REQUIRED READING: With Fannie Mae and Freddie Mac's overseer leading the national dialogue pertaining to servicing-compensation reform, and the government-sponsored enterprises (GSEs) themselves headed for a destiny that no one can confidently predict, the likelihood of a near-term and industry-wide shift in the way servicers are paid is low. But the conversation is happening, and some fear it is veering in the wrong direction from the very start.
Champions of compensation reform, such as Federal Deposit Insurance Corp. Chairwoman Sheila Bair, argue that the prevailing 25-basis-point (bp) fee has historically discouraged financial institutions from investing in default-servicing processes, as well as contributed to the market consolidation seen today, where the top five servicers handle nearly 60% of the market. The purpose of industry consolidation is to cut costs and achieve economies of scale, Bair told a Senate committee last year. The goals of changing servicing-compensation models, advocates say, are to correct misaligned incentives and ensure servicing operations do not lose their shirts in high-delinquency environments.
But with the most commonly discussed compensation alternatives pointing toward a reduced minimum servicing fee (MSF), there is a growing concern that the firms that stand to benefit most from such reform are the ones that have already achieved the lowest servicing costs and biggest books of business. Meanwhile, raising the pay scale for high-touch, nonperforming-loan servicing – another component found in many alternative models – has led some to wonder if servicer incentives will not ultimately become perversely out of whack.
Not to be left out of the equation are several wild cards, including the impact of looming Basel III requirements and the possibility of national servicing standards. Moreover, much of the modeling done in relation to servicing economics considers only the current landscape, which is headed toward a makeover.
"What's odd, to be honest, is having the GSEs driving the debate at the very same time that Congress is calling for their elimination," says Laurence Platt, an attorney with K&L Gates. "The servicing issues are relevant, but it's more important to figure out whether there will even be servicing that can be created, much less how servicers are compensated."
Lower MSF, but higher expectations
Those involved with the Federal Housing Finance Agency (FHFA) and U.S. Department of Housing and Urban Development's joint initiative to consider alternative compensation structures hold firm that no option has been ruled out at this early of a stage. An FHFA directive on the matter, published earlier this year, suggested the delivery of alternative models by summer 2012. Asked point-blank at a recent conference about the possibility of the current pay structure remaining in place, Kathleen Gibbons, director of Ginnie Mae's single-family mortgage-backed securities (MBS) division, said all options are on the table.
The idea of halving, or even fully eliminating, the MSF is not new. Former Countrywide CEO Angelo Mozilo publicly advocated the concept in 2005. Several of the proposals that were included in an FHFA working paper on the topic discuss lower MSFs, ranging from 0 bps to 12.5 bps. Servicers would still maintain a revenue stream via the float and ancillary fees.
Reducing the MSF would, in turn, alter the valuation of mortgage servicing rights (MSRs) and the need for banks to capitalize MSRs. With major financial institutions looking downstream to Basel III standards (which will cap the amount of MSRs that can go toward regulatory capital requirements), several large servicers would likely welcome a lower MSF, says David Fleig, president of Financial Analysis Partners LLC.
"Our point of view is that the motivation of the big four or five banks in supporting the conversation about a lower MSF is Basel III," Fleig says. "Obviously, they would love to have less to capitalize."
The agencies, meanwhile, might push for higher guaranty fees as a result of
this conversation, he suggests.
At the Mortgage Bankers Association's (MBA) National Mortgage Servicing Conference & Expo in February, Colonial National Mortgage President J. David Motley suggested Basel III is being used "as a scare tactic" to push the servicing industry toward alternative compensation structures.
Analysts say lowering the MSF and bifurcating performing- and nonperforming-loan-servicing incentives could belie one of the main arguments in favor of comp reform, which is to improve customer service. The most egregious examples of default-servicing deficiencies – lost documents, bulk affidavit signings and miscommunication among departments and with borrowers – seemingly highlight the drawbacks of economies of scale.
John Sullivan, managing director at Financial Analysis Partners, sees the current environment as an opportunity for smaller-sized firms to build their servicing portfolios. Reducing the value of performing-loan servicing would impede market diversity, to the detriment of the consumer, he says.
"I think these proposals play into the hands of the big banks and just enhance the systemic risk that we have," Sullivan says. "It's our opinion, given the dynamics of capital treatment and the marketplace, that this is a wonderful time for good old classic mortgage bankers to entertain becoming true mortgage bankers that we used to know, which is to be an originator and a servicer."
Capitalizing MSRs equates to ‘skin in the game’ for servicers. If servicing fees are reduced, the investment that must be capitalized will likely follow suit. If lower MSFs lead to reduced revenues and razor-thin margins, the service quality could suffer as a result.
Taken another way, Mark S. Garland, president of MountainView Servicing Group, says a zero-MSF environment could lead to a break-even equation for shops.
