Foreclosing Modifications: How Servicer Incentives Discourage Loan Modifications

• Publication year: 2021

FORECLOSING MODIFICATIONS: HOW SERVICER INCENTIVES DISCOURAGE LOAN MODIFICATIONS

Diane E. Thompson(fn*)

Abstract: Despite record losses to investors, homeowners, and surrounding communities, the foreclosure crisis continues to swell. Many commentators have urged an increase in the number of loan modifications as a solution to the foreclosure crisis. The Obama Administration created a program specifically designed to encourage modifications. Yet, the number of foreclosures continues to outpace modifications.

One reason foreclosures outpace modifications is that the mortgage-modification decision maker's incentives generally favor a foreclosure over a modification. The decision maker is not the investor or the lender, but a separate entity, the servicer. The servicer's main function is to collect and process payments from homeowners, and servicers do not necessarily have any ownership interest in the loan. Servicers, unlike investors, generally recover all their hard costs after a foreclosure, even if the home sells for less than the mortgage loan balance. Servicers may even make money from foreclosures through charging borrowers and investors fees that are ultimately recouped from the loan pool.

Existing regulatory guidance could be improved to facilitate modifications. Investors need increased transparency to hold servicers accountable for failing to make modifications when it is in the investors' best interests to make modifications. Fundamentally, servicers must be required to make modifications when doing so would benefit the trust as a whole.

INTRODUCTION. ...............................................................................758

I. THE FRAMEWORK OF MORTGAGE SERVICING IMPEDES MODIFICATIONS. ....................................................762

A. The Mortgage Market Has Evolved Into Fragmented Ownership ............................................................................ 762

B. Decision Making Is Divorced from Ownership for Most Home Loans.........................................................................764

1. Who Is a Servicer?....................................................765

2. Investors Seldom Can or Do Influence the Servicer's Actions on Loan Modifications...............768

3. Servicers Make Modifications that Benefit Themselves, Not Investors or Homeowners.............770

C. Third Parties Constrain Servicer Discretion.........................772

1. Credit Rating Agencies and Bond Insurers Exercise Influence over Servicers. ............................772

2. The FASB Accounting Rules Regulate Servicer Performance..............................................................775

II. CHOOSING BETWEEN FORECLOSURES AND MODIFICATIONS: THE BALANCE OF SERVICER INCENTIVES DISCOURAGES MODIFICATIONS..................776

A. The Cost-Benefit Analysis of a Foreclosure or a Modification ......................................................................... 776

B. Servicers Are Not Prevented from Modifying Loans by Securitization Contracts or Tax and Accounting Rules.......781

1. Investor Contracts Do Not Prevent Most Loan Modifications . ........................................................... 782

2. The Accounting Rules Do Not Prevent Modification of Loans in Default ............................. 785

C. Some Features of the Accounting Rules and Investor Contracts Can Discourage Sustainable Modifications ......... 788

1. FASB Requirements for the Immediate Recognition of Loss Discourage Permanent Modifications . ........................................................... 788

2. The Troubled Debt Restructuring Rules Discourage Sustainable Modifications.....................791

3. Dual-Track Provisions in Investor Contracts Hinder Modifications. ...............................................794

4. Repurchase Agreements Encourage Servicers to Pursue Short-Term Forbearance Agreements over Permanent Modifications..........................................796

5. Reliance on Industry Standards Slows the Pace of Innovation in Loan Modifications............................797

D. The Rules Promulgated by Credit Rating Agencies and Bond Insurers Discourage Modifications, Particularly Permanent Sustainable Modifications..................................799

1. Credit Rating Agencies' Mixed Messages Discourage Sustainable Modifications.....................799

2. Bond Insurers Favor Modifications When the Cost Is Borne Entirely by Junior Tranches. ......................801

E. Servicer Compensation Tilts the Scales Away from Principal Reductions and Short Sales and Towards Short-Term Repayment Plans, Forbearance Agreements, and Foreclosures ......................................................................... 802

1. Servicers' Entitlement to Fee Retention Encourages Foreclosure and Strips Wealth from Both Investors and Homeowners. ............................. 803

2. Servicers' Receipt of Float Interest Income Has a Negligible Impact on Servicer Incentives to Foreclose or Modify ................................................. 806

3. Servicers' Largest Form of Compensation-the Payment Based on Percentage of Outstanding Principal-Discourages Foreclosures and Modifications that Result in Principal Reduction and Encourages Modifications that Increase the Principal Balance...................................................... 807

4. Servicers' Retention of Residual Interests Encourages Servicers to Delay Loss Recognition and Promotes Temporary Modifications Rather than Permanent Modifications. .................................809

5. The Valuation of Mortgage Servicing Rights Encourages Servicers to Re-Age Loans Through Temporary Modifications and Forbearance.............. 811

F. Servicer Expenditures Encourage Quick Foreclosures........814

1. Interest and Principal Advances to Investors Drive Servicer Expenses and Push Servicers to Resolve Delinquencies Quickly.............................................. 814

2. Servicers' Fee Advances to Third Parties Are a Profit Center that Can Imperil Modifications. ..........819

3. Amortization of Mortgage Servicing Rights Can Encourage Modifications..........................................821

4. Staffing Costs and Institutional Inertia Favor Foreclosure over Modification.................................. 821

5. The Possibility of Refinancing or Cure Encourages Servicers to Foreclose Instead of Modifying . ................................................................ 824

III. SOLUTIONS................................................................................. 825

A. HAMP and Other Programs to Encourage Modifications Have Failed . ......................................................................... 825

B. Increased Accountability and Transparency Would Increase the Number of Sustainable Loan Modifications . ... 830

C. End the Dual-Track System and Mandate Loan Modification Before a Foreclosure ...................................... 830

D. Provide for Principal Reductions in HAMP and Via Bankruptcy Reform.............................................................. 831

E. Continue to Increase Automated and Standardized Modifications, with Individualized Review for Borrowers for Whom the Automated and Standardized Modification Is Inappropriate . ................................................................... 833

F. Ease Accounting Rules for Modifications ........................... 834

G. Encourage FASB and the Credit Rating Agencies to Provide More Guidance Regarding the Treatment of Modifications.......................................................................836

H. Encourage Investors to Regulate Default Fees..................... 837 CONCLUSION . ................................................................................... 838

INTRODUCTION

We are living through a period of historic levels of foreclosures. The foreclosure rate in 2010(fn1) was more than three times what it was in 1933, at the height of the Great Depression.(fn2) The crisis has impacted every part of our country and most of the world.(fn3) As the chairman of the Federal Reserve Board has noted, the crisis threatened our national economy.(fn4) Families who have lost their homes face losses projected to exceed $2.6 trillion,(fn5) with spillover effects on neighbors and communities in the trillions of dollars.(fn6)

One response to high rates of default and foreclosure is to modify, or restructure the loans in order to ease payment. Modifying loans to ease repayment makes sense because lenders lose a lot of money on foreclosures.(fn7) When a borrower makes payments under a modification, lenders can save money.(fn8) Modifications are routine in the commercial context, with lenders agreeing to drop interest rates, forgive or forbear principal, or provide a grace period for payments.(fn9) In spite of the benefits of modification, residential lending has long lagged behind commercial lending in the depth and variety of loan modifications offered to borrowers in default.(fn10) In residential lending, the most common form of modification historically was a relatively ineffective short-term forbearance agreement.(fn11) These agreements reduce the payment, sometimes to zero, for a few months. Homeowners are typically expected to make up the...