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Loan Servicing and the Financial Disincentive to Assist Borrowers in Avoiding Foreclosure

Posted by Jeffrey Foster | Jul 29, 2013 | 0 Comments

Foreclosure Manual for Judges
Foreclosure Manual for Washington Judges
Loan Servicer's Business Model:  Earn fees then foreclose.

A common line of thinking among property owners facing foreclosure is that banks do not want to foreclose because of the losses incurred by the bank if the property is auctioned for less than its market value.  Historically, this line of thinking would be correct.

However, in today's world of mortgage-backed securities, collateralized debt obligations and other mortgage loan securitization products, the loan servicer as opposed to the actual lender is the decision-maker when it comes to approving loan modifications, short sales and other foreclosure alternatives. In many securitizations, loan servicers have an financial disincentive to do nothing to help the borrower other than delay and delay only to foreclose when the servicer has earned enough revenue on the foreclosure.  Below is a compelling excerpt from Washington's Foreclosure Manual for Judges regarding the role of servicers in foreclosures.  The foreclosure manual was drafted by Washington attorneys who represent banks as well as borrowers in foreclosure and real estate finance-related matters.

Excerpt from Section 1.2 "Securitization of Home Loans" - Washington Foreclosure Manual for Judges:

Servicers also play a role in the residential mortgage securitization process. Servicers collect the loan or lease payments from the individual mortgages in a pool on behalf of the issuer. Originators may perform this servicing function.24 Alternatively, a third party may purchase or contract for the rights to service the mortgages.

Servicers are paid a fee to service securitized mortgage loans, but they do not share the investors' interest in maximizing the net present value of the loans.26 As a result, some argue that servicers' decisions about whether to modify a loan or initiate a foreclosure are based on their own cost and income structure, which is skewed toward foreclosure.  Because of the dynamics in the way servicers are paid, others argue that servicer incentives are skewed not simply toward foreclosure, but rather toward delay—either delayed modifications or delayed foreclosures. As discussed more fully infra Section2.4.4, the largest source of income for fee servicers is the “servicing fee”—a fixed percentage, typically at least 0.25-0.50% of the principal balance of a mortgage loan.

Thus, larger loan balances mean more servicing fees, and the longer the term of the loan, the larger the revenue potential over time. If a loan modification is eventually granted after extensive delays, larger principal balances and longer loan terms than would otherwise exist on the same loans result. As long as mortgagors are making payments, delay benefits servicers. According to one borrower advocate:  [t]he monthly fee that the servicer receives based on a percentage of the outstanding principal of the loans in the pool provides some incentive to servicers to keep loans in the pool rather than foreclosing on them, but also provides a significant disincentive to offer principal reductions or other loan modifications that are sustainable on the long term. In fact, this fee gives servicers an incentive to increase the loan principal by adding delinquent amounts and junk fees.

Similarly, according to the New York Times, industry insiders say that extending the foreclosure process can allow a servicer to profit off of an eventual foreclosure: “the road to foreclosure is lined with fees, especially if it's prolonged.” The article explains:  Even when borrowers stop paying, mortgage companies that service the loans collect fees out of the proceeds when homes are ultimately sold in foreclosure. So the longer borrowers remain delinquent, the greater the opportunities for these mortgage companies to extract revenue—fees for insurance, appraisals, title searches and legal services.  …[a]s a home slides toward foreclosure, mortgage companies pay for many services required to take control of the property and resell it.

They typically funnel orders for title searches, insurance policies, appraisals and legal filings to companies they own or share revenue with. Servicers' motivation to accrue fees may be further increased by the fact that “servicer[s] often own[] a share in companies which can be billed for ancillary services during the foreclosure process, and charge[] above market rates on these services.” Additionally, servicers may be required to repurchase loans from the investors in order to permanently modify the loans, presenting a substantial cost and lost revenue to the servicer that the servicer can avoid if it keeps loans in a state of constant default until it eventually forecloses.

Although securitization allows lenders to expand mortgage lending by increasing liquidity and reallocating risk, the practice was implicated in the 2008 financial crisis. By permitting lenders to package and sell their mortgages (often then to be serviced by somebody else), rather than retain the mortgages they originate and the associated risk of default, lenders' underwriting standards declined. Deteriorating underwriting practices, combined with a lack of transparency regarding the individual mortgages underlying MBS, resulted in a proliferation of securities collateralized by risky loans. When the housing market collapsed, securitization compounded the losses suffered by investors.  Legislative responses to the financial crisis, including provisions of the Dodd-Frank Act, were designed to mitigate some of these risks associated with the securitization of residential mortgages.

About the Author

Jeffrey Foster

Attorney Jeffrey Foster is the founding partner of Foster Law Offices. An accomplished litigation and transaction attorney, Jeff proudly represents Washington individuals and businesses in legal matters Personal Injury, Bankruptcy, Real Estate and Civil Litigation.

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