GEORGETOWN LAW The Scholarly Commons 2011 Mortgage Servicing Adam J. Levitin Georgetown University Law Center, [email protected] Tara Twomey National Consumer Law Center Georgetown Public Law and Legal Theory Research Paper No. 11-09 Georgetown Business, Economics and Regulatory Law Research Paper No. 11-01 This paper can be downloaded free of charge from: http://scholarship.law.georgetown.edu/facpub/498 http://ssrn.com/abstract=1324023 Yale J. on Reg. (forthcoming, 2011) This open-access article is brought to you by the Georgetown Law Library. Posted with permission of the author. Electronic copy available at: http://ssrn.com/abstract=1324023 5_LEVITIN&TWOMEY Mortgage Servicing Adam J. Levitin† & Tara Twomey‡ This Article argues that a principal-agent problem plays a critical role in the current foreclosure crisis. A traditional mortgage lender decides whether to foreclose or restructure a defaulted loan based on its evaluation of the comparative net present value of those options. Most residential mortgage loans, however, are securitized. Securitized mortgage loans are managed by third-party mortgage servicers as agents for mortgage-backed securities (―MBS‖) investors. Servicers‘ compensation structures create a principal-agent conflict between them and MBS investors. Servicers have no stake in the performance of mortgage loans, so they do not share investors‘ interest in maximizing the net present value of the loan. Instead, servicers‘ decision of whether to foreclose or modify a loan is based on their own cost and income structure, which is skewed toward foreclosure. The costs of this principal-agent conflict are thus externalized directly on homeowners and indirectly on communities and the housing market as a whole. This Article reviews the economics and regulation of servicing and lays out the principal-agent problem. It explains why the Home Affordable Modification Program (―HAMP‖) has been unable to adequately address servicer incentive problems and suggests possible solutions, drawing on devices used in other securitization servicing markets. Correcting the principal-agent problem in mortgage servicing is critical for mitigating the negative social externalities from uneconomic foreclosures and ensuring greater protection for investors and homeowners. † Associate Professor, Georgetown University Law Center. The views expressed in this Article are solely those of the authors. This Article incorporates parts of Professor Levitin‘s congressional testimony on foreclosures and mortgage servicing before the Senate and House Judiciary Committees. I would like to thank William Bratton, Larry Cordell, Anna Gelpern, Paul Koches, Sarah Levitin, Robert Van Order, Susan Wachter, and Elizabeth Warren for their comments and encouragement; and to thank Grant MacQueen and Tai Nguyen for their research assistance. Comments? [email protected]. ‡ Of Counsel, National Consumer Law Center; Amicus Project Director, National Association of Consumer Bankruptcy Attorneys; and former Lecturer in Law at Stanford Law School and Harvard Law School. The views expressed in this Article are solely those of the authors. This Article incorporates part of Ms. Twomey‘s congressional testimony on foreclosures and mortgage servicing before the House Financial Services Committee Subcommittee on Housing and Community Opportunity. I thank Alys Cohen, Katherine Porter, John Rao, and Diane Thompson for their help in building the foundation of this Article. Comments? [email protected]. 1 Electronic copy available at: http://ssrn.com/abstract=1324023 5_LEVITIN&TWOMEY Yale Journal on Regulation Vol. 28.1, 2011 Introduction ......................................................................................................... 2 I. Overview of the Mortgage Servicing Industry .............................................. 11 A. Servicing and Securitization .......................................................... 11 1. Traditional Portfolio Lending .................................................. 11 2. Mortgage Securitization ........................................................... 13 3. Segmentation of the Mortgage Securitization Market ............. 17 B. The Servicing Business .................................................................. 23 1. Servicer Specialization ............................................................ 23 2. Automation and Economies of Scale ....................................... 25 C. Servicing Contracts (Pooling and Servicing Agreements) ............. 31 1. Loan Management Standard .................................................... 31 2. Servicer Compensation ............................................................ 37 II. Regulation and Monitoring of Servicers ...................................................... 