why servicers foreclose when they should modify · vi why servicers foreclose when they should...

Servicer Compensation and its Consequences

October 2009

Why Servicers Foreclose When They Should Modify

and Other Puzzles of Servicer Behavior

NATIONALCONSUM ER LAW

CENTER INC——————————————

▲

Why Servicers Foreclose When They Should Modify and Other Puzzles of Servicer Behavior: Servicer Compensation and its Consequences

Written byDiane E. ThompsonOf CounselNational Consumer Law Center

ABOUT THE AUTHOR

Diane E. Thompson is Of Counsel at the National Consumer Law Center. She writes andtrains extensively on mortgage issues, particularly credit math and loan modifications. Priorto coming to NCLC, she worked as a legal services attorney in East St. Louis, Illinois, whereshe negotiated dozens of loan modifications in the course of representing hundreds ofhomeowners facing foreclosure. She received her B.A. from Cornell University and her J.D.from New York University.

ABOUT THE NATIONAL CONSUMER LAW CENTER

The National Consumer Law Center®, a nonprofit corporation founded in 1969, assists con-sumers, advocates, and public policy makers nationwide on consumer law issues. NCLCworks toward the goal of consumer justice and fair treatment, particularly for those whosepoverty renders them powerless to demand accountability from the economic marketplace.NCLC has provided model language and testimony on numerous consumer law issues be-fore federal and state policy makers. NCLC publishes an 18-volume series of treatises onconsumer law, and a number of publications for consumers.

ACKNOWLEDGEMENTS

My colleagues at NCLC provided, as always, generous and substantive support for this piece.Carolyn Carter, John Rao, Margot Saunders, Tara Twomey, and Andrew Pizor all made sig-nificant contributions to the form and content of this paper. Thanks as well to Kevin Byersfor reading and commenting on this piece. Particular thanks to Denise Lisio for help withthe footnotes, to Tamar Malloy for work on the charts, and to Julie Gallagher for graphic de-sign. All errors remain the author’s.

© 2009 National Consumer Law Center® All rights reserved.7 Winthrop Square, Boston, MA 02110617-542-8010 www.consumerlaw.org

TABLE OF CONTENTS

Executive Summary v

Introduction 1

The Rise of the Servicing Industry as a By-Product of Securitization 3

Securitization Contracts, Tax Rules, and Accounting Standards Do Not Prevent Loan Modifications But Discourage SomeModifications 5

The Only Effective Oversight of Servicers, by Credit Rating Agencies and Bond Insurers, Provides Little Incentive for Loan Modifications 14

Servicer Income Tilts the Scales Away from Principal Reductions and Short Sales and Towards Short-Term Repayment Plans, Forbearance Agreements, and Foreclosures 16

Servicer Expenditures Encourage Quick Foreclosures 23

Foreclosures vs. Modifications: Which Cost a Servicer More? 25

Staffing 28

Refinancing and Cure 29

Conclusion and Recommendations 29

Glossary of Terms 37

Notes 40

FIGURES AND CHARTS

Percentage of Loans in Foreclosure, 1995–2009 v, 1

Modifications, Foreclosures, and Delinquencies as a Percentage of 60+ Day Delinquencies in 4th Quarter, 2008 vi, 30

Ocwen Asset Management Servicing Fees vi, 18

Ocwen Asset Management Breakdown of Servicing Fees vi, 18

Effect of Components of Servicer Compensation on Likelihood and Speed of Foreclosure vii

HAMP Modifications as a Percentage of Delinquencies viii, 30

Securitization Rate, 1990–2008 3

Income Glossary 4

Expenses Glossary 5

Securitization, Tax, and Accounting Glossary 6

A Simplified Example of the Benefit to Servicers of Short-term Versus Permanent Modifications 13

Ocwen Solutions Mortgage Services Fees 18

Ocwen Solutions Process Management Fees Breakdown 18

A Simplified Example of the Impact on Residuals of Delayed Loss Recognition for Principal Reductions 21

A Simplified Example of the Advantage of Modifications That Permit Recovery of Advances 24

Effect of Servicer Incentives on Default Outcomes 31

Percentage of Loans in Foreclosure, 1995–2009

Sources: Inside Mortgage Finance, The 2009 Mortgage Market Statistical Annual; Mortgage Banker’s Association,National Delinquency Survey, Q2 09

5

4

3

2

1

0Perc

ent

Loan

s in

fore

clos

ure

1995 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2Q2009

EXECUTIVE SUMMARY

v

The country is in the midst of a foreclosure crisisof unprecedented proportions. Millions of fami-lies have lost their homes and millions more areexpected to lose their homes in the next fewyears. With home values plummeting and layoffscommon, homeowners are crumbling under theweight of mortgages that were often only mar-ginally affordable when made.

One commonsense solution to the foreclosurecrisis is to modify the loan terms. Lenders rou-tinely lament their losses in foreclosure. Foreclo-sures cost everyone—the homeowner, the lender,the community—money. Yet foreclosures con-tinue to outstrip loan modifications. Why?

Once a mortgage loan is made, in most casesthe original lender does not have further ongoingcontact with the homeowner. Instead, the origi-nal lender, or the investment trust to which theloan is sold, hires a servicer to collect monthlypayments. It is the servicer that either answersthe borrower’s plea for a modification or launchesa foreclosure. Servicers spend millions of dollars

advertising their concern for the plight of home-owners and their willingness to make deals. Yetthe experience of many homeowners and theiradvocates is that servicers—not the mortgageowners—are often the barrier to making a loanmodification.

Servicers, unlike investors or homeowners, donot generally lose money on a foreclosure. Ser-vicers may even make money on a foreclosure.And, usually, a loan modification will cost theservicer something. A servicer deciding between aforeclosure and a loan modification faces theprospect of near certain loss if the loan is modi-fied and no penalty, but potential profit, if thehome is foreclosed. The formal rulemakers—Congress, the Administration, and the Securitiesand Exchange Commission—and the market par-ticipants who set the terms of engagement—credit rating agencies and bond insurers—havefailed to provide servicers with the necessary in-centives—the carrots and the sticks—to reduceforeclosures and increase loan modifications.

Servicers remain largely unaccountable for theirdismal performance in making loan modifications.

Servicers have four main sources of income,listed in descending order of importance:

� The monthly servicing fee, a fixed percentageof the unpaid principal balance of the loans inthe pool;

� Fees charged borrowers in default, includinglate fees and “process management fees”;

� Float income, or interest income from thetime between when the servicer collects thepayment from the borrower and when it turnsthe payment over to the mortgage owner; and

� Income from investment interests in the poolof mortgage loans that the servicer is servicing.

Overall, these sources of income give servicerslittle incentive to offer sustainable loan modifica-tions, and some incentive to push loans into fore-closure. The monthly fee that the servicerreceives based on a percentage of the outstandingprincipal of the loans in the pool provides someincentive to servicers to keep loans in the poolrather than foreclosing on them, but also pro-vides a significant disincentive to offer principalreductions or other loan modifications that aresustainable on the long term. In fact, this feegives servicers an incentive to increase the loanprincipal by adding delinquent amounts andjunk fees. Then the servicer receives a highermonthly fee for a while, until the loan finallyfails. Fees that servicers charge borrowers in de-fault reward servicers for getting and keeping aborrower in default. As they grow, these feesmake a modification less and less feasible. Theservicer may have to waive them to make a loanmodification feasible but is almost always as-sured of collecting them if a foreclosure goesthrough. The other two sources of servicer in-come are less significant.

If servicers’ income gives no incentive to mod-ify and some incentive to foreclose, through in-creased fees, what about servicers’ expenditures?Servicers’ largest expenses are the costs of fi-nancing the advances they are required to make

vi WHY SERVICERS FORECLOSE WHEN THEY SHOULD MODIFY

Modifications, Foreclosures, and Delinquenciesas a Percentage of 60+ Day Delinquencies

in 4th Quarter, 2008

The 60+ day delinquency rate for 4th quarter 2008was 8.08% of all loans.

Sources: Mortgage Banker’s Association, NationalDelinquency Survey, Q4 08; Manuel Adelino, KristopherGerardi, and Paul S. Willen, Why Don’t Lenders RenegotiateMore Home Mortgages? Redefaults, Self-Cures, andSecuritization, Table 3.

60+ DaysDelinquent

Unmodified,Not in Foreclosure

ForeclosureInventory

4th Quarter2008

Modifications Performed 4th Quarter 20083%

41%56%

Ocwen Asset Management Servicing Fees

Source: Ocwen Fin. Corp., Annual Report (Form 10-K) (Mar. 12, 2009)

ProcessManagement

Fees 11%

89%

Servicing andSubservicing Fees

Ocwen Asset Management Breakdown of Servicing Fees


Loan Collection Fees 3%Other Commercial 0%

Custodial Accounts(Float Earnings)

LateCharges

Residential Loan Servicing and Subservicing

70%

15%

8%4%

to investors of the principal and interest pay-ments on nonperforming loans. Once a loan ismodified or the home foreclosed on and sold, therequirement to make advances stops. Servicerswill only want to modify if doing so stops the clockon advances sooner than a foreclosure would.

Worse, under the rules promulgated by thecredit rating agencies and bond insurers, servicersare delayed in recovering the advances when theydo a modification, but not when they foreclose.Servicers lose no money from foreclosures be-cause they recover all of their expenses when aloan is foreclosed, before any of the investors getpaid. The rules for recovery of expenses in a mod-

ification are much less clear and somewhat lessgenerous.

In addition, performing large numbers of loanmodifications would cost servicers upfrontmoney in fixed overhead costs, including staffingand physical infrastructure, plus out-of-pocketexpenses such as property valuation and creditreports as well as financing costs. On the otherhand, servicers lose no money from foreclosures.

The post-hoc reimbursement for individualloan modifications offered by Making Home Af-fordable and other programs has not been enoughto induce servicers to change their existing businessmodel. This business model, of creaming funds

WHY SERVICERS FORECLOSE WHEN THEY SHOULD MODIFY vii

Effect of Components of Servicer Compensation on Likelihood and Speed of Foreclosure

Likely Effect on Favors Foreclosure? Speed of Foreclosure?

Structural Factors

PSAs Neutral Speeds Up

Repurchase Agreements Neutral Slows Down

REMIC rules Neutral Neutral

FAS 140 Slightly Favors Foreclosure Neutral

TDR Rules Slightly Favors Foreclosure Neutral

Credit rating agency Slightly Favors Foreclosure Speeds Up

Bond insurers Slightly Favors Foreclosure Speeds Up

Servicer Compensation

Fees Strongly Favors Foreclosure Slows Down

Float Interest Income Slightly Favors Foreclosure Neutral

Monthly Servicing Fee Strongly Favors Modification Slows Down(but not principal reductions)

Residual Interests Slightly Favors Modification Slows Down(but not interest reductions)

Servicer Assets

Mortgage Servicing Rights Neutral Slows Down

Servicer Expenses

Advances Strongly Favors Foreclosures Speeds Up

Fee Advances to Third Parties Slightly Favors Foreclosure Speeds Up

Staff Costs Strongly Favors Foreclosures Speeds Up

from collections before investors are paid, hasbeen extremely profitable. A change in the basicstructure of the business model to active engage-ment with borrowers is unlikely to come bypiecemeal tinkering with the incentive structure.

In the face of an entrenched and successfulbusiness model, servicers need powerful motiva-tion to perform significant numbers of loanmodifications. Servicers have clearly not yet re-ceived such powerful motivation. What is lackingin the system is not a carrot; what is lacking is astick. Servicers must be required to make modifi-cations, where appropriate, and the penalties forfailing to do so must be certain and substantial.

Recommendations:1. Avoid irresponsible lending.We are now looking to loan modifications to

bail us out of a foreclosure crisis years in themaking. Had meaningful regulation of loanproducts been in place for the preceding decade,

we would not now be tasking servicers with res-cuing us from the foreclosure crisis. Any attemptto address the foreclosure crisis must, of neces-sity, consider loan modifications. We should alsoensure that we are not permanently facing fore-closure rates at current levels. To do so requiresthorough-going regulation of loan products, aswe have discussed in detail elsewhere.

2. Mandate loan modification before a foreclosure.

Congress and state legislatures should man-date consideration of a loan modification beforeany foreclosure is started and should require loanmodifications where they are more profitable toinvestors than foreclosure. Loss mitigation, ingeneral, should be preferred over foreclosure.

3. Fund quality mediation programs.Court-supervised mortgage mediation pro-

grams help borrowers and servicers find out-comes that benefit homeowners, communitiesand investors. The quality of programs varieswidely, however, and most communities don’t yethave mediation available. Government fundingfor mediation programs would expand theirreach and help develop best practices to maxi-mize sustainable outcomes.

4. Provide for principal reductions inMaking Home Affordable and viabankruptcy reform.

Principal forgiveness is necessary to make loanmodifications affordable for some homeowners.The need for principal reductions is especiallyacute—and justified—for those whose loans werenot adequately underwritten and either: 1) receivednegatively amortizing loans such as payment op-tion adjustable rate mortgage loans, or 2) obtainedloans that were based on inflated appraisals. As amatter of fairness and commonsense, homeown-ers should not be trapped in debt peonage, un-able to refinance or sell.

The Making Home Affordable guidelines shouldbe revised so that they at least conform to the Fed-eral Reserve Board’s loan modification program by

HAMP Modifications as a Percentage of Delinquencies

Total 60+ Days Delinquencies as of June 30, 2009 5,360,961

HAMP Trial Modification Through September 30, 2009 487,081

Sources: Mortgage Banker’s Association, NationalDelinquency Survey, Q2 09; Making Home AffordableProgram, Servicer Performance Report Through September2009

June 2009 60+ Day Delinquencieswithout a HAMP ModificationHAMP Trial Modifications as of September 30, 2009

9%

91%

viii WHY SERVICERS FORECLOSE WHEN THEY SHOULD MODIFY

WHY SERVICERS FORECLOSE WHEN THEY SHOULD MODIFY ix

reducing loan balances to 125 percent of thehome’s current market value. In addition, Con-gress should enact legislation to allow bank-ruptcy judges to modify appropriate mortgagesin distress.

5. Continue to increase automated andstandardized modifications, withindividualized review for borrowers for whom the automated andstandardized modification isinappropriate.

One of the requirements of any loan modifica-tion program that hopes to be effective on thescale necessary to make a difference in our cur-rent foreclosure crisis is speed. The main way toget speed is to automate the process and to offerstandardized modifications.

Servicers can and should present borrowers indefault with a standardized offer based on infor-mation in the servicer’s file, including the incomeat the time of origination and the current defaultstatus. Borrowers should then be free to accept orreject the modification, based on their own as-sessment of their ability to make the modifiedpayments. Borrowers whose income has declinedand are seeking a modification for that reasoncould then provide, as they now do under theMaking Home Affordable Program, income veri-fication. Only when a borrower rejects a modifi-cation—or if an initial, standard modificationfails—should detailed underwriting be done.

The urgency of the need requires speed anduniformity; fairness requires the opportunity fora subsequent review if the standardized programis inadequate. Borrowers for whom an automatedmodification is insufficient should be able to re-quest and get an individually tailored loan modi-fication, at least when such a loan modification isforecast to save the investor money. Many of theexisting loans were poorly underwritten, basedon inflated income or a faulty appraisal. Borrow-ers may have other debt, including high medicalbills, that render a standardized payment reduc-tion unaffordable. Subsequent life events, includ-

ing the death of a spouse, unemployment, or dis-ability, may also make a standardized modifica-tion unsustainable. These subsequent,unpredictable events, outside the control of thehomeowner, should not result in foreclosure if afurther loan modification would save investorsmoney and preserve homeownership.

6. Ease accounting rules formodifications.

The current accounting rules, particularly asinterpreted by the credit rating agencies, do notprevent modifications, but they may discourageappropriate modifications. The requirementsthat individual documentation of default be ob-tained may prevent streamlined modifications.The troubled debt restructuring rules may dis-courage sustainable modifications of loans notyet in default, with the unintended consequenceof promoting short-term repayment plans ratherthan long-term, sustainable modifications thatreflect the true value of the assets. Finally, limit-ing recovery of servicer expenses when a modifi-cation is performed to the proceeds on that loanrather than allowing the servicer to recover moregenerally from the income on the pool as awhole, as is done in foreclosure, clearly biases ser-vicers against meaningful modifications.

7. Encourage FASB and the credit ratingagencies to provide more guidanceregarding the treatment ofmodifications.

Investors, taken as a whole, generally losemore money on foreclosures than they do onmodifications. Investors’ interests are not neces-sarily the same as those of borrowers; there aremany times when an investor will want to fore-close although a borrower would prefer to keep ahome. Investors as well as servicers need im-proved incentives to favor modifications overforeclosures. Still, there would likely be far fewerforeclosures if investors had information as tothe extent of their losses from foreclosures andcould act on that information.

x WHY SERVICERS FORECLOSE WHEN THEY SHOULD MODIFY

Even where investors want to encourage andmonitor loan modifications, existing rules canstymie their involvement—or even their ability toget clear and accurate reporting as to the statusof the loan pool. Additional guidance by FASBand the credit rating agencies could force servicers to disclose more clearly to investors and the public the nature and extent of the modifica-tions in their portfolio—and the results of thosemodifications. Without more transparency anduniformity in accounting practices, investors areleft in the dark. As a result, servicers are free togame the system to promote their own financial-incentives, to the disadvantage, sometimes, of investors, as well as homeowners and the publicinterest at large.

