The credit crisis, asset write-downs and liquidity crunch experienced by financial institutions are causing senior executives and CEOs to fundamentally rethink business strategies, operational models and cost structures. At mortgage servicing shops, with servicing fee revenues largely fixed and servicing and default costs escalating, cost containment has again become top of mind and will remain so for the foreseeable future.Â
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Traditional approaches to cost reduction – often focused on operations and reactive in nature – remain on the table, including discretionary cost cutting, staff reductions, automation improvements and the like. The current environment also demands consideration of innovative cost-containment initiatives, especially by mortgage servicers that are contending with shifts in their business models. Many of these techniques will contribute to creating a long-term, lower-cost operating platform.Â
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Key areas of potential opportunity for mortgage servicers include funding strategies for servicing advances, flexible staffing and sourcing models, loan repurchase risk reduction and maximizing the benefits from government-assisted foreclosure prevention programs. With all cost-management initiatives, critical elements of success include active oversight and measurement of ongoing performance backed by a strong tone at the top that stresses sustainable improvement. Let's explore some of these cost-containment concepts further.
Funding strategies for advances
With the surge to historical levels of mortgage delinquencies across the product spectrum, servicer advances to investors, taxing authorities, insurance companies and for foreclosure expenses are greater than ever. Advance needs are further exacerbated by initiatives to delay foreclosures and roll out broad-based loan modification programs.
The resulting impact is a strain on funding sources, coming at a time when liquidity through servicing-advance financing facilities has been constrained, driving up funding costs. Securing low-cost funding sources for servicing advances has never been more critical, as it is a key support to modification programs and, for some firms, to survival. Companies should also focus on accurately forecasting advances to ensure peak funding needs are comfortably met.Â
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While traditional advance funding has come from accessing corporate debt, bank deposits and servicing-advance financing facilities, an additional alternative that mortgage servicers can now access is available through the Federal Reserve's Term Asset-Backed Securities Loan Facility (TALF). The TALF program, to date, is still in its early stages and has had limited participation for servicing advances; however, its merits and chances of success have been hotly debated.Â
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Key considerations surrounding the suitability of TALF for servicing advances include the following:
- lending haircuts, which reach up to 16% of pledged servicing-advance collateral;
- rating-agency perspectives on underlying assets;
- eligibility of collateral;
- competitiveness of funding rates that are consistent with business-unit return requirements; and
- compatibility with programs that prevent foreclosures and expand loan modifications.
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The jury is still out on whether TALF will be heavily utilized and provide much-needed low-cost advance funding for servicers; however, the program design is targeted to an important need for servicers and warrants serious consideration from servicing executives.Â
Sourcing and staffing models
Effectively managing servicing costs in an environment where business needs are rapidly changing requires flexibility. Two strategies that will enable companies to adapt to these changes and better manage both costs and capacity are outsourcing component servicing functions and expanding staff cross-training or retraining efforts. Â
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Outsourcing component servicing allows servicers to focus on core competencies and leverage the expertise of specialists trained in niche areas. While traditional outsourcing has focused on lockbox, tax and insurance processing, as well as real estate owned (REO) property preservation, today's environment – along with advances in servicing technologies – allows servicers to outsource a number of functions that have been traditionally performed in-house.
These include more specialized collections activities (which target specific groups of loans instead of traditional mass-targeting approaches), loan modifications analysis and fulfillment, and loss mitigation campaigns. One strategy being employed by certain servicers is to continue building some critical servicing capabilities that generate a competitive advantage while outsourcing lower value-added functions. Leveraging full-service specialty servicers with proven track records for distressed portfolios should also be considered.Â
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By prudently tapping into the resources and experience of capable vendors, servicers can better manage resource constraints. Best-in-class component servicers can contribute to cost containment by realizing greater operational efficiencies and increasing servicing cashflows. Cost-forecasting accuracy can also be improved by using transaction-based payment structures.Â
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Vendor management will remain an important focus in order to achieve the benefits of outsourcing strategies. Such strategies carry with them compliance and operational risks and require a strong vendor management infrastructure and oversight program. In this difficult economic environment, aggressive vendor negotiations also have been pursued to drive down costs. When managed effectively, including by formalizing detailed service-level agreements, the benefits of outsourcing programs can far exceed costs and perceived risks.
