This is the third installment of a three-piece blog series from former Consumer Financial Protection Bureau Director Richard Cordray. Go here for the first piece and here for the second.
How can we best achieve our goal of minimizing foreclosures in an economic downturn? Traditional mortgage lenders like community banks that maintain loans in their own portfolios have long seen foreclosure as a last resort; loan modifications (including refinancing) are their preferred options. Community norms also pressure local lenders to use gentler methods to resolve problem loans rather than moving immediately to oust people from their homes. Over decades of experience, they learned to use this tool only when truly necessary.
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In the 2008 crisis, this traditional response broke down spectacularly. Major changes in the market, especially mortgage securitization and greater specialization, severed the ownership and servicing of many loans from their originators. Confused customers suffered a “disconnect” in communicating with their servicers, and the paperwork to qualify for loan modifications became more burdensome. Sloppy corporate records produced frequent gaps in mortgage files. Incomplete files were costly to handle, and servicers faced huge fines for “fixing” the gaps by fraudulently fabricating the documents they needed to secure foreclosure.
Processes were a mess, with huge volumes of defaults. Some companies went out of business and stranded servicing rights; others merged and ran into balky technology adjustments. All of this further strained the creaky mechanisms of the foreclosure process. The story of the sluggish economic recovery after 2009 is a story marked by malignant tumors throughout the housing market that were extremely slow to heal.
Do we need to worry about those same problems in the current economic crisis? Much has changed in the last decade. New regulations and requirements for mortgage servicers, and closer supervisory oversight, have delivered some improvements.
The CARES Act also largely streamlined the mortgage forbearance process, cutting the Gordian knot of paperwork fiascos that marred mortgage servicing in the last crisis. We are approaching 5 million mortgages on forbearance plans, with increases likely at the beginning of each subsequent month for as long as unemployment stays elevated. Moratoriums are “flattening the curve” of foreclosures to ease the pressure on the legal system, at least temporarily.
But many servicers face another problem we have not yet addressed. Banks are diversified financial companies, with capital cushions mandated by their prudential regulators and ample financial backstops available from the Federal Reserve. Forgoing mortgage payments is costly, but they can weather the storm.
For specialized companies that focus on mortgage servicing as a separate business line, however, the economic incentives are different. They now make up close to half the market. They are not diversified, with less capital and fewer liquidity options than the banks, leaving them less able to support workout plans that forgo payments for any extended period. Their very survival is threatened when large numbers of expected payments are not received. Both the GAO and the FSOC have highlighted this regulatory gap, which poses increased risks to the overall financial system.
Although servicing specialty businesses operate efficiently during most of the business cycle, they become terribly inefficient in the trough, as non-performing loans demand costly personal attention that is not easily automated.
Servicers tend to under-invest in the personnel and technologies needed to cope with downturns. They may be unprepared to deal with a cascade of borrowers falling behind on their payments. Call volumes spike, resolutions are more complex, and processes are elongated. The estimated average cost to service non-performing loans is now about 15 times the cost for performing loans. In tough times, the capacity to assist borrowers with alternatives to avoid foreclosure is severely strained.
These internal dynamics of non-bank servicers pose two specific threats to implementing an effective “foreclosure minimization” strategy.
First, these companies feel the urgency to get paid by their customers; facing uncertainty about their liquidity, they know that substantial non-performance could spell bankruptcy. They thus may resist the forbearance promised under the CARES Act. Some falter in processing borrower requests (as happened routinely during the last crisis when many servicers ignored calls and lost paperwork), though regulatory reforms and the newly streamlined approach are helping so far.
Others seek to discourage non-payment by imposing onerous conditions, such as eventual lump-sum repayment of all arrears, which will inevitably produce deferred foreclosures. The FHFA and others have condemned this approach when it has been exposed, but servicers have many ways of managing those conversations to put off those seeking approval to skip their regular payments.
Second, without a sufficient financial backstop, some servicers are likely to go out of business. Their demise would create further legal tangles. The process for transferring servicing rights is not nimble even in consensual transactions. The collision of different IT systems trying to manage delinquent accounts can stymie consumers from securing relief. And when coupled with the complications of a bankruptcy, servicing transfers will generate even more frustration and futility for consumers seeking payment accommodations.
These two threats underscore the need for a vigorous regulatory response. The problem of servicers seeking to evade the CARES Act requirements can be addressed by close oversight from the CFPB and state officials, who can monitor how the companies process forbearance requests. By examining the scripts used on such calls, and listening to the audiotapes of sample calls, the regulators can ensure that consumers are being treated fairly under the new law.
For servicers in danger of bankruptcy, the FHFA and Treasury can work with state officials to make sure troubled servicers have sufficient financial backing to avoid going out of business during the current crisis. It may stick in their craw to have to provide the capital buffer these companies should have provided for themselves, but that can be sorted out later, when a more rationale safety-and-soundness regime for nonbank mortgage servicers can be devised as part of the reforms this new economic crisis will inevitably produce.
In the meantime, the ultimate magnitude of the economic downturn will dictate whether this strategy of “flattening the foreclosure curve” can succeed in averting another housing crisis. The streamlined forbearance process has introduced new risks of moral hazard, and the bump this spring in household income from federal infusions has masked an accurate assessment of the extent of the current economic distress. But the essential policy approach to infirmities in the housing market seems much clearer now than it did a decade ago.