8. Regulate default fees.Fees serve as a profit center for many servicers

and their affiliates. They increase the cost tohomeowners of curing a default. They encourageservicers to place homeowners in default. All feesshould be strictly limited to ones that are legalunder existing law, reasonable in amount, andnecessary. If default fees were removed as a profitcenter, servicers would have less incentive toplace homeowners into foreclosure, less incentiveto complete a foreclosure, and modificationswould be more affordable for homeowners.

Why Servicers Foreclose When They Should Modify and Other Puzzles of Servicer BehaviorServicer Compensation and its Consequences

Diane E. ThompsonNational Consumer Law Center

1

Introduction

As the foreclosure numbers have spiraled upwardover the last few years, policymakers and econo-mists have come to a consensus that the nationaleconomy needs a massive reduction in the num-ber of foreclosures, probably by modifying delin-quent loans.1 Everyone claims to be in favor ofthis: Congress, the President, the Federal ReserveBoard, bankers. Yet the numbers of modifica-tions have not kept pace with the numbers offoreclosures.2

At the center of the efforts to perform loanmodifications are servicers.3 Servicers are thecompanies that accept payments from borrowers.Servicers are distinct from the lender, the entitythat originated the loan, or the current holder orinvestors, who stand to lose money if the loanfails. Some servicers are affiliated with the origi-

nating lender or current holder; many are not.Yet, while servicers normally have the power tomodify loans, they simply are not makingenough loan modifications. Why? One answer isthat the structure of servicer compensation gen-erally biases servicers against widespread loanmodifications.

How servicers get paid and for what is deter-mined in large part by an interlocking set of tax,accounting, and contract rules. These rules arethen interpreted by credit rating agencies andbond insurers. Those interpretations, more thanany individual investor or government pronounce-ment, shape servicers’ incentives. While none ofthese rules or interpretations impose an absoluteban on loan modifications, as some servicershave alleged, they generally favor foreclosuresover modifications, and short-term modifica-tions over modifications substantial enough to

Percentage of Loans in Foreclosure, 1995–2009

Sources: Inside Mortgage Finance, The 2009 Mortgage Market Statistical Annual; Mortgage Banker’s Association, NationalDelinquency Survey, Q2 09

5

4

3

2

1

0

Perc

ent

Loan

s in

fore

clos

ure

0.9%

1.1% 1.2% 1.2% 1.2%1.5% 1.5%

1.3% 1.2%1.0%

1.2%

2.0%

3.3%

4.3%

1995 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2Q2009

2 WHY SERVICERS FORECLOSE WHEN THEY SHOULD MODIFY

be sustainable. Neither the formal rulemakers—Congress, the Administration, and the Securitiesand Exchange Commission—nor the market par-ticipants who set the terms of engagement—credit rating agencies and bond insurers—haveyet provided servicers with the necessary incen-tives—the carrots and the sticks—to reduce fore-closures and increase loan modifications.

Servicers’ incentives ultimately are not alignedwith making loan modifications in large num-bers. Servicers continue to receive most of theirincome from acting as automated pass-throughaccounting entities, whose mechanical actionsare performed offshore or by computer systems.4

Their entire business model is predicated onmaking money by lifting profits off the top ofwhat they collect from borrowers. Servicers gen-erally profit from: a servicing fee that takes theform of a fixed percentage of the total unpaidprincipal balance of the loan pool; ancillary feescharged borrowers—sometimes in connectionwith the borrower’s default and sometimes not;interest income on borrower payments held bythe servicer until they are turned over to the in-vestors or paid out for taxes and insurance; andaffiliated business arrangements.

Servicers, despite their name, are not set up toperform or to provide services.5 Rather, theymake their money largely through investmentdecisions: purchases of the right pool of mort-gage servicing rights and the correct interesthedging decisions. Performing large numbers ofloan modifications would cost servicers upfrontmoney in fixed overhead costs, including staffingand physical infrastructure, plus out-of-pocketexpenses such as property valuation and creditreports as well as financing costs.

Several programs now offer servicers somecompensation for performing loan modifica-tions, most significantly the Making Home Af-fordable program. Fannie Mae and FreddieMac—market makers for most prime loans—havelong offered some payment for loan modifica-tions. Other investors have sometimes done like-wise, and some private mortgage insurance

companies make small payments if a loan in de-fault becomes performing, as does the FHA loanprogram. Yet none of these incentives has beensufficient to generate much interest among ser-vicers in loan modifications.6

Post-hoc reimbursement for individual loanmodifications is not enough to induce servicersto change an existing business model. This busi-ness model, of creaming funds from collectionsbefore investors are paid, has been extremelyprofitable. A change in the basic structure of thebusiness model to active engagement with bor-rowers is unlikely to come by piecemeal tinkeringwith the incentive structure. Indeed, some of theattempts to adjust servicers’ incentive structurehave resulted in confused and conflicting incen-tives, with servicers rewarded for some kinds ofmodifications, but not others.7 Most often, if ser-vicers are encouraged to proceed with a modifica-tion at all, they are told to proceed with both aforeclosure and a modification, at the same time.Until recently, servicers received little if any ex-plicit guidance on which modifications were ap-propriate and were largely left to their own devicesin determining what modifications to make.8

In the face of an entrenched and successfulbusiness model and weak, inconsistent, and post-hoc incentives, servicers need powerful motiva-tion to perform significant numbers of loanmodifications. Servicers have clearly not yet re-ceived such powerful motivation.

A servicer may make a little money by makinga loan modification, but it will definitely cost itsomething. On the other hand, failing to make aloan modification will not cost the servicer anysignificant amount out-of-pocket, whether theloan ends in foreclosure or cures on its own. Ser-vicers remain largely unaccountable for their dis-mal performance in making loan modifications.

Until servicers face large and significant costsfor failing to make loan modifications and are ac-tually at risk of losing money if they fail to makemodifications, no incentive to make modifica-tions will work. What is lacking in the system isnot a carrot; what is lacking is a stick.9 Servicers

WHY SERVICERS FORECLOSE WHEN THEY SHOULD MODIFY 3

must be required to make modifications, whereappropriate, and the penalties for failing to do somust be certain and substantial.

The Rise of the ServicingIndustry as a By-Product of Securitization

Once upon a time, it was a wonderful life.10 Inthis prediluvian America, those that owned theloan also evaluated the risk of the loan, collectedthe payments, and adjusted the payment agree-ment as circumstances warranted. In this model,in most circumstances, lenders made money bymaking performing loans, borrowers had un-mediated access to the holder of their loan, andboth lenders and borrowers had in-depth infor-mation about local markets. Even if few bankowners or managers were as singularly civic-minded as George Bailey, they were at least recog-nizable individuals who could be appealed to andwhose interests and incentives, if not alwaysaligned with those of borrowers, were mostlytransparent.

This unity of ownership, with its concomitanttransparency, has long since passed from the

home mortgage market. Loans are typically origi-nated with the intention of selling the loan to in-vestors. Loans may be sold in whole on thesecondary market, so one investor ends up withthe entire loan, but, more commonly, the loansare securitized. The securitization process trans-forms home loans into commodities, with own-ership and accountability diffused.

In securitization, thousands of loans arepooled together in common ownership. Owner-ship is held by a trust. The trust is usually set upas a bankruptcy-remote entity, which means thatthe notes cannot be seized to pay the debts of theoriginator if the originator goes bankrupt. Bondsare issued to investors based on the combined ex-pected payment streams of all the pooled loans.Bonds may be issued for different categories ofpayments, including interest payments, principalpayments, late payments, and prepayment penal-ties.11 Different groups of bond holders—ortranches—may get paid from different pots ofmoney and in different orders.12 The majority ofall home loans in recent years were securitized.

Securitization—and the secondary market formortgage loans more generally—has created a rel-atively new industry of loan servicers. These enti-ties exist to collect and process payments onmortgage loans. Some specialize in subprimeloans; some specialize in loans that are already in

Securitization Rate, 1990–2008

Sources: Inside Mortgage Finance, The 2009 Mortgage Market Statistical Annual

90

80

70

60

50

40

30

20

10

0

Perc

enta

ge

1990 1991 1992 1993 1994 1995 1996 1997 19981999 2000 2001 2002 2003 2004 2005 2006 2007 2008

79.3%

56.6%

54.8%

59.2%65.3%

31.6%28.4% 30.6%

53.0%55.1%

37.4%

62.6%

67.7%

67.6%74.2%

40.8%

60.7%

63.0%67.5%


default (so-called special servicers). Some compa-nies contain entire families of servicers: primeand subprime, default and performing. Some ofthese servicers are affiliated with the origina-tors—nearly half of all subprime loans are serv-iced by either the originator or an affiliate of theoriginator13—but many are not. Even when theservicer is affiliated with the originator, it nolonger has exclusive control over the loan or anundivided interest in the loan’s performance. Ser-vicers are usually collecting the payments onloans someone else owns.

Servicers bid for the right to service pools ofmortgages at the time the mortgage pool is cre-ated. Most securitization agreements (poolingand servicing agreements or PSAs) specify a mas-ter servicer, who coordinates the hiring of varioussubservicers, including default servicers asneeded. Once the master servicer is set in thePSA, the master servicer typically is entitled to re-ceive a portion of the payments on the pool ofmortgages serviced until those mortgages arepaid off. Usually, the master servicer cannot bereplaced, absent both gross malfeasance in theperformance of its duties and concerted actionby a majority of investors.

Borrowers see none of this. Instead, a borrowertypically knows who originated the loan and towhom the borrower sends her payments. Borrow-ers—and even judges, the press, and academics—often refer to the payment recipient as the“lender.” In fact, though, the entity receiving theborrower’s payments is not necessarily “the”lender or even “a” lender. Instead, the paymentrecipient is a servicer. It is the servicer, not thelender or holder, who will have the records ofpayments; it is the servicer who will know of a de-fault; and it is through the servicer that any re-quest for a loan modification must pass.

The servicer’s function is to collect the pay-ments. Once the payments are collected, the ser-vicer passes them on to a master servicer, atrustee, or the securities administrator,14 whichthen disburses them to the investors. Althoughthe servicer may have some connection with theloan originator, or some interest in the pooled

loans, servicers are primarily neither originatorsof loans nor holders of loans.

Originators sometimes retain the servicingrights on loans they securitize. Not all origina-tors have servicing divisions, however. Even thoseoriginators that have servicing divisions do notalways retain the servicing rights.

Servicers affiliated with the sponsors of the se-curitization or originators of the pooled loanscommonly retain at least some junior interests inthe pool. In theory, retention of these interestsincreases servicers’ incentives to maximize per-formance. These junior tranches held by servicersare usually interest-only: if there is “excess” or“surplus” interest, then the servicer receives thatinterest income. If the servicer collects no moreinterest income than is required to satisfy thesenior bond obligations, then the servicer re-ceives nothing.

Servicers’ incentives thus are neither those ofthe investors—the beneficial owners of the mort-gage note—nor the borrowers. Nor are their con-cerns necessarily the same as those of the loanoriginator.

Servicers are not paid strictly speaking on theperformance of loans. Instead, servicers derivetheir compensation from a complex web of directpayments based on the principal balance of thepool of loans, fees charged borrowers, interest

INCOME GLOSSARY

Affiliates Related business organizations, withcommon ownership or control.

Float Income The interest income earned by ser-vicers in the interval between when funds are re-ceived from a borrower and when they are paid outto the appropriate party.

Mortgage Servicing Rights (MSRs) The rights tocollect the payments on a pool of loans.

Residual Interest A junior-level interest retained inthe mortgage pool by a servicer, typically by a ser-vicer who is an affiliate of the originator. These in-terests commonly pay out “surplus” interestincome, left over after specified payments to seniorbond holders are made.


income on the float between when payments arereceived from borrowers and when they arepassed on, residual interests in the pool, andoften some income from other hedging devices,including bonds on other pools of mortgagesand more exotic financial instruments. Servicersmay rack up extra compensation through affili-ated businesses, such as insurance companies orproperty valuation and inspection companies,with whom they contract for various services, thecosts of which are passed on to borrowers.15

These affiliated companies sometimes specializein providing services for loans that are in de-fault—giving servicers a way of profiting evenfrom loans that are belly up.16

Offset against servicers’ income are their ex-penses, which servicers, as rational corporate

actors, attempt to keep as low as possible.17 Ex-penses include financing the advances made tothe trusts on nonperforming loans,18 occasionalobligations under repurchase agreements, andstaff. Servicers’ largest expense, albeit a noncashexpense, is the amortization of their mortgageservicing rights.19

These competing financial pressures do notnecessarily provide the correct incentives fromthe perspectives of investors, borrowers, or soci-ety at large. In particular, servicers’ incentivesgenerally bias servicers to foreclose rather thanmodify a loan.

Securitization Contracts, Tax Rules, and AccountingStandards Do Not Prevent LoanModifications But DiscourageSome Modifications

OverviewThe large pools of securitized mortgages are gov-erned by an interlocking set of tax and accountingrules, repeated in the trusts’ governing documents.These rules do not forbid loan modifications. Someof these rules do, however, restrict the circum-stances in which loans can be modified or createcertain disincentives for loan modifications.

These rules are designed to ensure that the as-sets of the trust—the notes and mortgages—arepassively managed. Passive management is re-quired because the trusts receive preferential taxtreatment. So long as the trust complies withthese rules, the trust does not have to pay tax onits income, thus freeing more income for the ulti-mate investors. Compliance with the rules alsoprovides investors in these trusts with some pro-tection from the bankruptcy of the entity, usu-ally the mortgage originator, that transfers themortgages into the securitized trust. Withoutthese protections from bankruptcy, creditors ofthe originator could seize mortgage loans fromthe trust to satisfy the originator’s debts.

In the past, there was widespread concern thattax and accounting rules might prevent modifi-cations. Servicers often cited these rules as a rea-son for their failure to perform modifications.The concern that the tax and accounting rules,and their embodiment in the trusts’ governingdocuments, were preventing modifications wasalways largely overblown, at least for individualmodifications of loans actually in default. Recentclarifications to both the tax and accountingrules have eased most significant limitations onmodifications. Modification of a mortgage thatis in default or for which default is reasonablyforeseeable will seldom trigger adverse tax or ac-counting consequences.

EXPENSES GLOSSARY

Advances Under most PSAs, servicers are requiredto advance the monthly principal and interest pay-ment due on each loan to the trust, whether or notthe borrower actually makes the payment. The re-quirement to make these advances can continueuntil the home is sold at foreclosure.

Repurchase Agreement A clause in a contract forthe sale of mortgages that requires the seller or ser-vicer to repurchase any mortgage back from thebuyer if any one of a number of specified eventsoccur. Generally the specified events include bor-rower default or legal action and sometimes in-clude modification.


Some PSAs impose restrictions on the natureor number of loan modifications. The most com-mon limitation on modifications is a five percentcap on loan modifications, either of unpaid prin-cipal balance or number of loans, measured as ofthe pool’s formation. Although some subprimepools surpass that percentage in default andforeclosure,20 few, if any, servicers reach or evenapproach that percentage of modifications in thepool as a whole.21 As a recent CongressionalOversight Panel determined, after reviewing sev-eral of the pools containing the five percent cap,“the cap is not the major obstacle to successfulmodifications.”22 A small percentage of PSAs for-bid modifications, but many of these have beenamended.23 Some of the PSAs that limit modi-fications only do so for loans that remain in the pool. In that case, the servicer may modify as many loans as it chooses, so long as it is pre-pared to purchase the modified loans out of theloan pool.

None of the existing tax and accounting rulesor PSAs yet provide clear and comprehensiveguidance for servicers or investors in terms ofhow to account for modifications or which mod-ifications are preferred.24 The rules set some basicouter bounds: modifications must be done whendefault is actual or imminent; there must besome individual review and documentation ofthe impending default; no group of investorsshould dictate any particular loan modification;and modification should inure to the benefit of the trust as a whole. The rules have all beenupdated in the last few years to encourage modi-fications.

The following subsections take a detailedlook at the contract, tax, and accounting rules,in that order.

Neither PSAs nor Investor ActionBlock Loan ModificationsPooling and servicing agreements (PSAs) spellout the duties of a servicer, how the servicer getspaid, and what happens if the servicer fails to

SECURITIZATION, TAX, ANDACCOUNTING GLOSSARY

FAS Financial Accounting Statement, issued byFASB. The Financial Accounting Statements,through their incorporation into private contractsand SEC regulation, have the force of law.

FASB Financial Accounting Standards Board FASBis a private organization, but the Securities and Ex-change Commission often interprets FASB stan-dards and requires compliance with the FASBstandards by all public companies.

FAS 140 Accounting rules governing transfer of as-sets to and from trusts, designed to limit discretionin trust management in exchange for preserving thebankruptcy-remote status of the trust.

Junior Tranche, Junior Interest An interest in apool of mortgages that gets paid after more seniorsecurity interests.

Pooling and Servicing Agreement (PSA) The agree-ment between the parties to the securitization as tohow the loans will be serviced. PSAs spell out thecontractual duties of each party, the circumstancesunder which a servicer can be removed, and some-times give guidance as to when modifications canbe performed.

REMIC Real Estate Mortgage Investment Con-duits are defined under the U.S. Internal RevenueCode, and are the typical vehicle of choice for thepooling and securitization of mortgages. TheREMIC rules are the IRS tax code rules governingREMICs.