52 A. Consumer Protection Regulations Applicable to Servicers ........... 52 1. Fair Debt Collection Practices Act .......................................... 53 2. Real Estate Settlement Procedures Act .................................... 53 3. Truth in Lending Act ............................................................... 55 B. Investor Protection Regulations Applicable to Servicers: Regulation AB ................................................................................ 57 C. Supervision of Servicers by Investors and Trustees ....................... 58 D. Market Segment Specific Regulations ............................................ 64 1. Housing and Urban Development Regulations for Mortgages Insured by the Federal Housing Administration .... 64 2. Ginnie Mae Servicing Regulations .......................................... 65 3. Fannie Mae/Freddie Mac Servicing Guidelines ....................... 66 4. Rating Agencies‘ Ratings of PLS Servicers ............................ 67 5. State Regulation ....................................................................... 68 III. Mortgage Servicing‘s Principal-Agent Problem ......................................... 69 A. Servicing Compensation ................................................................ 69 1. Servicing Fees Come at the Expense of Investors ................... 70 2. Lack of Incentive to Maximize Net Present Value .................. 71 3. Implications for HAMP ........................................................... 77 4. Incentives To Favor Particular Forms of Modification............ 79 B. Why the Market Will Not Self-Correct ........................................... 81 IV. Reforming Mortgage Servicing: Require Special Default Servicers .......... 85 Conclusion ........................................................................................................ 90 Introduction The home is the most significant asset of many American families,1 and a wide array of federal and state regulatory schemes work to encourage and 1. See Brian K. Bucks et al., Changes in U.S. Family Finances from 2004 to 2007: Evidence from the Survey of Consumer Finances, FED. RES. BULL., Feb. 2009, at A1, A33, available at 2 Electronic copy available at: http://ssrn.com/abstract=1324023 5_LEVITIN&TWOMEY Mortgage Servicing protect homeownership.2 Homeownership is beyond the means of most families absent mortgage financing, and most of the regulatory schemes relate to the mortgage origination process and to the foreclosure sale process—the birth and death of the mortgage.3 There is scant regulation, however, of everything that occurs in the course of the mortgage‘s lifespan, between its origination and its eventual end via payoff or foreclosure. This in-between period involves the management of mortgage loans, including collection of payments and restructuring of the loan in the event of the borrower‘s financial distress, and is known as mortgage servicing. Mortgage servicing has begun to receive increased scholarly, popular, and political attention as a result of the difficulties faced by financially distressed homeowners when attempting to restructure their mortgages amid the home foreclosure crisis.4 In particular, the mortgage servicing industry has been identified as a central factor in the failure of the various government loan modification programs, including the $75 billion Home Affordable Modification Program (―HAMP‖).5 Mortgage servicing, however, remains a http://www.federalreserve.gov/pubs/bulletin/2009/pdf/scf09.pdf (reporting that home equity accounted for 31.8% of total family assets). 2. Examples include the federal income tax deduction for home mortgage interest payments, state and federal homestead exemptions that limit creditors‘ ability to levy on debtors‘ homes, and rights of redemption for defaulted mortgages. 3. See, e.g., Real Estate Settlement Procedures Act, 12 U.S.C. §§ 2601-2617 (2006); Home Mortgage Disclosure Act, 12 U.S.C. §§ 2801-2810; Homeowners Protection Act of 1998, 12 U.S.C. §§ 4901-4910; Truth in Lending Act, 15 U.S.C.A. §§ 1601-1616 (West 2010). 4. See, e.g., CONG. OVERSIGHT PANEL, AN ASSESSMENT OF FORECLOSURE MITIGATION EFFORTS AFTER SIX MONTHS (2009) [hereinafter CONG. OVERSIGHT PANEL, AN ASSESSMENT]; CONG. OVERSIGHT PANEL, EVALUATING PROGRESS OF TARP FORECLOSURE MITIGATION PROGRAMS (2010) [hereinafter CONG. OVERSIGHT PANEL, EVALUATING PROGRESS]; CONG. OVERSIGHT PANEL, THE FORECLOSURE CRISIS: WORKING TOWARD A SOLUTION 44-56 (2009) [hereinafter CONG. OVERSIGHT PANEL, THE FORECLOSURE CRISIS]; Peter S. Goodman, Late-Fee Profits May Trump Plan To Modify Loans, N.Y. TIMES, July 30, 2009, at A1; Daniel Wagner, Gov‘t Mortgage Partners Sued for Abuses, ASSOCIATED PRESS, Aug. 6, 2009; Marketplace: