan servicing presents to voluntary or consensual loan modification.

How Servicers Are Paid
An excellent article on the nefarious role of mortgage servicers, The 800 Pound Gorrilla in the Room: Servicers Profit While Investors Face Losses, outlines their general fee arrangement:

When loans are performing servicers generate most of their income through flat servicing fees based on the unpaid principal balance of the loans. When loans become delinquent, the lack of cash flow causes fees to be deferred until a cash-generating resolution occurs, but the opportunity to increase the fees grows more than enough to compensate for the delay. Such sources of ancillary revenue include penalty fees for late payments, “foreclosure fees and costs, insufficient funds charges, property inspection fees, broker price opinions or appraisals, corporate advances, post-petition fees and suspense funds.” . . . . These fees all flow to the servicer, not the investor.[Citations excluded.]

(See also Katie Porter's two excellent postings last May in Credit Slips on a Senate Judiciary Committee's subcommittee hearing on mortgage servicing at which she testified, where she refers to the testimony of Countrywide's executive for loan administration on how servicers generate income.)

Resulting Conflict of Interest Between Servicers and Investors
Since the servicer's fees are paid before investors, the above "Servicers Profit While Investors Face Losses" article also argues:

Increased fee rates on defaulted loans along with the certainty of receiving them encourages the servicer to lengthen the duration of default status, further reducing the value of the mortgage pool to the investor. Additionally, in a market of declining home equity, investors face greater likelihood of a loss of principal when servicers aggressively charge ancillary fees.

[Citations excluded.]

The Accepted Benefits of Mortgage Modifications With Principal Reduction
In a detailed but highly understandable speech by Fed Chair Ben Bernanke in March 2008 titled Reducing Preventable Mortgage Foreclosures, he strongly acknowledged (albeit in his necessarily understated tone) the great need for mortgage servicers and investors to modify mortgages through principle reductions, not just fiddling with the interest rate or term of the mortgage:

Loan modifications, which involve any permanent change to the terms of the mortgage contract, may be preferred when the borrower cannot cope with the higher payments associated with a repayment plan. In such cases, the monthly payment is reduced through a lower interest rate, an extension of the maturity of the loan, or a write-down of the principal balance.
. . . .
To date, permanent modifications that have occurred have typically involved a reduction in the interest rate, while reductions of principal balance have been quite rare. The preference by servicers for interest rate reductions could reflect familiarity with that technique, based on past episodes when most borrowers' problems could be solved that way. But the current housing difficulties differ from those in the past, largely because of the pervasiveness of negative equity positions. With low or negative equity, as I have mentioned, a stressed borrower has less ability (because there is no home equity to tap) and less financial incentive to try to remain in the home. In this environment, principal reductions that restore some equity for the homeowner may be a relatively more effective means of avoiding delinquency and foreclosure.

The Lack of Principal Reductions in the Voluntary Modification Programs
Notwithstanding the clear need for principal reductions, an empirical study of voluntary mortgage modification programs by Valparaiso University Law School professor Alan White, updated through November 2008, found that principal loan balances were reduced in less than 10 percent of modifications. Even monthly payments were reduced in only about 35% of the modifications. Indeed, more than half of the modifications actually increased the total amount of mortgage debt by capitalizing the unpaid contractual interest and fees onto the tail end of the mortgage, and 45% even increased the monthly payments. As a NACBA (the National Association of Consumer Bankruptcy Attorneys) press release last month quoted Professor White:

While banks have written down more than half a trillion in mortgages and mortgage-related securities, homeowners have gotten little or no relief. A broad range of economists from Nouriel Roubini to Ben Bernanke to Martin Feldstein have recognized the need to deleverage the American homeowner. The excess mortgage debt is depressing home prices and consumer spending, and acting as a drag on the broader economy. Empirical evidence from mortgage servicer reports to investors shows that for the most part, the necessary deleveraging of homeowners is not happening.

The Economic Disincentives for Servicers to Modify Mortgages
In the speech quoted above, Fed Reserve Chair Bernanke also acknowledged the disincentives for servicers to engage in modifications (which he here also calls "workouts"):

Unfortunately, even though workouts may often be the best economic alternative, mortgage securitization and the constraints faced by servicers may make such workouts less likely. . . .. Thus, servicers may not pursue workout options that are in the collective interests of investors and borrowers. Some progress has been made (for example, through clarification of accounting rules) in reducing the disincentive for servicers to undertake economically sensible workouts. However, the barriers to, and disincentives for, workouts by servicers remain serious problems that need to be part of current discussions about how to reduce preventable foreclosures.

Bernanke reemphasized this theme in a speech just a few weeks ago:

[D]espite the substantial costs imposed by foreclosure, anecdotal evidence suggests that some foreclosures are continuing to occur even in cases in which the narrow economic interests of the lender would appear to be better served through modification of the mortgage. This apparent market failure owes in part to the widespread practice of securitizing mortgages, which typically results in their being put into the hands of third-party servicers rather than those of a single owner or lender. The rules under which servicers operate do not always provide them with clear guidance or the appropriate incentives to undertake economically sensible modifications.

As more pointed stated by the author of the article above bylined "Servicers Profit While Investors Face Losses" (with extensive footnotes excluded):

Ancillary fees, which are profit centers for servicers, result in significant losses to investors. The servicer is ensured collection of the fees and costs as they are received prior to the investor getting any proceeds. Any deficiencies are covered from the securitized pool. Increased fee rates on defaulted loans along with the certainty of receiving them encourages the servicer to lengthen the duration of default status, further reducing the value of the mortgage pool to the investor. Additionally, in a market of declining home equity, investors face greater likelihood of a loss of principal when servicers aggressively charge ancillary fees.
. . . .
Not only do servicers have incentives to use strategies which are detrimental to investors, but the means to act with limited impunity. Lack of investor, borrower and regulatory oversight and informational asymmetry between the investor and servicer ensures servicers will act on their self interests. Additionally, the consolidation of the mortgage service industry leaves investors with few alternatives to their current servicers.

The Solution?
This is a problem that has been recognized and directly addressed in the past with proposed legislation that has gone nowhere. For example, HR 5679 last year, The Foreclosure Prevention and Sound Mortgage Servicing Act of 2008, would have required mortgagees and servicers to participate in "reasonable loss mitigation activities," a carefully defined term, before being able to start the foreclosure process. The bill also sought to address homeowners' challenges in communicating with the servicer about modification by commonsensically requiring servicers to provide a toll-free telephone number with which homeowners could reach a person at the servicer, within the U.S., with the necessary information and authority to deal with loss mitigation, and thus presumably with modifications. This bill never passed out of committee.

The multi-billion dollar question now is whether the Chapter 13 mortgage modification bill currently charging through Congress is about to be part of the attempted solution to this so-far intractable problem.

by Andrew Toth-Fejel
Bankruptcy Litigation Support for Attorneys
Andy@BLSforAttorneys.com

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