Repurchase Agreement A clause in a contract forthe sale of mortgages which requires the seller orservicer to repurchase any mortgage back from thebuyer if one of a number of specified events occur.Generally the specified events include borrower de-fault or legal action and sometimes include modifi-cation.

Tranche One of a number of related classes of se-curities offered as part of the same transaction.

Troubled Debt Restructuring (TDR) An account-ing term describing the modification of debt involv-ing creditor concessions (a reduction of theeffective yield on the debt) when the borrower isfacing financial hardship.

Trustee The legal holder of the mortgage notes, onbehalf of the trust and the ultimate beneficiaries,the investors in the trust.


perform as agreed. What control investors exer-cise over the servicer is usually contained in thePSA. While much has been made of the limita-tions imposed by these PSAs, there is wide varia-tion in how much detail they give. Most PSAsimpose no meaningful restrictions—or guid-ance—on individual loan modifications.25 Com-mon types of loan modifications, includingprincipal forbearance, are not even mentioned inmost PSAs.26 Modifications are generally per-missible, so long as they are in accordance withthe “usual and customary industry practice.”The result is that servicers are generally left totheir own discretion in approving, analyzing,and accounting for modifications.

Current PSA Limitations on LoanModifications Are Few and Far BetweenOf those PSAs that do limit loan modifica-

tions, most provide only general guidance, suchas limiting the total amount of loan modifica-tions to five percent or requiring loans to be indefault or at imminent risk of default beforebeing modified.27 Some PSAs, primarily those in-volving loans originated by Countrywide prior to2007, require the servicer to buy all modifiedloans out of the pool, thus avoiding any potentialREMIC or FAS 140 issues.28 Even in the earlyCountrywide loan pools, the repurchase require-ment has not posed a significant hurdle to modi-fications. In many instances, the repurchaserequirement appears to be waived for loans in default.29

Probably no more than 10% of all subprimeloans are in pools that originally prohibited allmaterial modifications.30 Where the PSAs pro-vided meaningful limits on the abilities of ser-vicers to perform modifications, those limitshave been eased. Sponsors of securitizations havesuccessfully petitioned the trustee to amend theprovisions barring modifications to allow modi-fications generally, so long as the loan is in de-fault or at imminent risk of default.31 Similarly,although there is no evidence that the five per-cent cap on modifications was ever the reason

that servicers failed to perform modifications,32

those limits are being lifted in PSAs as well.33

Credit rating agencies have made clear that theywill not count modified loans that are perform-ing 12 months after modification against the fivepercent cap.34 Thus, the modification caps aretransformed from an absolute limit to a limit onthe number that can be modified within anytwelve-month period. Finally, securitizations ofCountrywide loans in 2007 and later distin-guished between modifications that triggered the“troubled debt restructuring” standard and moremodest modifications that would permit loans tobe repackaged and resecuritized, thus avoidingthe repurchase requirement in the Countrywidesecuritizations.35

A more widespread—and persistent—problemis that many PSAs require the servicer to proceedwith foreclosure at the same time that it pursuesa loan modification,36 increasing the servicer’sand borrower’s costs and potentially undermin-ing any offered loan modification. This issue isdiscussed in more detail later in this paper.

Investors Seldom Can or Do Influence theServicer’s Actions on Loan ModificationsNominally, the servicer works at the behest of

the investors, through the trustee. PSAs will usu-ally set out the servicer’s duties and the remediesof the investors, acting through the trustee,should the servicer breach those duties.37 Ser-vicers are required by the PSA to act in the inter-ests of the investors taken as a whole.

In large subprime pools there may be hundredsof investors, who have differing views of what theappropriate response to a pending foreclosureis.38 Some investors may favor more aggressiveloan modification to prevent foreclosures; othersmay prefer a quick foreclosure.39 Nor do all in-vestors share the pain of a default equally. Formost subprime securities, different investors owndifferent parts of the security—principal pay-ments, interest payments, or prepayment penal-ties, for example—and get paid in different ordersdepending on their assigned priority. The higher


the priority of payment, the higher the certifi-cate’s credit rating, in general, and the more in-vestors are willing to pay for it in relation to itsreturn. Depending on the priority of paymentand whether or not a modification reduces inter-est or principal payments, two investors in thesame pool may fare very differently from a modi-fication, with one investor seeing no change inpayments and the other investor having its pay-ments wiped out completely.40

Investors, unsurprisingly, are typically more fo-cused on receiving the expected return on theircertificates than the details of loan modifications,even where loan modifications have a large impacton the pool as a whole. Moreover, obtaining in-formation about the nature and extent of loanmodifications is not easy, even for investors.41 De-termining how those loan modifications impactthe return on any one security may be evenharder. Similarly, the sometimes substantial feespaid to servicers in foreclosure tend to be invisi-ble to investors.42

Even when investors would favor modifica-tions over foreclosure, they generally do not haveauthority to directly control servicer actions. In-vestors can usually only take action against a ser-vicer through the trustee and then only if amajority of the investors agree.43 Partly as a resultof this common action problem, investors sel-dom give servicers guidance on how or when toconduct loss mitigation.44 Trustees, on behalf ofthe trust, can in exceptional cases fire a servicer,but this right is rarely invoked, usually only whenthe servicer is no longer able to pay the advancesof the monthly payments on the loans.45 Thus,although servicers are nominally accountable toinvestors, investors have, in most cases, little con-trol over the servicer’s decisions about how tohandle delinquencies and whether and how tooffer loan modifications.46

Servicers Face No Realistic Threat of Legal Liability for Making LoanModificationsServicers have claimed to fear investor law

suits. Securitization, by design, favors some in-

vestors over others, depending on which piece ofthe securitization, or tranche, an investor hasbought. Tranches are rated for their presumedcredit-worthiness; the higher the rating, the morestable and predictable the return is presumed tobe. Loan modifications that spread the lossevenly across all investors are likely to be metwith howls of outrage from the highest-ratedtranches.47 Most influential investors would likethe lower-rated tranches, often owned by the ser-vicer, to bear the brunt of the cost of loan modifi-cations. On the other hand, the servicer may havea financial interest in sparing the lower-ratedtranches. Loan modifications that favor onegroup of investors over another could potentiallygive rise to a successful suit against a servicer byinvestors.

Fears of legal liability were always overblown.Such suits are vanishingly rare and face signifi-cant hurdles.48 Among other hurdles, a signifi-cant number of investors have to agree to sue theservicer.49 The PSAs themselves largely authorizemodifications when doing so is in accordancewith standard industry practices. Moreover,under recent federal legislation, servicers are nowimmunized from investor litigation when theymake modifications in accordance with standardindustry practice or government programs suchas Making Home Affordable.50 Of course, ser-vicers often should—and occasionally do—makeloan modifications that go beyond standard in-dustry practice, and neither federal law nor mostPSAs provide protection for innovative loanmodifications, even if they are in the best inter-ests of investors. Nonetheless, the fact remainsthat of all the lawsuits filed by investors in 2008,not a single one questioned the right of a servicerto make a loan modification.51

Reliance on Industry Standards Slows thePace of Innovation in Loan ModificationsBut this standard creates a problem: how do

you move an entire industry to begin making loanmodifications when current standard industrypractice is to do none? Reliance on standard in-dustry practices as the benchmark of permissible


modifications, rather than either explicit guid-ance or a measure of the benefit to the investor,may chill innovation.

For example, some servicers have reduced theprincipal balance when a home is worth less thanthe loan amount (or “underwater”). In mostcases, such a reduction will benefit the pool: thecosts of foreclosure are avoided; the investors re-ceive the actual value of the collateral, the mostthey could expect to recover after a foreclosure;and investors retain the right to receive interestpayments over the life of the loan. Despite the ap-parent win-win nature of this result—the home-owner stays in place, the investors and servicercontinue receiving income, and everyone avoidscostly litigation—many servicers have been reluc-tant to do this, instead requiring the homeownerto sell the home in order to get a principal bal-ance reduction. One reason is that principal bal-ance reductions where the borrower stays inplace, called partial chargeoffs, are not common-place, and thus servicers prefer the more com-mon short sale, where the homeowner sells thehome for less than is owed and relinquishes own-ership.52 Short sales are more widely recognizedas “usual and customary industry practice” thanare partial chargeoffs. The GSEs53 encourageshort sales over modifications by paying severaltimes more in compensation to a servicer for ashort sale than for a modification.54 The morepunitive approach of short sales—the home-owner loses the home—may also reassure in-vestors that a servicer is not soft on deadbeatsand is aggressively looking out for the investors’interests. The net result, however, is that servicersavoid an outcome that would save both homesfor borrowers and money for investors.

Repurchase Agreements The repurchase agreements contained in PSAs

present a special case. The servicer may in certaincircumstances be required under the PSA to re-purchase any nonperforming loans or, in somecases, loans that are substantially modified. Usu-ally this obligation is only imposed on servicerswho are either the originator or an affiliate of the

originator. Nearly half of all subprime loans areserviced by either the originator or an affiliate ofthe originator.55 The servicer may have incentivesto report the loan as performing for the durationof its repurchase agreement.

Since many PSAs limit the repurchase require-ment to a few years, repurchase agreements maymotivate servicers to push short-term loss miti-gation approaches without any regard for theirlong-term sustainability. Forbearance plans withunrealistic repayment plans are one example.These short-term plans do not trigger repurchaserequirements for modifications56 and may delaythe need to repurchase the loan until the repur-chase time period has run.

REMIC Rules Permit Loan Modifications Most mortgages now are held in Real Estate Mort-gage Investment Conduits. These are special pur-pose trusts that are blessed by the IRS and givenpreferential tax status. A violation of the REMICrules revokes the preferential tax treatment.

In order to achieve REMIC status, the IRS im-poses certain requirements that can limit thepossibility of loan modifications. The mostsignificant limitations for our purposes are thefollowing:

� The trust must be passively managed.

� All but a de minimis amount of assets of thetrust must be “qualified mortgages.”57

Qualified mortgages must be put into thetrust within three months of its start up date. If amortgage goes into default before being put intothe trust, it is “defective.” Other common exam-ples of defective loans would include loans thatwere fraudulently obtained or do not comportwith the representations and warranties in thePSA.58 Once a loan is defective, either the defaultmust be cured within 90 days or the loan must bedisposed of to ensure that the loan does not loseits status as a qualified mortgage.59 Mortgages


may be substituted, but only for the first twoyears of the REMIC’s existence.

As the need for mass loan modifications in re-sponse to the foreclosure crisis became apparentin 2007 and 2008, many industry observers ex-pressed concerns over the REMIC restrictions onwhen a mortgage loan could be modified.60 Mostsignificant modifications render a mortgage nolonger qualified. Thus, if a servicer were to mod-ify more than an incidental number of mort-gages, so the reasoning went, the servicer wouldhave to dispose of the mortgages, presumablythrough foreclosure or repurchase, in order tostay under the de minimis threshold.

However, the REMIC rules always offered onebig escape clause: loans modified when they arein default or when default is “reasonably foresee-able” do not lose their status as qualified mort-gages.61 The IRS guidance issued in 2007 and2008 reinforced and elaborated on that excep-tion.62 Under the guidance, a safe harbor is pro-vided for modifications so long as they are donewhen default is either actual or reasonably fore-seeable and modified according to a standardizedprotocol. In fact, there are no reports of the IRSrevoking REMIC status based on the number ofmodifications in a pool. Thus, loan modifica-tions should not generally trigger a loss of quali-fied mortgage status nor, by extension, a loss ofREMIC status.

FAS 140 Accounting StandardsAuthorize Modifications WhenDefault Is Either Actual orReasonably ForeseeableFinancial Accounting Statement 140, Account-ing for Transfers and Servicing of Financial Assetsand Extinguishments of Liabilities (FAS 140), likeall the other Financial Accounting Statements, ispromulgated by the Financial Accounting Stan-dards Board (FASB).63 FASB is a private organiza-tion whose work nonetheless has the force ofmarket regulation. The Securities and ExchangeCommission requires compliance with the FASB

standards by all public companies,64 and theFASB standards are incorporated into the con-tracts governing the formation of the trusts.

Compliance with the FASB standards is essen-tial to maintain the trust. If there is no compli-ance with the FASB standards then, as a matterof SEC regulation under the Securities and Ex-change Commission Act of 1934 and as a matterof contract, the trust fails. Once the trust fails, itloses its REMIC status and the accompanyingpreferential tax treatment.

Compliance with the FAS 140 rules also pro-tects the bankruptcy-remote status of the trust.Ordinarily, at least in some circumstances, if alender filed bankruptcy, the lender’s creditorsmight be able to seize assets, including mort-gages, that the lender had previously sold tothird-parties. Some transfers are automaticallydisallowed and others may be. Such uncertaintyis anathema to the securitization process. Worse,from the standpoint of an originator, if the FAS140 rules are not complied with, the mortgageloans and any liabilities connected with them re-vert to the originator or other transferor, for ac-counting purposes, without necessarily anychange in legal title.65 If this happens, the origi-nator would have to account on its books forloans it no longer had any control over.

A servicer will want to shelter an affiliatedoriginator from having to report these possiblelosses. Even if the losses are not actual, the origi-nator will be required to report them, with the re-sult that its financial status will look weaker to

Originator transfers $200,000 loan to trust.Loan goes into default. Foreclosure

results in $100,000 loss.

Compliance with Noncompliance with FAS 140 Rules FAS 140 Rules

� �� Trust must Originator must account for account for

$100,000 loss $100,000 loss


investors and credit rating agencies. A servicer’sfinancial position will suffer more and more di-rectly from losses suffered by an affiliated origi-nator than from losses suffered by the trust.

Like the REMIC rules, the accounting stan-dards generally applicable to securitized mort-gage trusts are meant to ensure that themortgages are isolated from the originator andare passively managed, thus meriting their bank-ruptcy-remote status. FAS 140, in far more detailthan the REMIC rules,66 sets forth restrictions onactive management. Among other restrictions,FAS 140 requires trustee discretion to be nar-rowly constrained in the governing documents ofthe trust.67 Recent FASB guidance has expandedsomewhat the range of servicer discretion in ap-proving modifications.68 Still, trustees—and theiragents, servicers—cannot have untrammeled au-thority to modify a loan. Any modification mustbenefit the trust as a whole.

This focus on the benefit to the trust as awhole in theory allows servicers to ignore someof the complications caused by securitization.Servicers should be able to modify loans by ana-lyzing the overall cash flow to the trust and notworry about which certificate holders will bearthe cost. In general, servicers may modify loansthat are in default or for which default is “reason-ably foreseeable” without taking the loan out ofthe pool or jeopardizing the legal status of the se-curitization trust, provided that the modificationdoes not involve new collateral, new extensionsof credit, or an additional borrower.69

There is little question that most meaningfulmortgage modifications undertaken when theborrower is in default comply with FASB stan-dards.70 What has been more difficult is the ex-tent to which loans that are not in default may bemodified. When, in other words, is default “rea-sonably foreseeable”? For example, default is notreasonably foreseeable under the FASB standardsif refinancing is available.

Recent FAS 140 guidance from the Securitiesand Exchange Commission has loosened andclarified somewhat the restrictions on reasonably

foreseeable default for mortgage modifications.In particular, streamlined modification in accor-dance with the American Securitization Forum’sguidance will not jeopardize the trust.71 The ASFguidance is limited largely to modifications inanticipation of reset on an adjustable rate mort-gage.72 Practically, this means that the documen-tation burden is eased on servicers if the basis foranticipated default is a coming rate increase onan adjustable rate mortgage.

If the basis for anticipated default is some-thing other than a rate reset, FAS 140 requires in-dividual documentation of the default or the“reasonably foreseeable” prospect of default.73

The servicer must contact the borrower and doc-ument that the borrower will be unable to makepayments in the future.74 Bases for anticipateddefault, including job loss, fraud in originationor servicing, a death in the family resulting in re-duced income, or depleted cash reserves, muststill be documented and individually determined,including some showing that there is no reason-able prospect of refinancing. Significantly, the re-laxed guidance permits servicers to reach out toborrowers who are less than 60 days delinquent,at a time when a modification may have the mostchance of success.75

FAS 140 also has rules governing repurchaseagreements. The PSA may require originators torepurchase defective loans. So long as the repur-chase agreement complies with the terms out-lined in FAS 140, repurchase of a loan out of thetrust should not endanger the trust. Forcing re-purchase is sometimes the only way to get a modi-fication of a performing but unconscionable loan.

The availability of repurchase may make FAS140 limitations even less significant as impedi-ments to loan modifications. While an originatormay not want to repurchase a loan, so long as thePSA contains a repurchase agreement in accor-dance with the FAS 140 standards, an affiliatedservicer may repurchase a loan and modify itwithout regard to the FAS 140 limitations. Suchrepurchase may well have a negative impact onthe servicer’s books, and the originator’s as well.


Certainly originators that routinely repurchasedlarge numbers of mortgage loans out of securitizedpools would find disfavor with investors who pur-chased the mortgage-backed securities in expecta-tion of high-yield payments spread over time Onthe other hand, the repurchase rules underscorethat the FAS rules, by themselves, are not a majorimpediment to loan modifications.

FASB Requirements for theImmediate Recognition of LossDiscourage Permanent ModificationsThe accounting rules that govern when a loss isrecognized can affect a servicer’s willingness tomodify a loan and the terms under which a loanis modified.76 For example, FAS 15 generally re-quires immediate loss recognition of permanentmodifications.77 As a result, servicers have an in-centive to characterize modifications as “tempo-rary” or “trial” modifications in order to delayloss recognition.