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While outsourcing to subservicers or component servicers is in vogue, an equally important strategy is to evaluate in-house resource capabilities and skills sets for alignment with evolving business needs. The explosion in borrower delinquency and defaults has vastly increased servicers' resource needs focused on default management and loss mitigation, while heightening the emphasis on compliance. At the same time, with origination volumes declining, resources are being freed up from the production side of the business.Â
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An effective strategy for adapting to the shifting environment is to tap into available in-house resources and focus attention on priority areas. This approach may require additional retraining costs to get staff up to speed with new functions. In many cases, however, these costs will be limited, as many production personnel already have the skills needed to support a growing loss mitigation group, including underwriting, borrower credit reviews and quality control.Â
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Considering the available external pool of skilled resources in default management, loss mitigation and risk management have largely been depleted, flexible staffing is an option to consider. Retention of key personnel through cross-training and flexible staffing will also pay off when normal market activity resumes and shifts in resource allocation again become necessary.
Repurchase risk reduction
Following typical cyclical patterns, representation and warranty loan repurchase claims have again ramped up and are impacting bottom lines. While investor repurchase demand volumes remain hard to predict, companies are exploring strategies aimed at mitigating repurchase losses, including repurchase claim rejections, negotiated settlements and preemptive quality control reviews with remedial action for missing documentation.
On the production side, there is a renewed focus on compliance with investor underwriting and delivery standards. However, these prospective steps will not address historical loan-quality deficiencies.Â
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The industry is also working with the American Securitization Forum to develop standardized representation and warranty language for prospective asset-backed securitizations that will provide firmer investor protections, remove uncertainty in contracts and allow for more accurate estimation of repurchase exposure.Â
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Emerging repurchase exposures are arising around the risk of noncompliance with government foreclosure prevention programs, including Making Home Affordable (MHA), Hope for Homeowners and the Federal Housing Administration's version of the Home Affordable Modification Program. Compliance with these program guidelines is expected to be closely monitored, and noncompliance could potentially lead to buybacks of loans. As a result, and given the speed with which recent programs have been implemented, servicers should ensure that quality control measures are in place to mitigate these risks.
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In today's environment, companies are revisiting their processes for estimating future repurchase losses to reflect new realities and help ensure sufficient reserves are maintained and reliable budgets can be established. With greater scrutiny over repurchase exposure and a compliance focus to reduce future claims, companies will be better positioned to mitigate the costs associated with repurchases.
Government programs
Sizable government payouts have been allocated to mortgage modification and refinance programs. MHA alone has been allocated funding of up to $75 billion. A significant portion of these funds will find their way to servicers and can significantly defray the costs of bringing large-scale modification programs online. If government payouts are leveraged to the maximum extent possible, there could even be a net positive impact on the bottom line.
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Rapid program start-up and aggressive solicitation efforts will likely position firms to garner the most benefits from these programs. Initial indications from loan modification performance show higher levels of success for current borrowers at risk of imminent default and those in early stages of delinquency; therefore, servicers should ensure that this group of borrowers receives appropriate attention.
Efforts to maximize loan modification volumes should not forsake quality, as failure to meet program requirements will lead to additional compliance costs. Close collaboration with the Treasury, Fannie Mae, Freddie Mac, the Department of Housing and Urban Development and investors will help mitigate program noncompliance risk.Â
Profitability measurement, accountability
An understanding of the true profitability of each business is an essential element of effective cost-containment strategies. This can be accomplished by establishing robust and granular management reporting and profitability metrics that are acted upon by senior management. Close tracking and attribution of the right performance metrics enforce accountability and must run in tandem with any cost-management effort. This process begins with a detailed and realistic budgeting process; however, budgets should remain open to revision in this rapidly changing environment.Â
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Performance measurement must look beyond operational costs. Attributing front-office expenditures – such as risk management, accounting and funding – provides a more realistic picture of unit performance. Business units can truly be held accountable for performance if each business is run and measured on a stand-alone basis, including assigning capital with the expectation that front-office return thresholds be met.
Performance indicators to measure business-unit performance include return on equity, capital ratios and overhead ratios. Linking business-unit performance to employee compensation further drives home the message of pay-for-performance and reinforces the concepts of cost containment.
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The future state of the mortgage industry is fueling a healthy debate and will begin to take form over the next several months. Agility and receptiveness to game-changing strategic decisions will position firms to succeed in the new environment. However, companies must not lose sight of the here and now.
Close scrutiny of expenses and intelligent cost reductions done in a flexible manner will drive firms' ability to achieve short-term cost savings and help transition them to sustainable long-term, lower-cost operational models. We've explored several cost containment concepts, and others include strategies around process workflow and automation, risk-based calling routines, REO portfolio management and customer retention. These concepts should remain on the radar for servicing executives.
John Kowalak is a senior manager with PricewaterhouseCoopers' Consumer Finance practice, where he focuses on audit examinations and advisory projects for financial institutions. He can be contacted at john.kowalak@us.pwc.com or (646) 471-3519.
