REQUIRED READING: In the face of steadily rising loan delinquencies, nationwide home-price depreciation, housing shadow inventories that may take years to work out, persistently high unemployment and the phenomenon of strategic default, the current model for residential mortgage servicing is broken. While this is true for residential mortgage servicing generally, it has proven particularly unwieldy for servicers administering loans within private-label securitizations.
This article will not attempt to provide a causal analysis for why the servicing model has broken, as that subject has been aptly covered and discussed in numerous books and articles examining not just the role of servicers, but that of issuers, rating agencies, underwriters and other intermediaries in the securitization process. Instead, this article will attempt to provide a basic framework of a workable loan servicing model and attempt to define the new roles and responsibilities of the servicer in a residential mortgage-backed securitization (RMBS) transaction.
Historically, the loan servicing model was built around workflow efficiencies designed to maximize productivity and minimize cost. However, when escalating delinquencies and financial hardship urgently increase the need for effective borrower contact, automation cannot adequately substitute for a high-touch approach. The traditional flat-fee compensation structure embedded in most servicing contracts has likewise proven incapable of adequately incentivizing servicers in the economic environment of the past several years.
Many of these same servicers participating in private-label securitizations have also been called upon to act as primary credit providers in these transactions by advancing principal and interest payments on delinquent accounts. Certain aspects of the current servicing model lack economic or functional sense, especially in an environment of unprecedented defaults and the corresponding need for intensive borrower contact. If the servicing industry is to move forward and succeed in delivering on its three most important goals – providing the highest level of borrower service, serving the needs of investors and maintaining profitability – the loan servicing paradigm must change.
The current flat servicing fee structure fails to recognize that servicing functions differ in complexity and, therefore, require different infrastructures and technology in order to be performed successfully. The skill sets and technology required to operate a successful payment-processing operation are completely different from those required to run an effective customer-service call center.
Likewise, the costs of such functions also differ considerably. In times of low delinquencies and high levels of home equity, the deficiencies in more labor-intensive, borrower-centric functions were not as noticeable, and the profits reaped by relatively high fees for performing highly automated, more rote task processing masked the incongruities in pricing for those functions.
However, as delinquency levels rose, it became more apparent that certain functions require more highly trained – and, therefore, more expensive – personnel, which were not only more costly, but also more time-consuming to expand as companies began to find a shortage of such readily available and qualified personnel.
Suddenly, the automation, which seemed to serve all servicing functions so well when delinquency volumes were small, was overwhelmed by the demands placed on it. This is evident by the reported "robo-signing" crisis, whereby there was a seemingly substantial breakdown in policy and process compliance integral to the foreclosure process due to overwhelming volume.
A potential solution to this problem would seem to be to segregate certain servicing functions involved in administering a mortgage loan throughout its life cycle. This was the approach taken by the commercial mortgage industry when it developed standardized guidelines for securitization in the mid-1990s at the time of the Resolution Trust Corp.'s sunset.
At that time, servicing for commercial mortgage-backed securities was bifurcated between performing loans and distressed loans. A transfer timeline was established – in that case, at 60 days of delinquency, or earlier if the servicer had good reason to suspect a default was imminent. Rules for communication and cooperation between the performing servicer (usually deemed a "master servicer") and the special servicer were established, as was a distinct compensation scheme for each.
The industry also created standardized reporting formats so that investors could benchmark the performance of their portfolio with comparable data. The development of this servicing model clearly aligned the roles and functions of the different servicers with their compensation, providing a different cost structure and compensation model to mirror the different needs of that function.
A similar, although not identical, bifurcation should be undertaken for RMBS servicing. Due to the regulatory environment of residential mortgage servicing, different challenges will have to be addressed, such as the mandated notification requirements and grace periods for borrowers whose loans are transferred under the Real Estate Settlement Procedures Act (RESPA).
Another challenge posed is where to house loans that are successfully rehabilitated. While a transfer back to the performing servicer would seem logical, excessive transferring of residential loans has proven to cause confusion for borrowers and often leads to redefaults.
One potential answer to this problem could be more widespread use of component servicers. These are servicers that focus on a particular function, such as loan modifications or real estate liquidations, on behalf of performing-loan servicing clients. Bifurcation of servicing between these two entities may avoid triggering RESPA notification requirements if done on a private-label basis or, at the very least, reduce the level of borrower confusion.
A distinct separation of servicing duties could accomplish a number of goals. For instance, it would permit large, well-automated, high-volume servicers to do what they do most efficiently – mass processing of large numbers of loans for routine functions such as payment processing, escrow administration and customer service. For performing loans, these functions can be effectively performed using high levels of workflow automation and minimum manual intervention.
This bifurcated structure provides a more individualized and focused approach necessary to deal with distressed borrowers, including a high level of direct counseling and relationship-building with borrowers. The much reported "single point of contact" concept emphasized by regulators could be embraced in this model, which would have the requisite infrastructure and compensation formula to support such an approach.
Another challenge in servicing private-label RMBS loans is the practice of advancing delinquent principal and interest on nonperforming loans. This essentially provides a form of credit support to a transaction and is, in many cases, the responsibility of the servicer, which also determines whether a particular advance is recoverable upon liquidation. While the need for servicers to evaluate and fund property preservation advances, such as property tax and insurance premiums, can be readily understood given the servicer's position with regard to both the borrower and the collateral, no such case can be made for servicers to fund credit support for a transaction.
Large, highly capitalized banks aside, the typical servicing entity is a relatively thinly capitalized corporate entity with a modest amount of equity that funds its advancing obligation through the use of various credit facilities. The obligation to advance substantial sums for delinquent principal and interest, which are not reimbursable until ultimate loan liquidation (except in the case of loan modifications), and for which no interest is accrued, creates an undue financial burden on loan servicing entities. An alternate means of funding such advances must be introduced. These alternate financing vehicles could include letters of credit provided by a bank, a cash reserve account built into the transaction, or the introduction of a paying agent or other such participant into the securitization transaction.
With respect to the best interests of investors, the servicing industry as a whole needs to adopt and adhere to a standardized reporting format that would provide comparable performance data for all loan portfolios. This would allow for meaningful comparisons and benchmarking of performance across different transactions. The American Securitization Forum has already spearheaded much of this work with the input of issuers, investors and servicers, but implementation is still awaiting the return of private-label securitizations of residential mortgage loans to the marketplace.
Finally, the disparate patchwork of laws and regulations governing residential real estate needs to be addressed. While real estate itself will likely always be governed by state and local law, the legally required standard of servicing for loan administrators must be consistent nationally. Thus, minimum standards of service for functions such as call-center management, hazard and flood insurance monitoring, loan payoff processing, escrow analysis and default management, to name a few, need to be uniform in order for servicers to effectively budget for and implement compliance with such standards.
The nation desperately needs a stable and robust private capitalization of the residential mortgage markets. The reforms discussed in this article represent necessary steps that must be taken in order to lay the groundwork for the return of such funding to this marketplace. It will take a concerted effort by all parties involved – originators, issuers, investors, servicers, regulators and housing advocates – to turn this industry around and prepare it for the next generation of residential mortgage funding and securitizations.
Michael Gutierrez is managing director of Morningstar's operational risk assessments group. The opinions expressed herein are solely those of the author and do not necessarily represent the opinions of Morningstar. Gutierrez can be reached at michael.gutierrez@morningstar.com.