When a loss is recognized, the total cost ofthat loss is generally allocated to the junior inter-ests.78 As a result, the junior interests are entitledto a smaller fraction of any subsequent income.Further, under the terms of many PSAs, once rec-ognized losses reach a certain level, the most jun-ior interests may be cut off from some sources ofincome, such as principal repayments, altogether.Since servicers often hold one or more of the jun-ior interests,79 if a loss is recognized immediately,the servicer will likely suffer most of the lossfrom the modification.

On the other hand, if recognition of the entireloss is delayed, accounting rules may allow the ser-vicer to spread the loss to more senior tranches.For over-collateralization structures,80 whichmost subprime securitizations are, the seniortranches are only entitled to principal paymentsafter every class of certificate holder receives thepre-determined interest payments. Thus, a cut inincome occasioned by a modification will likelycut into the principal payments to the seniortranches, but will not necessarily reduce the inter-est payments to the junior certificate holders.81

In addition to characterizing a modification astemporary, servicers may look to other methodsto delay recognition of loss. For example, untilrecently, there was no industry consensus on howprincipal forbearance should be treated. At leastsome servicers were able to argue that recogni-tion of the interest losses on principal forbear-ance should be delayed. A servicer could thussubstantially modify the loan through principalforbearance without experiencing any drop in in-come on any junior certificates it might hold. Thismade principal forbearance attractive as a lossmitigation tool to servicers who were also holdersof junior certificates. Most available industry guid-ance now requires principal or interest forbearanceto be treated in the same manner as principal orinterest forgiveness for accounting purposes.82 Asa result, principal or interest forbearance, like aprincipal reduction, will result in an immediatehit to the most junior level tranches. Thus, ser-vicers have nearly the same incentive to offerprincipal forbearance as a principal reduction—and not much incentive to offer either.

The Troubled Debt RestructuringRules Discourage SustainableModificationsAnother set of FASB requirements that have acritical impact on servicers’ willingness to modifyloans are the troubled debt restructuring (TDR)rules found in FAS 15 and FAS 114. These rulesrules discourage those modifications most likelyto be successful. The rules do so in three distinctways: they penalize the modification of loans be-fore default, they favor temporary modificationsover permanent ones, and they encourage shal-low modifications.

FAS 15 generally requires all permanent modi-fications occasioned by the “borrower’s financialdifficulties” to be treated as “troubled debt restructurings.”83 Modifications can escape the reach of FAS 15 if they are temporary or donot involve “creditor concessions.” While theTDR accounting rules only apply to loans held inportfolio,84 maintenance of the off-balance sheet


bankruptcy-remote status of the trust has re-quired that servicers generally categorize modifi-cations using the TDR rules.85 The TDR rulesthus act as a curb on servicer discretion.

The FAS 15 rules apply whether the loan iscurrent or delinquent when modified. Servicerscan evade the reach of FAS 15 if they re-under-write the loans and demonstrate that the termsof the loan modification reflect market realities,and not a concession.86 But re-underwriting aloan is slow and cumbersome and interferes withstreamlined modifications. As a result, a servicerwho converts an adjustable rate mortgage to a

fixed rate, holding the current rate constant, inadvance of a reset and without any default, maybe stuck reporting a paper loss, even if the bor-rower was not in default and never missed ormisses a payment. When a loan is modified in ad-vance of default, it seems particularly harsh tomany servicers to treat it as a troubled debt re-structuring.87 FAS 15 accounts in part for ser-vicers’ reluctance to modify loans before default,despite data that shows that modifications priorto default have the most chance of success.

The TDR rules encourage servicers to pushborrowers into short-term repayment and for-

A Simplif ied Example of the Benefit to Servicers of Short-term Versus Permanent Modif ications

We assume a fixed monthly payment of $300:

� $250 in interest88

� $50 in principal

� $200 a month in interest income allocated to senior tranches

� $50 a month in possible surplus interest income

Compare the servicer’s results from a short-term forbearance and a permanent modification:

3 month short term Permanent forbearance modification

Payments for months 1–3 $0 $750

Payment month 4 $1200 $250

Payments made to senior bond holders months 1–389 $750 $750

Payments made to senior bond holders month 4 $250 $250

Surplus interest income generated for servicer90 $200 $0

Further compare the results for a short-term payment reduction and a permanent modification, assuming no advances required on principal under the PSA:

6 month short term Permanent payment reduction to modification to $225 a month $250 a month

Payments for months 1–6 $1,350 $1,500

Payments allocated to interest $1,350 $1,200

Payments allocated to principal $0 $300

Payments made to senior bond holders $1,200 $1,500

Surplus interest income generated for servicer $150 $0


bearance plans, which do not involve creditorconcessions, even though these plans are unlikelyto forestall a foreclosure for long. Modificationssuch as these short-term plans that do not in-volve creditor concessions do not trigger theTDR requirements.

These short-term plans also generally benefitthe servicer. The benefit to the servicer is particu-larly pronounced if the servicer can escape require-ments to advance principal and is not requiredunder the PSA to allocate payments to principal inthe event of a TDR. (For loans subject to the TDRaccounting rules, payments must be allocated toprincipal before interest). In addition to improvingthe servicer’s income stream through its monthlyservicing fee, allocating payments to interest in-stead of principal provides additional benefits tothose servicers who hold junior-level interests inthe pool. The result of allocating payments to in-terest instead of principal is, for most subprimesecuritizations, more money for the junior-levelinterest only and particularly the surplus interestonly interests often held by servicers.

The Only Effective Oversight of Servicers, by Credit RatingAgencies and Bond Insurers,Provides Little Incentive for Loan Modifications.

In theory, servicers should be responsive to theentity that can hire or fire it. And, in theory, in-vestors would have that power over servicers. Aswe have seen above, however, few PSAs permit in-vestors to exercise the power to hire and fire ser-vicers in a meaningful manner. Instead ofinvestors, servicers are more often responsive tothe credit rating agencies and the bond insurers.Even organizations representing investors arelikely to defer to the credit rating agencies andbond insurers.91

As discussed in the following sections, thecredit rating agencies and bond insurers have

more power than either investors or borrowers.92

Both credit rating agencies and bond insurershave weighed in with discussions of what loanmodifications are and are not appropriate. Whatthey approve in terms of loan modifications car-ries a great deal of weight.

In particular, the credit rating agencies haveinsisted that servicers adhere to a two-track sys-tem: pushing through foreclosures as fast as pos-sible even while pursuing loan modifications.Bond insurers have been involved in restrictingsome of the most promising forms of loan modi-fications: principal reductions and forbearances.

Credit Rating AgenciesThe major credit rating agencies provide themost meaningful oversight of servicers.93 Howmuch the servicer must bid for servicing rightsdepends to a large extent on the rating it is givenby the credit rating agencies. A servicer with apoor credit rating from the agencies will likelyhave to discount its bids for servicing rights.94

Credit rating agencies exercise the most dra-matic control over a servicer when the loan poolis created. At that point in time, their blessingcan make or break a servicer’s bid for the mort-gage servicing rights. Yet credit rating agenciescontinue to monitor the performance of poolsthroughout their life, and those ratings impactboth the servicers’ ability to acquire new mort-gage servicing rights and the servicers’ ongoingcost of credit. Since interest can be a major oreven the largest cost component for a servicer,the assigned credit rating matters. Moreover, adrop in the credit rating of the pool or of the ser-vicer could be used as grounds for terminating aservicer or may prevent the servicer from biddingon new contracts.95

The credit rating agencies have been generallysupportive of increased numbers of modifica-tions.96 At the same time, they have imposed ratingcriteria that can impede successful modifications.The credit rating agencies typically look at ser-vicers’ default rates, roll rates (the rate at which


loans move between various classes of delin-quency), and resolution rates (how many of thedelinquencies are resolved short of foreclosure).97

Subprime servicers, in particular, are expected toshow “strict adherence to explicit timelines,”offer and accept workouts from only a predefinedand standardized set of options, and not delayforeclosure while loss mitigation is underway.98

The rating agencies do not set benchmarks forany of these, but expect servicers to develop time-lines and standardized loss mitigation optionsfor each loan product, with reference to the in-dustry standards as developed by Fannie Mae andFreddie Mac. The speed at which loans are movedfrom default through foreclosure is “a key driver inthe servicer rating,”99 encouraging servicers to com-pete for the fastest time to foreclosure.

Loan modifications take time to work out andoften must be customized to fit the homeowner’sparticular circumstances. Worse, the dual fore-closure and modification track causes havoc withhomeowners. Homeowners engaged in negotia-tion often believe or are led to believe that theycan safely ignore the foreclosure papers—only todiscover that their home is sold out from underthem. Other homeowners, under the pressure ofan impending foreclosure deadline, agree to un-sustainable modifications in a desperate bid tobuy time. Even those homeowners who are some-how able to obtain a sustainable modificationfrom the servicer’s bureaucracy before a foreclo-sure sale incur increased costs as the servicerpasses on the expenses of proceeding with theforeclosure,100 not to mention their own in-creased costs and stress of defending the foreclo-sure. The problems of the two-track system areexacerbated because foreclosures, deeds-in-lieu,and short sales have historically been givengreater weight by the rating agencies than resolu-tions that result in saving the home.101

Other guidelines imposed by credit rating agen-cies make it disadvantageous for servicers to per-form loan modifications. For example, Standard& Poors allows a servicer to reimburse itself foradvances in a modification only from payments

made on the modified loan itself or principal pay-ments made on other loans in the pool.102 The in-terest payments made by other borrowers whoseloans are in the pool must be left untouched fordistribution according to the PSA, primarily tothe benefit of the senior bond holders.103 In con-trast, most PSAs provide that the servicer recoversall costs, fees, and advances in full upon comple-tion of a foreclosure, before the bond holders re-ceive anything. Thus, a servicer faces a delay inrecovering its advances when it modifies a loancompared to when it forecloses upon a loan.

Another example is the credit rating agencies’requirement that modified loans count againstthe delinquency triggers in the PSA for twelvemonths.104 Once delinquency triggers in a poolare reached, the servicer may be replaced, some-times automatically. Servicers may also lose theirrights to receive income from their residual inter-ests105 As a result of the credit rating agencies’rules, a servicer who converts an adjustable ratemortgage to a fixed rate, holding the current rateconstant, in advance of a reset and without anydefault, is stuck reporting those modified loansas delinquent, while a servicer can report a bor-rower in a three-month forbearance agreement,during which time the borrower makes no pay-ments, as current. The result is that servicers arediscouraged from making sustainable modifica-tions or addressing the need for modificationsglobally, prior to default. Under these rules, ser-vicers lose less if they wait until a loan is alreadyin default before modifying it.

Bond InsurersOften, subprime junk mortgages were turnedinto gold through the use of bond insurance.Bonds based on a pool of, say, undercollateral-ized, subprime, hybrid ARMs achieved the AAArating necessary for purchase by a Norwegianpension fund through bond insurance. If (orwhen) those bonds fail to deliver the above-aver-age returns promised, bond insurers are on thehook to make up some or all of the difference.


Bond insurers, therefore, may have significantskin in the game as to the performance of thebonds. As a result, the bond insurers often main-tain an active role and interest in the manage-ment of the pool of securities.106 And they arelarge enough institutional players that their voiceis heard. Many PSAs give bond insurers specialrights with respect to approving waivers of limi-tations on modifications.107

Bond insurance generally exists only on themost highly rated securities. So long as the top-rated tranches continue to deliver the promisedreturns, bond insurers don’t have to advance anymoney. Bond insurers need the top-ratedtranches to perform; what happens to subordi-nate tranches is of, at best, secondary importanceto the bond insurers. As a result, bond insurersseek to confine the cost of nonperforming loansto the lowest rated tranches. Thus, bond insurerswill support modifications whose weight is pri-marily borne by the lowest-rated tranches but op-pose modifications when the losses are spreadevenly across all tranches.

For example, most PSAs are silent on the treat-ment of principal reductions or forbearance withregard to the timing of loss recognition.108 As dis-cussed above, the timing of the recognition ofloss can make a large difference to a servicer, ifthe servicer holds junior-level security interests inthe pool as most do. If recognition of the loss isdelayed, and interest payments are deeply cut dueto reduced principal obligations, then even sen-ior bond holders may see their monthly interestpayments shrink, reflecting the lower monthlyincome to the pool as a whole. This scenario isprecisely what happened during 2007 when someservicers made deep principal reduction modifi-cations. Senior bond holders, including AAA-rated bond holders, saw payments on theirinterest certificates drop. The bond insurers re-acted swiftly. As leading industry analysts re-ported, shortly after these losses first appeared,despite the silence in the PSAs, there emerged an“industry consensus” that the losses from princi-pal reductions should be charged first, in theirentirety, to the bottom-rated tranches.109

The bond insurers, unlike investors, haveenough leverage that their opposition matters—and the results of their intervention shape whatmodifications servicers are willing to accept.Since servicers usually hold some interest in thelowest-rated tranches, allocating the cost of prin-cipal reductions or forbearance in their entiretyto the lowest-rated tranches discourages servicersfrom accepting modifications with principal re-ductions or principal forbearance.

Servicer Income Tilts the ScalesAway from Principal Reductionsand Short Sales and TowardsShort-Term Repayment Plans,Forbearance Agreements, andForeclosures

Servicer compensation creates a web of incen-tives, some of which favor foreclosure and someof which favor certain types of loan modifica-tions over others.110 Among the factors favoringforeclosure are the following:

� Servicer fees (such as late fees, foreclosure fees,and broker price opinion fees) create some in-centive to keep a borrower in default and ulti-mately give the servicer an incentive tocomplete a foreclosure.

� The servicer’s float interest income may in-crease when a loan is prepaid due to refinance,sale, or foreclosure (the impact of this incen-tive is reduced because most PSAs require theservicer to turn over most of extra income gen-erated by prepayments).

Among the factors favoring modification (al-though not necessarily a sustainable modifica-tion) are the following:

� The servicer’s monthly servicing fee, com-puted as a percentage of the outstanding bal-ance, gives the servicer some incentive to keep


a loan in the pool and avoid foreclosure or ashort sale. These fees also give servicers an in-centive to avoid principal reductions and tofavor loan modifications that increase theprincipal.

� When a servicer owns a residual interest—typi-cally the most junior tranche—it has an incen-tive to keep the loan performing, to delayforeclosure, and to resist modifications thatreduce interest payments, whether directly orbecause they trigger the troubled debt restruc-turing rules.

Even more important than compensation, formost servicers, is the value of their mortgageservicing rights. Whether or not the servicermade the correct speculative investment decisionwhen it bought the mortgage servicing rights toa pool of mortgages does more to shape its prof-itability than any other single factor. The way aservicer increases its net worth is not by doing atop-notch job of servicing distressed mortgagesbut by gambling on market trends.

These and other financial incentives are dis-cussed in the following subsections.

FeesMost PSAs permit servicers to retain fees chargedto delinquent homeowners and to collect themfrom the proceeds of a foreclosure sale, if thehomeowner doesn’t pay up. Examples of thesefees include late fees that are paid directly to theservicer111 and fees for “default management”such as property inspections that a servicer mayretain or may pay to a third party and then recoverfrom the homeowner.112 While generally small inmonetary amount, these fees generate substan-tial income when spread over an entire portfolioof loans.113 These fees may become a profit cen-ter, particularly for those large servicers who areable to refer business to affiliated entities.114

Late fees alone constitute a significant fractionof many subprime servicers’ total income andprofit.115 For example, late fees and loan collec-tion fees made up almost 18% of Ocwen’s 2008

servicing income.116 Thus, servicers have an in-centive to push borrowers into late payments andkeep them there: if the loan pays late, the serviceris more likely to profit than if the loan is broughtand maintained current. The very presence ofthese fees may later make a modification unaf-fordable to the homeowner.117

Usually the fees charged in a foreclosure are recovered completely by the servicer, once theforeclosure sale is completed, before the investorsreceive any funds.118 As a result, a rational profit-maximizing servicer has a strong incentive tocomplete a foreclosure and recover the fees.119

Servicers may also have an incentive to delay aforeclosure in order to impose more fees.120 De-pending on the interplay of the servicers’ abilityto charge additional fees during the foreclosure,on the one hand, and the servicer’s interest costsfor any hard advances and the time limits forproceeding through foreclosure imposed by theREMIC rules, FASB statements, the PSA, and thecredit rating agencies, on the other hand, a ser-vicer might draw out a foreclosure for as long aspossible to maximize the amount of fees im-posed and ultimately collected or speed througha foreclosure to recover the fees as soon as possi-ble. If the servicer can juggle the time limits—per-haps by reporting the loans current a mite longerthan is strictly true or re-aging the loans—the ul-timate recovery of fees may outweigh the interiminterest costs. Whether the servicer processes aforeclosure slowly or quickly, however, it has anincentive to complete foreclosure rather thanprocess a modification once a loan is in default,so that it will recover its fees. The more fees itpiles on, the greater that incentive becomes.

