Working in a New Playing Field, Complete With New Headaches
Disruptions in critical markets are known to bring regulatory change. What is known, but less talked about, is that these changes sometimes result in unintended consequences that further burden market participants and often run counter to the intended effect of the change.
It is no secret that the mortgage market lacks liquidity in the form of a private secondary market and that the market would likely crumble without the ongoing support of the federal government. Most impartial observers would agree that measures should be taken to increase the attractiveness of investment in mortgages for the private market.
Although most of the talk in the mortgage servicing industry centers on servicers' preparedness for new rules about to take effect, could new liability and risk imposed on servicers alter the liquidity of loans and mortgage servicing rights (MSRs)? This is particularly important in terms of its effects on seasoned loans trading in the secondary market.
Liquidity is obviously the Holy Grail for any normally functioning market, and providing a base for transparency and liquidity in the private mortgage market is supposedly a goal of all the government intervention into the market since the crisis began. But if owners of mortgages and MSRs are ultimately liable for compliance, and the loan has been sold from previous owners/servicers, will buyers be willing to accept that liability?
Or will large pools of private capital stay away from the mortgage market as a result of the increased liability? Most importantly, for the buyers who are willing, will this translate into higher risked-based premiums, thereby lowering the price buyers are willing to pay to acquire loans?
More drastically, will this shift in liability mean that bank and non-bank servicers eventually have to hold reserves against servicing-related ongoing liability after portfolio and MSR sales that contain representations and warranties for prior servicing practices? As the largest bank servicers look to shed loans and MSRs, will the financial pendulum swing back in their favor as they would represent the lowest counterparty risk? Most buyers are not equipped to assess counterparty risk as it relates to loan servicing.
Our industry has spent a great deal of time debating ways to bring greater certainty to originators with respect to repurchase liability. From Fannie and Freddie to the Dodd-Frank Act, we have all acknowledged that there is a need to define time limits and implement a default causality standard around the ongoing liability of originating a loan. Should we now think about applying the same logic to new servicing standards and rules?
Some servicers may be able to differentiate themselves by managing the ongoing liability and confidently making representations and warranties about their servicing practices during the time they were responsible for servicing loans. But it is likely that will not apply to all servicers.
A Closer Look
To date, the majority of the scrutiny placed on servicers has focused on the foreclosure process and the attendant fallout of robo-signing. The new servicing rules announced in January by the Consumer Financial Protection Bureau expand that focus to a larger segment of servicing portfolios by creating rules for, most, notably, hazard insurance, payment application and adjustable-rate mortgage (ARM) changes.
The issue could become partially acute when loans are transferred multiple times and current owners/servicers of the loans are unwilling to make assurances that all previous payments were applied timely and correctly, that the ARMs were adjusted appropriately, and that all partial payments and escrows were administered in the correct manner. While those functions apply to a majority of loans serviced, we still need to consider the more complex compliance regulations around the default servicing functions- bankruptcy, loss mitigation and foreclosure.
Servicers that want to retain the ability to sell their loans and MSRs for the maximum price will need to have a comprehensive auditing program in place to be able to confidently state that they adhere to the new compliance standards. That process starts with full documented policies and procedures, as well as loan-level testing that verifies adherence to each stated policy.
Many servicers are rushing to fortify their policies and to implement testing as a further mediation measure. Vendors in the loan file review space are busy creating technology that assists in the process and adds rigor to testing servicing practices.
Clearly, these items will add to the cost of servicing and the cost of compliance- costs that no doubt the industry will have to address. Most likely, it will mean passing those new costs back to borrowers in some fashion. In the future, the industry may not only have to grapple with the cost of compliance- and, by definition, the correlating potential cost of non-compliance- but also hope that the market remains liquid.
It is too early to assess the effect these new rules will have on liquidity in the secondary mortgage market, and we all hope that the effect is nominal But with any new compliance burden placed on business, we would do well to keep in mind Newton's Third Law of Motion: For ever action, there is an equal and opposite reaction. Let us maintain a guarded optimism that the new rules have the intended reaction.