Servicer Conflicts of Interest and the Principal-Agent Problem

Professors Adam Levitin and Tara Twomey have written a new paper for the Yale Journal on Regulation: Levitin Principal Agent Problem in Loan Servicing.  I’m not sure if it has even been published yet, but the abstract and the paper are available on SSRN.   I have excerpted segments of interest.  I have been arguing this principal-agent issue on a much more elementary level, namely, that the servicer is ostensibly an agent of the owner of the note/deed of trust, often–despite federal law—refusing to disclose the owner, thus acting with an unnamed principal in foreclosing while shifting between identifying itself as an agent (servicer) and the actual principal (beneficiary of the deed of trust) at will.  This is obviously legally incorrect and infuriating.  Moreover, in Arizona, as in all states, an agent cannot confer authority on itself; it must derive from the principal.  Nobody can verify the agent’s authority to act if you cannot determine who the source of power even is.    At any rate, here are the excerpts from Levitin’s new article:

Summary of the Argument and Scope of the Paper

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 restructurea 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 asagents 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 AffordableModification 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 thenegative social externalities from uneconomic foreclosures and ensuring greater protection for investors and homeowners

Principal-Agent Conflict:

The current structure of the mortgage servicing industry creates a principal-agent conflict between mortgage investors and servicers, the costs of which are borne by both investors and homeowners, with second-order spillovers to communities. The core of this principal-agent conflict is that servicers‘ incentives in managing a loan diverge from that of investors. Existing regulatory and monitoring structures are inadequate for ensuringalignment of servicer and investor interests, and the market is unlikely to self-correct because neither investors nor affected homeowners have the incentives or the bargaining power to fix the system.

Servicers‘ incentives diverge from investors on two levels. First, in reference to individual loans, servicers do not have a meaningful stake in the loan‘s performance; their compensation is not keyed to the return to investors.  Second, the servicing industry‘s combination of two distinct business lines—transaction processing and default management—encourage servicers to underinvest in default management capabilities, leaving them with limited ability to mitigate losses. Servicers‘ monetary indifference to the performance of a loan only exacerbates this situation.

On servicing fees for a securitized loan:

Because servicing fees are treated as an interest-only strip, they are sometimes paid only to the extent that interest payments are collected on a mortgage, including accrued interest collected upon liquidation of foreclosure property. In such a situation, the servicing fee on a nonperforming loan will not be paid until the loan reperforms or is liquidated, and the servicer is not compensated with interest for the delay in payment. Sometimes, however, servicing fees continue to be paid on delinquent mortgages and even, in some cases, on properties that are in REO (based on the pre-REO balance).

Float

Servicers earn ―float‖ income by investing the funds they receive from mortgagors for a short period before remitting them to the trust. Homeowners might pay their mortgage by the first of the month, but the servicer has to remit the payments to the trust only on the twenty-fifth of the month. In the interim, the servicer will place the payments in investment-grade investments and keep the investment income itself.

Many Fees Charged To Borrowers, Even If Caused By Servicers:

Servicers are typically permitted to retain any ancillary fees they levy on the homeowner to the extent they are collected.

Ancillary fees are imposed on borrowers to compensate servicers for the occurrence of particular events,such as late payment, bounced checks, and mortgage modification or extension.

. . .

Even small illegal fees, which are less likely to draw attention, can be quite profitable. Just one improper late fee of $15 on each loan in a fairly typically sized loan pool of 7000 loans would generate an additional $105,000in income for the servicer. Whereas illegal fees on performing mortgages might engender complaints and pushback from the mortgagors, a defaulted homeowner is unlikely to have the presence of mind to notice an illegal fee, much less the financial means to fight it. Even if a mortgage is performing, a small fee is easily overlooked, especially as servicers are under no obligation tosend borrowers detailed payment histories with the loan accounting, and typically send just an invoice. Thus, there is relatively low risk to imposing illegal fees upon defaulted accounts, and a significant upside.  If challenged about an illegal fee, a servicer can easily refund the fee, apologize, and claim that it was a one-off mistake; the homeowner is unlikely to pursue legal action or to know if illegal fees are a systemic practice.  There has been little investigation of illegal fees in general; in bankruptcy, however, there is greater scrutiny of mortgagees‘ claims, and  patterns of illegal fees become apparent and are challenged. Katherine Porter has documented that when mortgage creditors file claims in bankruptcy, they generally list amounts owed that are much higher than those scheduled by debtors.

There is also growing evidence of servicers requesting payment for services not performed or for which there was no contractual right to payment.  For example, in one particularly egregious case from 2008, Wells Fargo filed a claim in the borrower‘s bankruptcy case that included the costs of two brokers‘ price opinions on a property in Jefferson Parish, Louisiana. According to Wells Fargo, the price opinions were obtained in September 2005—a time when the entire Parish was under an evacuation order due to Hurricane Katrina.

Because of concerns about illegal fees, the United States Trustee‘s Office has undertaken several investigations of servicers‘ false claims in bankruptcy and brought suit against Countrywide,while the Texas Attorney General has sued American Home Mortgage Servicing for illegal debt collection practices.

Similarly, Kurt Eggert has noted a variety of abusive servicing practices, including ―improper foreclosures or attempted foreclosures; imposition of improper fees, especially late fees; forced-placed insurance that is not required or called for; and misuse of escrow funds.‖

Borrowers are Entitled to Know Who Owns and Who is Servicing Their Loan

[Beth: In practice, this information is often withheld, infuriatingly].

The consumer protection regime gives homeowners the right to know that servicing and ownership of their mortgage loan can be transferred, the right to receive notice of the transfer and contact information for the servicer and owner, and some error resolution rights. Homeowners are not, however, given any rights regarding loss mitigation decisions. The Fair Debt Collection Practices Act (FDCPA), the primary protection for consumer debtors against debt collectors, has little applicability to mortgage servicers. Servicers are,however, subject to some provisions of the Real Estate Settlement Procedures Act (RESPA) and Truth in Lending Act. There are also specific regulations for government-insured and guaranteed mortgages, as well as state regulations, that apply only to servicers not affiliated with national banks and thrifts, and some private regulation through ratings agencies.

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