Many of the servicer’s fees do not actually repre-sent significant dollars out of pocket. For example,Wells Fargo reportedly charged a borrower $125for a broker price opinion when its out-of-pocketexpense was less than half that, $50.121 With thatkind of mark-up, a servicer can afford to incur in-terest costs for months before it starts to feel thepinch. The incentives to delay a foreclosure andmaximize fees are compounded by the fact thatmany servicers subcontract with affiliates for fee-


generating services, thus multiplying their sourcesof revenue from the same fees.122

Servicers’ dependence on fees may also partlyexplain their reluctance to enter into shortsales.123 In a short sale, the borrower typicallybears the cost of arranging the sale, thus depriv-ing the servicer and its affiliates of the fees theycould charge for default management, includingselling the property.124 Short sales are an exam-ple of a divergence in interests between the ser-vicer and the investor: the investor saves moneyif the borrower, rather than the servicer, bearsthe cost of arranging the sale, since the investormust reimburse the servicer, but not the bor-rower, for the costs of the sale, even if the saledoes not generate enough money to cover theoutstanding principal balance. The servicer,

however, may lose some money and is unlikely toprofit at all from the transaction. Only if the ser-vicer’s financing costs outweigh the foreclosurefees charged and a short sale is significantlyfaster than a foreclosure will a servicer profit byagreeing to a short sale over a foreclosure. Thisdisjoint may explain in part investors’ willing-ness to pay servicers greater incentives for shortsales than for modifications.125 As between ashort sale and a foreclosure, the servicer’s only in-centive to favor the short sale are payments bythe investor for performing a short sale. Only ifthose payments are larger than what the servicerexpects to squeeze out in fees from the borrowerand default management fees from the REO saleproceeds will the servicer’s scales tilt towards ashort sale.

Ocwen Solutions Mortgage Services Fees


Process Management Fees 93%

Other 1%Servicing and Subservicing

6%

Ocwen Solutions Process Management Fees Breakdown


OutsourcingServices 21%

Other 2%Mortgage Due Diligence 0%

Title Services 24%

Residential PropertyValuations

53%

Ocwen Asset Management Breakdown of Servicing Fees


Loan Collection Fees 3%Other 8% Commercial 0%

Custodial Accounts (Float Earnings) 4%

Late Charges15% Residential Loan Servicing and Subservicing

70%

Ocwen Asset Management Servicing Fees


Process Management Fees 11%

Servicing and Subservicing Fees 89%


Float Interest IncomePart of servicers’ income comes from the interestpaid during the period between when the home-owner pays and when the servicer turns over thepayment to the trust or pays the taxes and insur-ance, in cases of escrowed funds.126 Servicers whocan stretch the time to turn over funds—by payingtaxes or insurance late or at the last possible mo-ment, for example—will have more float income.

Prepayments of loans can increase this floatincome since there are then larger amounts ofmoney sitting in the float account, accumulatinginterest, until turned over to the investors.127

This could give the servicer an incentive to favorany resolution that involves a prepayment, suchas a refinance, a sale of the home, or a foreclo-sure. However, the PSA usually requires the ser-vicer to remit “compensating interest” at payoff,or the difference between a full month’s interestand the interest collected.128 And, as discussed inthe next section, the fact that the servicer’smonthly servicing fee is based on the outstand-ing balance of the loans in the pool creates astrong countervailing incentive to avoid or atleast postpone prepayment.

Payment Based on Percentage of Outstanding PrincipalMost servicers derive the majority of their in-come based on a percentage of the outstandingloan principal balance.129 The outstanding loanprincipal balance is typically calculated on allloans, even non-performing ones. For mostpools, the servicer is entitled to take that com-pensation from the monthly collected payments,even before the highest-rated certificate holdersare paid.130 The percentage is set in the PSA andcan vary somewhat from pool to pool, but is gen-erally 25 basis points annually for prime fixed-rate loans, 37.5 basis points for primevariable-rate and Alt-A loans, and 50 basis pointsfor subprime loans.131 For a subprime loan hav-ing an average unpaid principal balance of

$250,000, a servicer can expect to receive a totalservicing fee of $3,750 over a three year period($1,250 per year).

Servicers stand to benefit from any delay in re-duction of the principal balance on any loan,whether by postponing a short sale or foreclosureor by refusing to provide a payoff statementupon request. Servicers may also benefit from thedelay in principal reduction when they hold a bor-rower’s payments in a suspense account instead ofapplying them to the borrower’s account. Thehigher a servicer can keep the principal balance,whether by capitalizing arrears and unpaid feesor by refusing loan modifications with principalwrite-downs, the larger the servicer’s main sourceof income, the monthly servicing fee, will be.

Loan modifications that increase the principalbalance by capitalizing arrears and fees boost theservicer’s monthly fee. The incentive this createsto stretch out a delinquency prior to modifica-tion is offset by the requirement that the serviceradvance to investors the borrower’s monthlyprincipal and interest payment. These advances,discussed in detail below, are usually financed,and those financing costs may be substantial.The tradeoff between this cost of financing ad-vances and the higher monthly servicing fee de-pends on how long it takes for the servicer torecover its advances.

Servicers suffer a permanent loss of income byagreeing to a principal reduction. Under this sce-nario, short sales, short payoffs, and realizedprincipal reductions or forbearances as part ofloan modifications are costly for both third-partyand affiliated servicers. In fact, any reduction ofprincipal, even by regular payments, represents aloss to servicers, compared to a result that keepsprincipal balances high. Thus, even interest-ratereductions may cut into a servicer’s profit, by al-lowing homeowners to pay down principal morequickly. Prolonging the inevitable—and carryinghigh principal balances—may serve the servicer’s fi-nancial interests better than a result that reducesthe principal amount of payments, at least solong as borrowers continue to pay enough inter-


est to cover the servicer’s ongoing advances obli-gation. Delaying payment of principal serves ser-vicers’ interests.

Principal forbearance, instead of an outrightprincipal reduction, allows servicers to keep theirmonthly servicing fee high. Principal forbearanceis generally less desirable than principal reduc-tion from a borrower’s viewpoint: it often leavesthe borrower owing more than the house isworth and facing a large balloon payment at theend of the loan. Still, principal forbearance con-tinues to be far more common as a tool in loanmodification than principal reduction. This isdespite the fact that, for purposes of the timingof loss recognition, principal forbearance andprincipal reduction must be treated the same.132

As a result, when principal is forborne, just aswhen it is reduced, servicers’ income from theresidual interests may be reduced or cut off en-tirely. Nonetheless, residual income is usuallynegligible compared to the monthly servicing fee,and most PSAs appear to allow servicers to in-clude in their calculation of the outstanding bal-ance the amount of principal forbearance.133

Principal write-downs, on the other hand, gener-ally cannot be included in the amount of the out-standing principal balance. Thus, servicers havean incentive to agree to principal forbearanceover reduction, even though both reduce the in-terest payments on the loan

Principal forbearance may result in higher-rated bond holders being shorted on interestpayments, but the servicing fee, the servicer’slargest source of income, comes off the top, be-fore the interest payments to bond holders. Andprincipal forbearance does not reduce thatsource of income, and even allows it to stay artifi-cially high throughout the remainder of the loanterm, since borrowers will not be paying downthe portion of principal which is forborne. In-vestors may lose money if principal repayment isdelayed; servicers generally do not. For all ofthese reasons, servicers are likely to prefer princi-pal forbearance as a loan modification tool overprincipal or interest rate reductions.

Residual Interests

Servicers often have an investment interest in thetrust as a whole. Commonly, servicers affiliatedwith the originator of the loans holds the lowestlevel investment interests in the pool, calledresiduals.134 This is particularly true for servicerswho are affiliated with the loan’s originator.

In most subprime securitizations, bond hold-ers are paid designated amounts of interest in-come every month. If all borrowers make theirpayments, there will be some excess income.Residuals represent payment of this excess in-come after the senior certificate holders havebeen paid. If the pool shrinks, through foreclo-sure, prepayment, or principal reduction, or theinterest rate drops on the loans in the pool due tomodifications, there will be less of a surplus, andthe servicer will suffer a loss. Since residuals al-ways take the first hit, their interest may shrinkto nothing if recognized losses on the pool risetoo far. Under most PSAs, payment to residuals iscut off when certain performance triggers are notmet. In particular, if overall losses in the pool reacha pre-defined level, the residuals can no longer re-ceive the surplus interest income, even if the poolcontinues to generate surplus interest income.Modifications that reduce principal and interestcount against these cumulative loss triggers.135

Ownership of residual interests is meant to en-courage servicers to keep loans performing, andit does skew servicers’ incentives. Servicers whohold residual interests delay foreclosures and resist modifications that reduce interest pay-ments.136 If a particular form of loan modifica-tion shifts the costs to higher-rated bond holdersand away from the first-loss position residuals, aservicer may be more willing to pursue that formof loan modification. For example, principal re-ductions that are not recognized immediately aslosses spread the cost of the modification outamong all classes. Some industry analysts believethis dispersion of the cost of modifications wasone reason Ocwen performed a large number ofprincipal reductions during 2007.137


Residual income is not the main source of ser-vicer income nor the main driver of servicer be-havior. But it likely still influences a servicerchoosing between two closely balanced alterna-tives and helps frame the loss mitigation optionsa servicer makes available.

Mortgage Servicing RightsServicers buy mortgage servicing rights—and apercentage of the stream of money from the bor-rowers—by bidding on the rights at the time apool is initiated. The decision of how much tobid for those servicing rights is based, much likean investor’s decision, on projections as to the fu-ture performance of that pool. In the servicer’scase, the projection is based primarily on defaultand prepayment forecasts.138 The main source ofrevenue for servicers is the percentage paymenton unpaid principal balance.139 Default that endsin foreclosure and prepayment via refinancingboth reduce that outstanding principal balance.High default rates will reduce the revenue stream,but may not significantly reduce the value of themortgage servicing rights, depending on how

management chooses to account for those mort-gage servicing rights.

The value of mortgage servicing rights is, formost servicers, the largest item on their balancesheets and the biggest driver of their net worth.140

The amortization of the mortgage servicingrights is typically the largest expense on a ser-vicer’s books. Yet the valuation of mortgage ser -vicing rights has little, if anything, to do withhow the servicer services the pool,141 and far moreto do with the underlying strength of the mort-gages—and the market valuation of that strength.Thus, servicers may be rewarded more for cor-rectly predicting the market’s moods—or manip-ulating market perceptions of the quality of thepool—than for actually making the mortgagesperform.

Prior to 2007, there was no transparency in ac-counting for mortgage servicing rights; even today,management has considerable discretion over howto value mortgage servicing rights.142 Such valua-tion may not reflect directly the actual experienceof default and delinquency in the portfolio. Cer-tainly the difference between the price paid andthe current valuation has more to do with the

A Simplif ied Example of the Impact on Residuals of Delayed Loss Recognition for Principal Reductions

We assume a fixed monthly payment of $300:

� $250 in interest


� $200 a month in interest income allocated to senior tranches

� $50 a month in possible surplus interest income

Principal Reduction with Principal Reduction with Delayed Loss Recognition Immediate Loss Recognition

Total monthly payment after modification $250 $250

Payment allocated to interest $250 $210

Payment allocated to principal $0 $40

Monthly interest payment to senior bond holders $200 $200

Monthly payment to residuals $50, assuming other Possibly zero, if lossesperformance triggers have reached a triggerare met point


servicer’s powers of prognostication (and manip-ulation of accounting standards) than perform-ance of loans in the servicing portfolio.

Because the valuation of the mortgage servic-ing rights is so important to a servicer’s bottomline, servicers have a strong incentive to camou-flage any weaknesses in the pool.143 One way ser-vicers have camouflaged weaknesses in the poolhas been by “re-aging” delinquent mortgages.Servicers accomplish re-aging by entering intoshort-term workout agreements that skirt the ac-counting rules that require that modified loanscontinue to be reported as delinquent for a pe-riod after modification.144 These short-termworkout agreements may allow the borrower toskip a few months of payments, or pay an ele-vated payment for as long as a year in order tomake up an arrearage. Sometimes, the borrowerpays a fee for the privilege of entering into theagreement; often at the end of a period of re-duced payments, the borrower is expected tocome up with a lump sum payment of all arrear-ages and fees. These short-term workout agree-ments help few borrowers, but they are a boon toservicers. In addition to boosting the market val-uation of the mortgage servicing rights, re-agingalso helps servicers in three other ways:

� a delayed recognition of losses to the residualinterests in the pool, which reduces servicers’losses if they hold residual interests;

� avoidance of delinquency trigger threshholdsin the PSA that may permit the trustee or mas-ter servicer to appoint a special servicer (orreapportion the allocation of payments, to thedetriment of the residual interests); and

� avoidance of repurchase agreements.

Re-aging has been of signal concern to in-vestors, since it obscures the true value of thepool.145 Re-aging is about kicking the can downthe road, not about sustainable modifications.

An example of both the impact of mortgageservicing rights’ valuation and the disconnect be-

tween the value of mortgage servicing rights andthe performance of the mortgage pool is con-tained in a major subprime servicer’s recent an-nual report:

Servicing continues to be our most profitable seg-ment, despite absorbing the negative impact, first, ofhigher delinquencies and lower float balances that wehave experienced because of current economic condi-tions and, second, of increased interest expense thatresulted from our need to finance higher servicing ad-vance balances. Lower amortization of MSRs [mort-gage servicing rights] due to higher projecteddelinquencies and declines in both projected prepay-ment speeds and the average balance of MSRs offsetthese negative effects. As a result, income . . . im-proved by $52,107,000 or 42% in 2008 as comparedto 2007.146

Here, the accounting treatment of the mort-gage servicing rights more than offsets any lossattributed to high rates of delinquency and de-fault. This is true in part because prepayment issuch a drain on a portfolio. Prepayment offers anominal bump in float income, but it slashes theunpaid principal balance and shortens the ex-pected lifetime of the pool. Since a percentagepayment on the unpaid principal balance of thepool is the single largest source of income for ser-vicers, the decline in prepayments means moreincome for servicers. This effect may be enhancedbecause the high rates of default and delinquencymean that borrowers are not paying down theirloans as quickly at the same time servicers are in-creasing some loan principal balances by capital-izing arrears and fees and realizing increased latefee income.147 The decline in prepayments is re-lated to the same macroeconomic trends producinghigh rates of default and delinquency. Those highrates of default and delinquency may cost the ser-vicer something, but, on the servicer’s bright side,borrowers currently aren’t generally able to sell orrefinance and thus prepay. The remaining loansin the pool, after accounting for historically highrates of default, have, paradoxically, longer lives.


And thus, with the decreased (non-cash) expenseof amortizing mortgage servicing loans (sincethere is now a longer expected life to spread thatexpense over), servicers can still make money,even if they are not adding new bundles of mort-gage servicing rights. For accounting purposes,then, valuation of mortgage servicing rights cou-pled with reduced prepayments and aggressivereimbursement of advances and fees may actuallycounterbalance high rates of default, at least ifthe servicer did not significantly overbid for themortgage servicing rights.

At the outset of a pool, a servicer will decidewhether or not it wants to service that pool, andhow much it is willing to pay for the privilege. Ifprepayments increase above the servicer’s expec-tations, it loses money. If foreclosures increaseabove expectations, the servicer may or may notlose money, depending on its ability to chargeand recoup high fees in the foreclosure, either di-rectly or through an affiliate. Financing of ad-vances to cover payments to the trust, on the onehand, and fees, on the other, may shift the bal-ance towards a profit or loss, but the fundamen-tal driver of a servicer’s profit is whether or not itpaid too much for the mortgage servicing rightson a pool that is destined for the dumpster. Oneacademic reviewing several failed servicers con-cluded that servicers who made a bad deal—whooverbid on a pool with high defaults—are likelyto lose money no matter what.148 A servicer facedwith high defaults can only mitigate its losses bysqueezing borrowers for extra fees. Modifying themortgages is unlikely to redeem a bad initial in-vestment decision by the servicer.

Servicers with thin margins may need tosqueeze all they can out of delinquent loans byincreasing performance; servicers with strongerpools are likely to be less invested in the perform-ance of the loans they manage.149 This dynamicleaves many of the latter group of servicers indif-ferent to the performance of the loans they serv-ice and unmotivated to hire and train the staffneeded to improve performance.

Servicer Expenditures Encourage Quick Foreclosures

As shown in the previous section, the sources ofservicers’ income generally encourage servicers toperform short-term workout agreements and topile on fees. Servicers’ out-of-pocket expendi-tures weigh heavily towards speeding to a foreclo-sure once initiated. Servicers have two primaryexpenditures when a loan is in default: advancesof principal and interest to the trust and pay-ments to third parties for default services, suchas property inspections. Since these costs are gen-erally recovered in full upon the sale of the homepost-foreclosure, and since servicers must financetheir out-of-pocket expenditures, servicers arestrongly incented to complete a foreclosure asquickly as possible. Servicers also have muchlarger staffing and infrastructure costs when theyperform modifications than when they foreclose.