"It will become very dangerous," he remarks. "In break-even operations, businesses strive to either earn their way out of it or cut their way out of it. I don't see shops providing thousands of bodies and millions of dollars to a break-even operation in the coming years."
A principal objective, from an industry perspective, is for servicing to be an economically viable business in which the fees reasonably reflect the scope of services that investors and regulators want, says Platt. From every angle, servicers are increasingly pushed to respond more quickly to delinquent accounts. Freddie Mac, for example, recently revised its performance metrics to place a greater emphasis on early consumer contact. Treasury officials have instructed the industry to be more in tune with imminent-default trends. To reduce the fee in spite of intense expectations and more stringent requirements is "preposterous," Platt says.
MountainView has observed that the costs to service a current or mildly delinquent loan have shot up in comparison to the increased costs associated with later-stage delinquencies. This signifies that servicers are doing more work up front, says Garland. "The cost equation is changing dramatically for the worse, but we're trying to change the revenue number at the same time, and that's very problematic," he says.
Indeed, the comp-reform discussion cannot progress beyond the hypothetical until servicing standards are made clear. Defining protocol, and pay, for performing-loan servicing versus nonperforming-loan servicing depends on many factors. Regulators and consumer advocates have continually pointed toward a better alignment of incentives, but many industry experts say that task is not as easy as it appears on the surface. Aligning the incentives between servicers and investors is one thing, but adding the consumer into the mix can be complicated.
"It's pretty clear what we do on behalf of the investor," Alan W. Jones, senior vice president of Wells Fargo Home Mortgage, said at the MBA conference. "It's not clear what we should be doing on behalf of the consumer."
With so many moving parts, it is important not to lose sight of the operating costs, says Scott Gillen, senior vice president of strategic initiatives for Stewart Lender Services. "We can talk about servicer comp all day long, but until somebody tells us what our operating standards are, we're just throwing numbers in the air," he says. "I can't model anything until I understand what my cost structure's going to be."
Among the concepts in circulation by the FHFA is a nonpeforming-loan compensation method that would be financed by mortgage guarantors. Servicers (or, in theory, specialty servicers and third-party vendors) would be paid market rates for handling clearly defined default-servicing functions. "By construct, these fees would be "adequate compensation' while fixing the misaligned servicer-guarantor incentives," the FHFA working paper explains.
There are difficulties associated with this approach, namely the lack of "a bright line between performing and nonperforming loans," Jones said at the MBA event.
In an ideal world, servicers would be able to invest in technology and personnel for when downturns happen, Bryan Pommer, a vice president at Freddie Mac, also said at the conference. However, while higher payments for more intensive servicing is a notion that is accepted by most, the compensation amounts for performing- and nonperforming-loan servicing must not be so wildly different as to turn default servicing into a profit center. The implied risk is that servicers could become less diligent about keeping loans out of delinquency buckets. The industry has to "be careful of incentives," Pommer said.
The economics of servicing inform lending costs and help define the interest-rate environment. Servicing revenue can also help buffer rough production years, analysts explain. When interest rates rise and prepayment speeds decline, servicing-generated cashflows can act as a counterbalance to production, in a concept known as the "natural hedge." When servicing fees are reduced, the income on retained servicing drops, and the ability for servicing to be a natural hedge against production would lessen.
At the MBA conference, Fannie Mae's senior vice president of capital markets, Andrew BonSalle, noted that the servicing-comp discussion is "not about removing the economics of servicing; it's about moving them around." One concern is that a lower investment in MSRs on future loans could cause lenders to look to their servicing portfolios for refinance solicitations. This would generate income from origination activities but also shift the interest-rate risk to investors, causing volatility on the MBS side.
The economics of mortgage banking will look elsewhere in the lending model to make up for lost servicing revenues, most agree. Whether lenders retain or release servicing rights, the dynamic is the same, and the expectation is that borrowing costs will rise as a result. Brokers that see their servicing-released premiums fall are unlikely to simply accept less profit on each loan, Fleig says.
"Servicing has really subsidized the origination process, because the value of servicing is carved out of the loan," adds Garland. The current high-foreclosure environment is "a production issue; it's really not a servicing issue," he says.
The irony is that future borrowers would presumably be the ones to absorb the costs tied to reduced servicing fees. By most accounts, the 2009 and 2010 books of business are among the strongest in history, from an underwriting perspective.
"Why would you change the approach to future loan servicing contracts, when we can immediately see the loan quality today is the highest it's been in decades, if not forever?" asks Fleig. "Don't penalize future borrowers unfairly on new loans and, in the process, completely destroy the economics of the servicing equation."
Garland says it is important not to underestimate the impact of servicing related to production. "If you give somebody an advantage in servicing, you're very well giving them an advantage in production," he says, adding that reduced MSFs could lead to more aggregation in the big shops.
Fleig agrees, noting, "These servicing fee proposals could well further cement the consolidation of power in loan servicers, which is probably not good for the consumer."