Interest and Principal Advances to InvestorsServicers typically, under their agreements withinvestors, are required to continue to advance in-terest on loans that have become delinquent.150

Unpaid principal may or may not be advanced,depending on the PSA.151

Servicers may be exempted from this obliga-tion once there is no longer any realistic expecta-tion of recovering these costs from the borroweror the collateral. Thus, once a loan modificationis done, and payments are permanently reduced,servicers generally no longer need make continu-ing advances. Servicers can also escape the re-quirement for advances if a borrower files forbankruptcy.152

In a small number of cases, servicers may beexempted from continuing to make advancesonce the loan is in foreclosure or more than fivemonths delinquent.153 Usually, the servicer mustcontinue making advances throughout foreclosure


until the advances exceed the likely recovery froma foreclosure sale.154 At that point, the advances are deemed “nonrecoverable” and ser-vicers may begin to recover their advances from thegeneral income on the pool. Servicers are usuallyempowered to withhold nonrecoverable advancesfrom the funds sent to the trust or they may requestreimbursement directly from the trust’s bank ac-count of these nonrecoverable advances.155 Reim-bursement for nonrecoverable advances usuallyhas super-priority in the securitization: servicerscan recover their nonrecoverable advances beforesenior bond holders receive their interest pay-ments. But even if servicers’ failure to make ad-vances is in accord with the accounting rules and

not a breach of their contract, servicers who do soare likely to receive a black mark from investors.156

The cost of financing advances is one of thebiggest risks servicers face.157 Thus, it is againstthe servicer’s financial interest to permit lengthyforbearance periods or accept repayment plansthat do not quickly bring in cash from the home-owner. Servicers generally recover all their ad-vances once a foreclosure is completed, so acash-strapped servicer has a strong incentive topush through foreclosures as quickly as possibleto recover their advances.158 Conversely, servicersmay be willing to agree to workouts once a home-owner is delinquent if the workout results in arapid repayment of the advances. Modifications,

A Simplif ied Example of the Advantage of Modif ications That Permit Recovery of Advances

We assume a fixed monthly payment of $1050

� $1000 in interest


� $950 a month in interest income allocated to senior tranches.

3 month short 6 month short Permanent modification, term forbearance, term payment after 3 missed payments, with balloon reduction, with with $3,150 of thepayment, after balloon payment, missed payments 3 missed after 3 missed added to the end of payments payments the note

Monthly payment during duration $0 $1,000 $1,000of workout agreement

Balloon payment at end of agreement $7,350 $10,500 $3,150 (arrearages added to end of note)

Total advances of principal and $6,000 $3,000 $3,000interest to senior bond holders

Monthly cost of financing advances, $25 $12.50 $12.50assuming a 5% interest rate

Cost of financing advances until $62.85 $87.52 $4,063repaid, assuming a 5% interest rate (assuming that the

advances can only be recovered frompayments on this loan)

Amount of advances remaining to be $0 $0 $3000recovered at the end of 6 months


if quickly done, can also help servicers by stop-ping the ongoing requirement to make advancesbefore a foreclosure would. Servicers favor modi-fications that reduce their interest advances.159

Even a period of time with no payments can be cheaper for a servicer than an extended periodof time where payments do not cover the ad-vances. The cost of financing advances drives ser-vicers to offer short-term, unsustainable workoutagreements.

Few PSAs specify how advances are treated inthe event of a modification.160 What clarity thereis in how servicer advances are recovered has comelargely from the credit rating agencies.161 Furtherguidance from the credit rating agencies could al-leviate some servicer uncertainty and encouragemodifications. In general, servicers may recovertheir advances from payments on the modifiedloan alone, after the required payments of princi-pal and interest are made to the trust. Only oncethe advances on a loan are deemed unrecoverableare servicers generally authorized to look to in-come from other loans in the pool to recover ad-vances, and then servicers are often limited to theprincipal payments alone on other loans for re-covering advances on modified loans. And deter-mining that advances are unrecoverable is a blackmark against servicers. Thus, servicers are likelyto insist on recovering directly from the home-owner all interest and principal advances as acondition of agreeing to a modification. Modifi-cations with principal reductions may be particu-larly tricky for servicers since they shrink thepossibilities for recovering advances on any indi-vidual modified loan and on other modified loans.

Controlling delinquencies—and the accompa-nying advances—is a major factor that affects aservicer’s profitability.162 However, as notedabove, the servicer’s ability to impose fees ondelinquent borrowers, the certainty of recoveringfees and advances in any ultimate foreclosure,and the fact that delinquent loans may staylonger in the pool than a modified loan (since amodified loan may allow a borrower to rebuildcredit and refinance or sell), creates countervail-

ing incentives to proceed with a foreclosure, de-spite the increased costs of advances.

Fee Advances to Third PartiesIn addition to interest advances, servicers also ad-vance expenses associated with default servicing,such as title searches, drive-by inspections, orforeclosure fees.163 Taxes and insurance costs are alsooften advanced.164 These advances are recoveredeither when the borrower catches up payments orwhen the house is foreclosed and sold. Usually,advances get taken off the top in a foreclosure,once the property is liquidated.165 Generally,these fee advances are not eligible for pool-levelrecovery: the servicer must collect the fees fromthe borrower or from the sale of the home.166

Some PSAs impose caps on these fee advances.167

Servicers, therefore, in order to avoid any am-biguity, will often require the payment of at leasta portion of the advances as part of entertainingany loss mitigation option and usually requirethe payment to be made up front. Loss mitiga-tion that waives advances, including the advanceof past-due interest, or that delays repayment ofadvances results in lost money for servicers. Fore-closure may be the more profitable option for aservicer than loss mitigation that waives or delaysthe repayment of advances, depending on howlong it will take to complete the foreclosure andultimate sale of the property.168

Foreclosures vs. Modifications:Which Cost a Servicer More?

The Servicer’s Duty to AdvancePayments to Investors FavorsForeclosures and Unsustainable Loan ModificationsAs discussed above, servicers must advance inter-est and sometimes principal payments, evenwhen the borrower is delinquent. Servicers get


repaid all advances when a foreclosure is con-cluded.169 They can also recognize as revenue ontheir books after foreclosure all previously un-paid charges, such as late fees, and collect thecosts of those unpaid charges from the foreclo-sure sale.170 Moving to foreclose—and to sell theproperties after foreclosure—can help servicersoffset the costs of interest advances in two ways:first, once the property enters foreclosure and theservicer judges the loan can no longer be madeperforming, the obligation to continue makingadvances may cease, depending on various fac-tors, and second, the advances can be recoveredonce the property is sold. Even if the investortakes a hit on the post-foreclosure fire sale, theservicer has stopped its bleeding and recoveredany fees, costs, and advances.171

Servicers do not, however, get repaid the costsof funding those advances—their cost of credit—and those funding costs can drain the bank.172

Thus, the servicer’s decision whether to forecloseor modify a loan will shift towards modificationthe longer it takes for a foreclosure and, conse-quently, for the servicer’s advances to be repaid,assuming of course that foreclosure fees do notoutweigh the cost of financing advances.173 Whenservicers are under extreme financial pressuredue to advances, as many have been, servicers aremotivated to expedite resolution of the delin-quency—primarily by completing a foreclosurequickly but also by entering into a quick modifi-cation that moves the loan back into performingstatus and returns advances to the servicer. Suchmodifications, alas, are seldom sustainable, sincefew borrowers, having entered foreclosure, are ina position to make the large payments requiredto bring delinquent loans current and then con-tinue making regular payments.174 Often the re-sult of these quick modifications is ultimatelyforeclosure—although the servicer may have re-covered some of its advances early and avoidedthe black mark associated with finding advances“unrecoverable.”175

The Reduction of the Loan Pool Whena Foreclosure Occurs Is an IncentiveFavoring ModificationsOn the other hand, foreclosures, like prepay-ments, shrink the overall pool of loans on whicha servicer’s income is based and reduce its long-term financial prospects, unless those loans—orthe servicing rights to a different pool—can bequickly replaced at the same or lower price.176 Re-plenishment of the loan pools is currently a slimprospect for most servicers.

The Costs of Handling LoanModifications, Including Staff Costsand Delays, Favor Foreclosure overModification, but Institutional Inertiais a Greater FactorIn a foreclosure, there is no question that the ser-vicer gets reimbursed off the top for all of its ad-vances and costs. How and when a servicer getspaid for costs incurred in a modification is muchmore problematic.177 Advances made by the ser-vicer can generally be recovered from paymentsmade on that mortgage, if the borrower startsmaking payments again. They may also be recov-ered from the principal payments on other loans,at least once the advances are judged, by the ser-vicer, as “nonrecoverable” from the borrower.These payments to the servicer for “nonrecover-able” expenses are paid to the servicer before anypayments of principal to the bond holders.178

Thus, servicers are certain of ultimately recover-ing advances on a loan modification, just as theyare certain of recovering advances in a foreclosure.What is less certain in a modification is how longit will take to recover the advances.179 Althoughall advances are ultimately recovered, dependingon how deep the modification is and how the restof the pool is performing, servicers can face a sig-nificant delay in recouping their advances.

This delay compounds the servicer’s largestcost of performing a modification, the cost of fi-nancing advances. Each month that the loan is


not paying, the servicer must continue advancingthe unpaid payments to investors. The servicermay also be advancing other fees to third parties.Even if those payments are all ultimately recov-ered as part of the modification, the servicer willhave incurred the cost of borrowing the funds tomake the payments. This interest expense is alarge cost for most servicers facing either foreclo-sures or modifications, and not one that is clearlyrecoverable in either a foreclosure or a modifica-tion. The recent decline in the availability of financ-ing for servicers—and the relative increase in thecosts of financing advances—may have heightenedsome servicers’ willingness to perform modifica-tions, if they can do so quickly and cheaply.180

As discussed in the next section, modificationsalso require significant staffing, a sunk cost thatcannot be charged off directly to any one modifi-cation and must be incurred before any modifica-tion is made. Most modifications prior to theMaking Home Affordable plan did not compen-sate servicers for staff time in performing themodification. The costs attributable to perform-ing a modification, according to the servicing in-dustry, are between $750 and $1000 apiece.181

The Making Home Affordable Plan provides in-centives to both servicers and investors for per-forming loan modifications. Servicers can bepaid by the government as much as $2,000 forperforming a Making Home Affordable modifi-cation, but this payment is post-hoc, after themodification has been performed and the in-creased staff costs have been incurred.

Mortgage insurers will also sometimes provideincentives for modifications in order to avoidpaying out on a full claim post-foreclosure forthose loans with mortgage insurance (most loanswith original loan-to-value ratios over 80%). Thegovernment sponsored enterprises (the GSEs)—Fannie Mae and Freddie Mac—and HUD, for FHAloans—do require and reimburse for some lossmitigation activities.182 Most investors, however,do not pay servicers for performing modifica-tions.183 In addition, even the GSEs have histori-

cally paid less than a modification costs.184 In-deed, Fannie and Freddie have tilted the scalesaway from modifications in their compensationschemes: both pay servicers several times morefor processing a short sale than for a loan modifi-cation.185

Prior to the roll-out of the Making Home Af-fordable plan under the Obama administration,which prohibits charging borrowers fees for amodification, mainstream servicers were increas-ingly charging borrowers hundreds to thousandsof dollars in order to enter into a modification—above and beyond the reimbursement of ad-vances and probably in excess of hard costs.Reports persist of servicers who continue tocharge large downpayments before a modifica-tion will even be discussed, even though suchpractices are banned under the Making Home Af-fordable program.186

Nonetheless, the limited compensation formodifications is probably not a driving factor inservicers’ decision making. A Federal ReserveBoard working paper reports that few servicersexpressed any interest in being compensated fordoing modifications, at least by investors.187 In-deed, the incentives offered by mortgage insurersand the federal government on insured loans ap-pear not to have significantly increased modifica-tions on those pools. Early returns on theincentive scheme under Making Home Afford-able are also not promising: total modificationsin the country fell in its first few months of oper-ation.188 Modifications of FHA loans, at least,often appear driven by the consequences of fail-ing to make the modification rather than the in-centives for making a modification. The FHAmandated loss mitigation activities have beenheld to be a pre-foreclosure requirement in manystates.189 And HUD can and has penalized ser-vicers for not complying with its requirements toconduct loss mitigation activites prior to pro-ceeding with a foreclosure.190 The stick, ratherthan the carrot, appears to drive servicer behaviorin this regard.


Staffing

Even before the foreclosure crisis erupted in2007, servicers struggled with adequate staffingof their loss mitigation departments. Staffing hasalways favored collection over loss mitigation,191

in part because it is cheaper to hire and train line-level collections employees than line-level lossmitigation staff.192 It is also not the case that ser-vicers can simply transfer loss mitigation func-tions to collection and foreclosure departments.In fact, because servicers typically continue withthe formal foreclosure process at the same timethey are conferring with homeowners about lossmitigation options, additional staffing is neededto handle loss mitigation operations.193 The ex-isting inadequacy of the staffing of loss mitiga-tion departments has become blatant in recentyears, with an increasing number of delinquen-cies straining the system.

Since May of 2007, servicers have been publiclypledging themselves to increase their staffing.Many servicers actually have increased staffing,194

yet virtually all observers agree that the efforts ofservicers to date have been insufficient.195 Onecommentator estimates that servicers wouldneed to increase staffing 1000% in order to mod-ify as few as 10% of the loans in default.196

At a time when the number of loans in foreclo-sure is increasing and even doubling year-to-year,197

servicers are playing catch-up in staffing.198 Andthe crisis itself may well exacerbate staffing prob-lems: financial pressures may cause servicers tocut staff or staff may leave, fearing future layoffsoccasioned by their employer’s financial instabil-ity.199 Ironically, the servicers with the worst loanpools may be the best positioned in terms ofstaffing: they may not have enough staff, butthey have had to squeeze margins out of weakmortgage pools for a long time.200 Lack of experi-ence exacerbates staffing shortages: servicersoften have redundant, time-consuming processesbuilt into their loan modification process.201

While underwriting and foreclosure proce-dures have now become largely automated, most

loss mitigation is still done by hand. The processis slow and cumbersome, intensive in staffingand time.202 Unlike foreclosure, most loan modi-fications rely on time-intensive direct borrowercontacts. Moreover, while loss mitigation em-ployees are generally more highly trained thancollections employees, line-level loss mitigationemployees are still not extensively trained, ade-quately supported, or given meaningful discre-tion as to the terms of a modification. Mostservicers do not reward loss-mitigation employ-ees for performance: staff are typically paid on anhourly basis, and only a few servicers offerbonuses for completing a modification.203 At thesame time, it is these relatively poorly-trainedand –paid line level employees, fielding some-times hundreds of calls a week or even a day, whomust decide whether or not any particular bor-rower is eligible for an approved form of loss mit-igation or not. These employees may or may notbe aware of the servicer’s formal matrix for evalu-ating loss mitigation options and may or maynot be motivated to use it even if they are awareof the matrix. Turnover among line-level lossmitigation employees remains high.204

One partial solution to staffing shortages is toincrease the use of automated loan modifica-tions.205 Automation can speed the process. Anautomated system works well for resolvingquickly the easy, standard cases, thus conservingservicer resources for more time-intensive cases.It poses significant risks of failure, however, sincean automated modification cannot be carefullytailored to a borrower’s circumstances.206 To beeffective and fair, automation requires servicersto reassess failed modifications: the standardmodification may not fit some borrowers and theneed for a customized modification may only be-come apparent once the first, one-size-fits-all,modification has failed.

Some of the log jam is caused by the imposi-tion of a double standard on loan modifications.Servicers insist on underwriting loss mitigation,even short sales and repayment plans, to a higherstandard than the initial loan.207 Stories abound


of homeowners turned down for a modificationbecause they were unable to fully document theirliving expenses, yet many of these homeownerswere approved for a loan without any documen-tation at all. While some of this drive for docu-mentation is imposed by the FASB standards,servicers often go beyond the FASB requirementsin what they ask of borrowers.

Full underwriting takes time and trained staff,both significant costs for servicers.208 Indeed, thecost of full underwriting was one reason manylenders abandoned it in the years leading up tothe market crash in 2007. Full underwriting alsoimposes significant hurdles for borrowers whodo not have complete documentation. Requests forfull documentation are often a source of frictionbetween borrowers and loss mitigation staff.209

Both servicers and investors must be per-suaded to change their mindsets as to the func-tion of staff. In 2004, one credit rating agencydescribed “communication techniques” as a“nonservicing area[]” of training.210 Servicer em-ployees are not expected to learn how to talk toborrowers. Getting information from borrowersand communicating information to borrowers isoutside the defined core tasks performed by ser-vicers. In order to do effective loan modifications,servicers and investors must see that there isvalue added in communicating with borrowersand that such work is part of core servicing work,not a marginalized afterthought.

Refinancing and Cure

The cheapest option for a servicer is to do noth-ing. If the servicer does nothing, the borrowermay resolve the situation on her own, one way oranother. A borrower can cure in various ways—byrefinancing, by borrowing money from friendsand family, or by winning the lottery. Many ser-vicers prefer to play those odds—historicallyaround 1 in 4—rather than incur the costs of amodification.211

The availability of refinancing as an option re-duces a servicer’s incentives to do loan modifica-tions. In part, of course, if refinancing is availablefor an individual homeowner, a modificationmay not pass muster under the FASB rules, be-cause then default is not “reasonably forseeable.”More importantly, refinancing, even if it only“kicks the can down the road” for the home-owner, offers a full payoff to investors and sparesthe servicer the costs of all modifications.212 A re-financing will not trigger repurchase require-ments on the part of the servicer, nor requireadvances, or a loss of float income. Indeed, refi-nancings generate some float income for ser-vicers, since they can earn interest on the payoffamount until it is turned over to the investor.Better still, all classes usually share in prepay-ments, at least after certain triggers are met.213 Ifthe servicer can engineer the refinancing with anaffiliate or otherwise acquire the mortgage servic-ing rights to the refinanced loan, the servicer willnot even suffer a net reduction of its mortgageservicing fees due to the prepayment. For ser-vicers, refinancing may be the only form of modi-fication that costs nothing upfront and provides,at least sometimes, a return.

Until June 2008, refinancings exceeded eventhe total number of foreclosures.214 As long as re-financing is an available option, servicers have lit-tle incentive to make their loss mitigationdepartments work. Only recently, as cure ratesdropped below seven percent,215 have servicersbegun to realize that refinancing alone will notmanage their escalating default rates.

Conclusion andRecommendations

Foreclosures continue to outstrip modificationsof all kinds. In part, this is due to the structure ofservicers' financial incentives. The compensationand constraints imposed on and chosen by ser-vicers generally lead servicers to prefer refinancing,


foreclosures, and short-term repayment plans tomodifications.

Servicers recover all costs in a refinancing orforeclosure, without incurring unreimbursed ex-penses. Refinancing, where available, will alwaysbe preferred: the servicer incurs no costs in a refi-nancing, other than the staff cost of providing apayoff statement, and may gain some incidentalfloat income from the prepayment.

A foreclosure is the next best option. The ser-vicer’s expenses, other than the costs of financingadvances, will be paid first out of the proceeds ofa foreclosure. Thus, unless the servicer’s advancesoutstrip the value of the collateral, the servicerwill recover all sunk expenditures upon comple-tion of the foreclosure (even then, the servicerwill be able to recover its remaining unpaid ad-vances from the general income on the portfo-lio).216 The servicer’s costs of financing thoseadvances will not be recovered—but all othercosts, including those services provided by affili-ated entities, like title and property inspection,will be.217 The servicer is unlikely to lose moneyon a foreclosure, even if the investors do.218

Whether and when costs are recovered in amodification is more uncertain. While the creditrating agencies have made steps to improve clar-ity on the treatment of advances in a modifica-tion, there are still ambiguities. Existing PSAsprovide at best spotty coverage of how a servicershould be paid for doing a modification andwhat kinds of modifications are preferred, rely-ing on the vague “usual and customary practices”to provide guidance to skittish servicers. Somecosts may take months to recover, depending onthe size of the servicer’s outlay. Other costs, par-ticularly the sunk costs of staffing and time, arenot recovered at all. Modifications are disfavoredin part because of the large initial outlay in

HAMP Modifications as a Percentage of Delinquencies

Total 60+ Days Delinquencies as of June 30, 2009 5,360,961

HAMP Trial Modification Through September 30, 2009 487,081

Sources: Mortgage Banker’s Association, National Delin-quency Survey, Q2 09; Making Home Affordable Program,Servicer Performance Report Through September 2009

June 2009 60+ Day Delinquencieswithout a HAMP ModificationHAMP Trial Modifications as of September 30, 2009

9%

91%

Modifications, Foreclosures, and Delinquencies as a Percentage of 60+ Day Delinquencies in 4th Quarter, 2008

The 60+ day delinquency rate for 4th quarter 2008 was 8.08% of all loans.Sources: Mortgage Banker’s Association, National Delinquency Survey, Q4 08; Manuel Adelino, Kristopher Gerardi, and PaulS. Willen, Why Don’t Lenders Renegotiate More Home Mortgages? Redefaults, Self-Cures, and Securitization, Table 3

60+ Days DelinquentUnmodified,

Not in Foreclosure56%

Foreclosure Inventory4th Quarter 2008

41%

Modifications Performed4th Quarter 2008

3%


staffing and infrastructure. That there will becosts for a servicer of doing a modification is cer-tain. The recovery of those costs is uncertain.And, in most cases, the servicer faces no penaltyfor avoiding the certain out-of-pocket expendi-tures and uncertain recovery of a modification.

If a servicer is going to do a modification, ashort-term repayment plan is most attractive tothe servicer. Such a plan requires little to no un-derwriting, does not require the servicer to recog-nize any long-term loss and, because it is quick,addresses servicers’ largest expense: the blackhole of financing principal and interest advancesto investors. Time is money, perhaps even morefor servicers than for others, given their acute de-pendence on financing. In order to be attractiveto a servicer, a modification must provide for thequick and full recovery of all advances.

Modifications that respond more sensitively toborrowers’ needs require more staff and moretime, and may require the recognition of losses,either through a principal writedown or an inter-est rate reduction. Recognized losses can ripplethrough a servicer’s incentive scheme, drainingthe residuals dry and reducing the monthly

mortgage servicing fee. Principal or interest ratereductions or forbearances—the sorts of modifi-cations that most borrowers need to make theloans sustainable—will generally result in an im-mediate recognition of loss to the servicer and anelevated number of reported delinquencies,which can result in the servicer losing its mostvaluable asset, the mortgage servicing rights.

Other options pushed by investors and regula-tors, such as short sales, are no more attractive toservicers than foreclosure and perhaps less so. Ashort sale should return a higher sales price thanan REO sale after foreclosure, but so long as theREO sales price is higher than the servicer’s ad-vances, that higher price does not benefit the ser-vicer. The time to complete a short sale versus aforeclosure may be more attractive to a servicerfacing high interest costs on advances. On theother hand, the servicer’s obligation to make ad-vances may be cut off by putting the loan in fore-closure, the servicer’s affiliates may be able tocharge and collect more fees for a foreclosure andREO than for a short sale, and, if the servicer isoptimistic, a future foreclosure may take advan-tage of rebounding home prices.219 Thus, in most

Effect of Servicer Incentives on Default Outcomes

This chart shows whether specific elements of servicers' compensation and expenses create positive, negative, orneutral incentives for them pursue different types of outcomes for homeowners in default.

Short-TermForbearance or InterestRepayment Rate Principal PrincipalAgreement Reduction Forbearance Reduction Short Sale Foreclosure

Repurchase Agreements Positive Negative Negative Negative Neutral Neutral

TDR Rules Positive Negative Negative Negative Neutral Neutral

Fees Positive Neutral Negative Negative Negative Positive

Float Interest Income Neutral Negative Negative Negative Positive Positive

Monthly Servicing Fee Neutral Neutral Positive Negative Negative Negative

Residual Interests Positive Negative Negative Negative Negative Negative

Advances Positive Neutral Negative Negative Positive Positive

Staff Costs Neutral Negative Negative Negative Negative Positive

instances, a servicer has little to gain from agree-ing to a short sale and potentially some loss.220

Given the complex web of incentives—and dis-incentives—servicers face in performing modifi-cations and choosing among modifications, it isunsurprising that most servicers continue to fol-low the path of least resistance and surest re-turns: foreclosure or refinancing. All other pathsrequire complex calculations and certain sunkcosts without any guarantee of an offsetting re-turn. Upfront payments to servicers without ex-plicit mandates are unlikely to shift thisdynamic, since such payments will not be suffi-cient for servicers to staff up nor will they coverservicers’ large investment losses in the pools oftoxic mortgages.

Patchwork incentives alone will not addressthe foreclosure crisis, nor ensure that the inter-ests of investors, borrowers, and communities areserved.221 In the interest of maximizing profits,servicers have engaged in a laundry list of bad be-haviors, which have considerably exacerbatedforeclosure rates, to the detriment of both in-vestors and homeowners.222 The financial inter-ests of servicers do not necessarily align withinvestors, nor are those existing financial incen-tives easily overcome by one-time incentive pay-ments. Instead, specific steps must be taken if wewant loan modifications performed when doingso would save investors money and preservehomeownership.

1. Avoid irresponsible lending.It is easier to prevent Humpty Dumpty’s fall thanto put him back together again. Untangling ser-vicer incentives would be much less important ifwe were not facing the current economic catas-trophe. We are now looking to loan modifica-tions to bail us out of a foreclosure crisis years inthe making. Had meaningful regulation of loanproducts been in place for the preceding decade,we would not now be tasking servicers with res-cuing us from the foreclosure crisis.

Any attempt to address the foreclosure crisismust, of necessity, consider loan modifications.

We should also ensure that we are not permanentlyfacing foreclosure rates at current levels. To do sorequires thorough-going regulation of loan prod-ucts, as we have discussed in detail elsewhere.223

2. Mandate loan modification beforea foreclosure.

Foreclosures impose high costs on families, neigh-bors, extended communities, and ultimately oureconomy at large.224 Proceeding with a foreclo-sure before considering a loan modification resultsin high costs for both investors and homeowners.These costs—which accrue primarily to the benefitof the servicer—can make an affordable loanmodification impossible. Moreover, the twotrack system, of proceeding simultaneously withforeclosures and loan modification negotiations,results in many “accidental” foreclosures, due tobureaucratic bungling by servicers,225 as one de-partment of the servicer fails to communicatewith another, or papers are lost, or instructionsare not conveyed to the foreclosure attorney.

If a servicer can escape doing a modification byproceeding through a foreclosure, servicers canchoose, and in many instances have chosen, toforgo nominal incentives to modify in favor ofthe certainty of recovering costs in a foreclosure.Staying all foreclosures during the pendency of aloan modification review would encourage ser-vicers to expedite their reviews, rather than delay-ing them. Congress and state legislatures shouldmandate consideration of a loan modification be-fore any foreclosure is started, and should requireloan modifications where they are more prof-itable to investors than foreclosure. Loss miti-gation, in general, should be preferred over fore-closure.

3. Fund quality mediation programs.Court-supervised mortgage mediation programshelp borrowers and servicers find outcomes thatbenefit homeowners, communities and investors.The quality of programs varies widely, however,and most communities don’t yet have mediation


available. Government funding for mediation pro-grams would expand their reach and help developbest practices to maximize sustainable outcomes.

4. Provide for principal reductions inMaking Home Affordable and viabankruptcy reform.

The double whammy of declining home valuesand job losses helps fuel the current foreclosurecrisis.226 Homeowners who could normally refi-nance their way out of a lost job or sell theirhome in the face of foreclosure are denied bothoptions when they owe more on their home thanit is worth. Without principal reductions, home-owners who lose their jobs, have a death in thefamily, or otherwise experience a drop in incomeare more likely to experience redefault and fore-closure.227 Existing data on loan modificationsshows that loan modifications with principal re-ductions tend to perform better.228 In order tobring down the redefault rate and make loan mod-ifications financially viable for investors, principalreductions must be part of the package.229

Principal forgiveness is also necessary to makeloan modifications affordable for some home-owners. A significant fraction of homeownersowe more than their homes are worth.230 Theneed for principal reductions is especially acute—and justified—for those whose loans were not ad-equately underwritten and either: 1) receivednegatively amortizing loans such as payment op-tion adjustable rate mortgage loans, or 2) obtainedloans that were based on inflated appraisals. As a matter of fairness and commonsense, home-owners should not be trapped in debt peonage,unable to refinance or sell.

Making Home Affordable permits principalreductions, but does not mandate them, even inthe most extreme cases. Making Home Affordabledoes require forbearance, but only as a methodfor reducing payments. While forbearance pro-vides affordable payments, it prevents a home-owner from selling or refinancing to meet a neededexpense, such as roof repair or college tuition,and sets both the homeowner and the loan modi-

fication up for future failure. For all of these rea-sons, the Making Home Affordable guidelinesshould be revised so that they at least conform tothe Federal Reserve Board’s loan modificationprogram by reducing loan balances to 125 percentof the home’s current market value.

In addition, Congress should enact legislationto allow bankruptcy judges to modify appropri-ate mortgages in distress. First-lien home loansare the only loans that a bankruptcy judge cannever modify.231 The failure to allow bankruptcyjudges to align the value of the debt with thevalue of the collateral contributes to our ongoingforeclosure crisis. Permitting bankruptcy judgesto modify first-lien home loans also provides asolution to the severe implementation problemshomeowners face when they are forced to seek helpdirectly from mortgage servicers. The exclusion ofhome mortgages from bankruptcy supervisiondates back to the 1978 Bankruptcy Code, whenmortgages were generally conservative instru-ments with a simple structure. The goal was tosupport mortgage lending and homeownership.Today, support for homeownership demandsthat homeowners have greater leverage in theireffort to avoid foreclosure.

5. Continue to increase automatedand standardized modifications,with individualized review forborrowers for whom theautomated and standardizedmodification is inappropriate.

Servicers are not originators. They lack staff,training, and software to underwrite loans.232

Moreover, underwriting takes time—and thelonger it takes to make a delinquent loan per-forming, the more money, generally speaking,servicers will lose. One of the requirements of anyloan modification program that hopes to be ef-fective on the scale necessary to make a differencein our current foreclosure crisis is speed.

The main way to get speed is to automate theprocess, and to offer standardized modifications.This was one of the key insights of the FDIC’s


loan modification program on the Indymacmortgages.233 This insight has been at least par-tially incorporated into the Making Home Af-fordable Program. Both programs allow theprocess to begin without any documentationfrom the borrower at all.

More could and should be done to automatethe process.234 We simply cannot afford the wait,delay, and confusion caused by failed contactsbetween servicers and borrowers.235 Servicers canand should present borrowers in default with astandardized offer based on information in theservicer’s file, including the income at the time oforigination and the current default status. Bor-rowers should then be free to accept or reject themodification, based on their own assessment oftheir ability to make the modified payments. Bor-rowers whose income has declined and are seek-ing a modification for that reason could thenprovide, as they now do under the Making HomeAffordable Program, income verification.

Only when a borrower rejects a modification—or if an initial, standard modification fails—should detailed underwriting be done. Theurgency of the need requires speed and unifor-mity; fairness requires the opportunity for a sub-sequent review if the standardized program isinadequate. Borrowers for whom an automatedmodification is insufficient should be able to re-quest and get an individually tailored loan modi-fication, at least when such a loan modification isforecast to save the investor money.

Many of the existing loans were poorly under-written, based on inflated income or a faulty ap-praisal. Borrowers may have other debt, includinghigh medical bills, that render a standardizedpayment reduction unaffordable. A standardizedapproach cannot cure all reasons for default. Butit will make many loans affordable, saving in-vestors the costs of foreclosure and servicers thecost of detailed underwriting. The savings inspeed and staffing created by using truly auto-mated and standardized modifications to handlethe easy modifications should more than com-pensate for the costs of underwriting modifica-tions that require more individualized attention.

Additionally, borrowers may be unable to per-form on a loan modification for many reasons—aspouse may die or the borrower may become un-employed or disabled. These subsequent, unpre-dictable events, outside the control of thehomeowner, should not result in foreclosure if afurther loan modification would save investorsmoney and preserve homeownership. Foreclos-ing on homes where homeowners have sufferedan involuntary drop in income without evaluat-ing the feasibility of a further modification ispunitive to homeowners already suffering a lossand does not serve the interests of investors.Some servicers provide modifications upon re-default as part of their loss mitigation programs.This approach should be standard and mandated,and should include continued eligibility for Mak-ing Home Affordable modifications rather thanonly specific servicer or investor programs.

6. Ease accounting rules formodifications.

The current accounting rules, particularly as in-terpreted by the credit rating agencies, do notprevent modifications, but they may discourageappropriate modifications. In particular, the re-quirement that individual documentation of de-fault be obtained may prevent streamlinedmodifications. The troubled debt restructuringrules may discourage sustainable modificationsof loans not yet in default and promote short-term repayment plans rather than long-term,sustainable modifications that reflect the truevalue of the assets. Finally, limiting recovery of ser-vicer expenses when a modification is performedto the proceeds on that loan rather than allowingthe servicer to recover more generally from theincome on the pool as a whole, as is done in fore-closure, clearly biases servicers against meaning-ful modifications, particularly modificationswith principal reduction or forbearance. Thecredit rating agencies and bond insurers shouldreview their guidance on how servicers get reim-bursed for advances when a modification is en-tered into.


Streamlined modifications should be allowedto proceed without full documentation, for thereasons discussed above. A standardized modifi-cation can and should be offered based on infor-mation in the servicer’s files, to be followed withdetailed individual documentation only wherethe standardized modification does not work foran individual borrower. Where a loan is alreadyin default, individual documentation of defaultbeyond noting the fact of default seems unneces-sary. If the goal is the return to the investors, thereason for the default is largely irrelevant; what isrelevant is whether or not the loan can be madeperforming.

FASB and the Securities and Exchange Com-mission could help by formalizing more flexibleservicer discretion in determining “reasonablyforeseeable default” and the ability to pursue sus-tainable, systematic, streamlined loan modifica-tions without the threat of punitive regulatory oraccounting consequences. The guidance issuedby the Office of the Chief Accountant of the Se-curities and Exchange Commission permittingstreamlined modifications in the event of a ratereset should be extended to all standardized pro-grams, in line with the REMIC requirements.

The SEC and FASB should also review the rele-vant troubled debt restructuring, impairment,and recognition guidance to ensure that ownersof 1–4 unit residential mortgages are not undulypenalized for undertaking modifications of loansprior to default. Such review could encourageservicers to modify more loans in a timely way.Such pre-default modifications are particularlyimportant since they have a higher rate of successand fewer negative consequences for both borrow-ers and investors than post-default modifications.

7. Encourage FASB and the creditrating agencies to provide moreguidance regarding the treatmentof modifications.

Investors are losing mind-boggling large sums ofmoney on foreclosures.236 The available data sug-

gests that investors lose ten times more on fore-closures than they do on modifications.237 In par-ticular, leading investor groups have advocatedbroader use of principal reductions as part of theanti-foreclosure arsenal, but only a handful ofservicers have obliged.238 Part of the solution tothe foreclosure crisis must be giving investors thetools they need to police servicers.

Investors’ interests are not necessarily thesame as those of borrowers. There are manytimes when an investor will want to foreclose al-though a borrower would prefer to keep a home.Investors as well as servicers need improved in-centives to favor modifications over foreclosures.Still, there would likely be far fewer foreclosuresif investors had information as to the extent oftheir losses from foreclosures and could act onthat information.

Even where investors want to encourage andmonitor loan modifications, existing rules canstymie their involvement—or even their ability toget clear and accurate reporting as to the statusof the loan pool. Additional guidance by FASBand the credit rating agencies could force ser-vicers to disclose more clearly to investors andthe public the nature and extent of the modifica-tions in their portfolio—and the results of thosemodifications. Without more transparency anduniformity in accounting practices, investors areleft in the dark. As a result, servicers are free togame the system to promote their own financialincentives, to the disadvantage, sometimes, of in-vestors, as well as homeowners and the public in-terest at large.

8. Regulate default fees.Fees serve as a profit center for many servicersand their affiliates. They increase the cost tohomeowners of curing a default. They encourageservicers to place homeowners in default. All feesshould be strictly limited to ones that are legalunder existing law, reasonable in amount, andnecessary. If default fees were removed as a profitcenter, servicers would have less incentive to


place homeowners into foreclosure, less incentiveto complete a foreclosure, and modificationswould be more affordable for homeowners.

Making Home Affordable already requires thewaiver of late fees in a modification. Servicersshould be required to waive all default-relatedfees in a modification or in the event of cure, butthese fees should be treated as nonrecoverableadvances, subject to recovery from the pool. Thistreatment would spread the cost of doing modifi-cations more uniformly across the pool, in line

with the loss allocations contemplated at thepool’s origin. Borrowers would no longer befaced with large downpayments in order to makea loan modification financially viable for the ser-vicer. Investors are in a far better position thanborrowers to limit the imposition of default feesto circumstances when they are reasonable andnecessary. Permitting servicers to recover waiveddefault fees from all the income from a poolwould give investors the incentive to monitor ser-vicers’ use of default fees as a profit center.


Affiliates Related business organizations, with com-mon ownership or control.

Advances Under most PSAs, servicers are required toadvance the monthly principal and interest paymentdue on each loan to the trust, whether or not the bor-rower actually makes the payment. The requirementto make these advances can continue until the homeis sold at foreclosure.

Basis Points One basis point equals 1/100th of a per-centage point. For example, an increase in an interestrate from 8.75% to 9.00% is an increase of 25 basispoints.

Bankruptcy-remote status When the assets of a trustcannot be seized by creditors of the transferor (oftenthe originating lender) in the event of the transferor'sbankruptcy.

Bond Insurance Bond issuers pay bond insurers forthe promise to make payments if the bond does notperform as advertised. Bond insurance may cover allor, more commonly, a portion, of the payments dueon the bond. The larger the coverage, the higher therating on the bond. Bond insurers will charge morethe riskier they believe the underlying securities to be.

Broker Price Opinion A valuation of the property bya broker. As the name indicates, it is not a full ap-praisal, and not conducted by an appraiser, but simplyan “opinion” by a broker as to the value of the home.

Capitalizing Arrears Adding past due amounts onthe loan and adding them to the principal balance,with a resulting increase in the size of the monthlypayment.

Credit Rating Agencies These are private companiesthat assign ratings to bonds and to corporate borrow-ers, such as servicers. Moody’s, Standard and Poors,and Fitch are all credit rating agencies.

Cure To “cure” a default is to pay the full amountdue, often by refinancing.

Default Rates The rate at which borrowers default onloans as compared to the total number of loans.

Fannie Mae The Federal National Mortgage Associa-tion, chartered by the U.S. government, provides liq-uidity to the mortgage market by purchasing loans,then packaging those loans into securities, and sellingthose securities on the secondary market. Fannie Maeprimarily purchased prime loans.

FAS Financial Accounting Statement, issued byFASB. The Financial Accounting Statements, throughtheir incorporation into private contracts and SECregulation, have the force of law.

FASB Financial Accounting Standards Board. FASBis a private organization, but the Securities and Ex-change Commission often interprets FASB standardsand requires compliance with the FASB standards byall public companies.

FAS 140 Accounting rules governing transfer of as-sets to and from trusts, designed to limit discretion intrust management in exchange for preserving thebankruptcy-remote status of the trust.

Federal Reserve Board The central bank of theUnited States, in charge of ensuring the flow of moneythroughout the financial system.

FHA loans The Federal Housing Administration in-sures, at 100% of any losses, home mortgage loansmade to lower-income borrowers and others who donot qualify for prime loans without FHA insurance.

Float Income The interest income earned by servicersin the interval between when funds are received from aborrower and when they are paid out to the appropri-ate party.

Freddie Mac The Federal Home Loan Mortgage Cor-poration, chartered by the U.S. chartered by the U.S.government, provides liquidity to the mortgage mar-ket by purchasing loans, then packaging those loansinto securities, and selling those securities on the sec-ondary market. Freddie Mac primarily purchasedprime loans.

GSE Government sponsored entities. The GSEs helpmake the credit markets, including home mortgages

37

Glossary of Terms


primarily through the Federal National Mortgage As-sociation (Fannie Mae) and the Federal Home LoanMortgage Corporation ( Freddie Mac).

HAMP The Home Affordable Modification Programis a standard modification program designed by theU.S. Treasury. Participating servicers are required toreview all eligible borrowers to determine whether ornot they qualify for a modification. Modificationsunder HAMP can reduce the interest rate to as low astwo percent for as long as five years, permit, but donot require, principal reductions, sometimes mandateprincipal forbearance and an extension of the term ofthe loan from 30 years to 40.

Hybrid ARMs Adjustable rate mortgages that havefixed rates for a period of time, usually two- or three-years, followed by a period where the rate can adjust inrelationship to an index, usually every six months.

Junior Tranche, Junior Interest An interest in a poolof mortgages that gets paid after more senior securityinterests.

Making Home Affordable Program The Obama Ad-ministration’s program designed to help millions ofhomeowners refinance or modify their mortgages tomore affordable payments. The program created aloan modification program (HAMP) in which allmajor servicers of home mortgages agreed to partici-pate. The plan establishes loan modification guide-lines that require a loan modification when ananalysis finds that the net present value of the costs offoreclosing on a home is will return less to investorsthan the net present value of the return from an af-fordable loan modification.

Master Servicer The Master Servicer is the servicer incharge of hiring, firing, and selecting special servicersand ensuring timely payments to the trust. The Mas-ter Servicer may or may not actually service any of theloans in the pool. Sometimes PSAs will require thatservicing of loans in default automatically be trans-ferred to a designated special servicer outside the Mas-ter Servicer’s control.

Mortgage Insurance Insurance, paid for by the bor-rower, that covers some fraction of the investor’slosses on a loan in the event of the borrower’s default.

Mortgage Servicing Rights (MSRs) The rights to col-lect the payments on a pool of loans.

Partial Chargeoff When the servicer writes down theprincipal balance, but does not require the homeowner

to sell the property. A partial chargeoff can take placeeither through a refinancing or a loan modification.

Passive Management Management of a loan poolwith discretion constrained to ensure no undue influ-ence by the transferor, thus justifying the bankruptcy-remote status of the trust's assets.

Pooling and Servicing Agreement (PSA) The agree-ment between the parties to the securitization as tohow the loans will be serviced. PSAs spell out the con-tractual duties of each party, the circumstances underwhich a servicer can be removed, and sometimes giveguidance as to when modifications can be performed.

Principal Forbearance Principal on which no interestaccrues and no payments are due until a specifiedevent in the future occurs, usually the payment in fullof the loan.

REMIC Real Estate Mortgage Investment Conduitsare defined under the U.S. Internal Revenue Code (TaxReform Act of 1986), and are the typical vehicle ofchoice for the pooling and securitization of mort-gages. The REMIC rules are the IRS tax code rules gov-erning REMICs.

REO Real estate owned. Often, a holder or servicerwill acquire property at a foreclosure sale. The prop-erty is then listed as REO property until it is sold to athird party. Sales of REO property typically generateless income than sales of occupied property by thehomeowner.

Repurchase Agreement A clause in a contract for thesale of mortgages that requires the seller or servicer torepurchase any mortgage back from the buyer if anyone of a number of specified events occur. Generallythe specified events include borrower default or legalaction and sometimes include modification.

Residual Interest A junior-level interest retained inthe mortgage pool by a servicer, typically by a servicerwho is an affiliate of the originator. These interestscommonly pay out “surplus” interest income, left overafter specified payments to senior bond holders aremade.

Securities and Exchange Commission (SEC) Thefederal agency charged with regulating securities.

Securitization Securitization combines groups ofloans in pools, transfers those pooled loans to a differ-ent entity, and then sells securities based on the com-bined projected income on the loans in the pool.


Servicer The entity responsible for taking paymentsfrom the borrower and distributing them accordingto the terms of the pooling and servicing agreement.

Short Sales A sale of real estate in which the pro-ceeds from the sale fall short of the balance owed on aloan secured by the property sold and the lendernonetheless releases the mortgage.

Subprime Loans Loans made at higher than primerates, often with other less desirable terms.

Tranche One of a number of related classes of secu-rities offered as part of the same transaction.

Troubled Debt Restructuring (TDR) An accountingterm describing the modification of debt involvingcreditor concessions (a reduction of the effective yieldon the debt) when the borrower is facing financialhardship.

Trustee The legal holder of the mortgage notes, onbehalf of the trust and the ultimate beneficiaries, theinvestors in the trust.

Underwriting The lender’s evaluation of the likeli-hood of repayment of the loan, including evaluationof the borrower’s creditworthiness and the value ofthe security offered.


Notes

1 See, e.g., Ben S. Bernanke, Chairman, Board of Governors ofthe Federal Reserve System, Speech at the Federal ReserveSystem Conference on Housing and Mortgage Markets:Housing, Mortgage Markets, and Foreclosures (Dec. 4, 2008)[hereinafter Bernanke, Speech at Federal Reserve], avail-able at http://www.federalreserve.gov/newsevents/speech/bernanke20081204a.htm (“Despite good-faith efforts byboth the private and public sectors, the foreclosure rate re-mains too high, with adverse consequences for both thosedirectly involved and for the broader economy.”).2 The Worsening Foreclosure Crisis: Is It Time to Reconsider Bank-ruptcy Reform? Hearing Before the Senate Subcomm. on Adminis-trative Oversight and the Courts of the Comm. on the Judiciary,111th Cong. 6–13 (2009) (testimony of Alys Cohen).3 Many of today’s servicers are third-party servicers, unaffili-ated with a lender. Others may be affiliated with a lender,but may or may not be servicing loans originated by thatlender. This paper will discuss the incentives common toboth types and will attempt to distinguish between the twogroups where appropriate.4 See In re Taylor, 407 B.R. 618 (Bankr. E.D. Pa. 2009) (de-scribing the extreme reliance on a computer system to per-form the servicing, to the point that the computer system waspersonified by the actual living employees of the servicer).5 Cf. Joe Nocera, Talking Business; From Treasury to Banks, An Ulti-matum on Mortgage Relief, N.Y. Times, July 11, 2009 (character-izing work of servicers as “relatively simple” whose defaultservicing consisted largely of either “prodd[ing] people” to payor “initiat[ing] foreclosure”). 6 Id. (noting that servicers find the Making Home Affordableincentives “meaningless”).7 See, e.g., Bernanke, Speech at Federal Reserve, supra note 1(“The rules under which servicers operate do not always pro-vide them with clear guidance or the appropriate incentivesto undertake economically sensible modifications.”).8 American Securitization Forum, Discussion Paper on theImpact of Forborne Principal on RMBS Transactions 1 (June18, 2009) [hereinafter American Securitization Forum, Dis-cussion Paper], available at http://www.americansecuritiza-tion.com/uploadedFiles/ASF_Principal_Forbearance_Paper.pdf.9 See Helping Families Save Their Homes: The Role of BankruptcyLaw: Hearing Before the S. Comm. on the Judiciary, 110th Cong.,2nd Sess. (Nov. 19, 2008) [hereinafter Helping Families SaveTheir Homes: Hearing], available at http://judiciary.senate.gov/hearings/testimony.cfm?renderforprint=1&id=3598&wit_id=4083 (statement of Russ Feingold, Member, Sen.Comm. on the Judiciary) (“One thing that I think is not wellunderstood is that because of the complex structure of thesesecuritized mortgages that are at the root of the financialcalamity the nation finds itself in, voluntary programs toreadjust mortgages may simply be doomed to failure.”).10 See It’s a Wonderful Life (Liberty Films 1946) (narrating theadventures of a mid-20th century bank manager of a buildingand loan that provides home loans for the working poor).

11 See, e.g., Prospectus Supplement, IndyMac, MBS, Deposi-tor, IndyMac INDX Mortgage Loan Trust 2007-FLX5, at S-11 (June 27, 2007) [hereinafter Prospectus Supplement,Indy -Mac, et al.] (listing various certificates offered).12 A tranche is a portion of the securitization bearing a spe-cific credit-risk rating. Riskier tranches have correspond-ingly higher rates of return but do not get paid until afterless risky tranches do, thus giving rise to “tranche warfare.”Kurt Eggert, Held Up in Due Course: Predatory Lending, Securiti-zation, and the Holder in Due Course Doctrine, 35 Creighton L.Rev. 503 (2002). 13 State Foreclosure Prevention Working Group, Analysis ofSubprime Mortgage Servicing Performance, Data ReportNo. 1, at 23 (2008), available at http://www.csbs.org/Content/NavigationMenu/Home/StateForeclosurePreventionWork-GroupDataReport.pdf (44.9% by number of loans, 42.85%by dollar volume).14 A securities administrator typically oversees the transfer offunds from one party to another.15 Peter S. Goodman, Lucrative Fees May Deter Efforts to AlterTroubled Loans, N.Y. Times, July 30, 2009 [hereinafter Good-man, Lucrative Fees].16 Ocwen Fin. Corp., Annual Report (Form 10-K), at 9 (Mar.12, 2009).17 See Joseph R. Mason, Servicer Reporting Can Do More forModification than Government Subsidies 17 (Mar. 16, 2009)[hereinafter Mason, Servicer Reporting Can Do More], avail-able at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1361331 (noting that “servicers’ contribution to corpo-rate profits is often . . . tied to their ability to keep operatingcosts low”).18 Under most PSAs, servicers are required to advance to in-vestors at least a portion of the monthly payment due on aloan, whether or not the borrower is making payments.Sometimes interest only is advanced; sometimes principaland interest are both advanced. Advances are discussed indetail below, in text accompanying footnotes 150–162.19 Mortgage servicing rights are discussed below, in text ac-companying notes 138–149.20 Alan M. White, Rewriting Contracts, Wholesale: Data on Volun-tary Mortgage Modifications from 2007 and 2008 Remittance Re-ports, Fordham Urb. L.J. 15 (forthcoming 2009) (reportingaverage delinquency rates in studied loan pools as reaching35% in June 2008).21 See Manuel Adelino, Kristopher Gerardi, and Paul S.Willen, Fed. Reserve Bank of Boston, Why Don’t LendersRenegotiate More Home Mortgages? Redefaults, Self-Cures,and Securitization 35 (Public Pol’y Paper No. 09–4, July 6,2009), available at http://www.bos.frb.org/economic/ppdp/2009/ppdp0904.pdf (reporting that less than 8% of loans60+ days delinquent modified during 2007–2008; at the endof 4th quarter 2008, according to the Mortgage Banker’s As-sociation, 8.08% of all loans were 60+ days delinquent and28.30% of subprime loans were delinquent, suggesting amodification rate for all loans of somewhere between 0.6%and 2.3% percent); Alan M. White, Deleveraging the AmericanHomeowner: The Failure of 2008 Voluntary Mortgage ModificationContracts, Conn. L. Rev. 12–13 (forthcoming 2009), available


at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1325534 (reporting a range of modifications performed by47 servicers in November 2008 from a high ratio of 35% ofloans in foreclosure modified to a low of 0.28% of loansmodified; multiplying these numbers by the average rate ofsubprime loans in foreclosure for the last quarter of 2008 asreported by the Mortgage Banker’s Association, 13.71%, theratio of modifications performed by the servicer doing thelargest percentage of modifications, is only 4.8%); cf.Gretchen Morgenson, Fair Game—So Many Foreclosures, So Lit-tle Logic, N.Y. Times, July 4, 2009 (reporting that modifica-tions peaked in February 2009 and have since declined whilethe number of foreclosures and delinquencies has contin-ued to rise). 22 Congressional Oversight Panel, Foreclosure Crisis: Work-ing Toward a Solution (March 6, 2009).23 See, e.g., Morgan Stanley Omnibus Amendment (Aug. 23,2007) (on file with the author). 24 American Securitization Forum, Discussion Paper, supranote 8, at 1.25 Adelino et al., supra note 21, at 28 (summarizing severaldifferent studies finding no meaningful PSA restrictions in amajority of securitizations reviewed); John P. Hunt, BerkeleyCtr. for Law, Business, and the Economy, What Do SubprimeSecuritization Contracts Actually Say About Loan Modification:Preliminary Results and Implications 6 (Mar. 35, 2009), avail-able at http://www.law.berkeley.edu/files/bclbe/Subprime_Securitization_Contracts_3.25.09.pdf (reporting that thePSAs of 90% of subprime loans surveyed generally permittedmodifications); Larry Cordell, Karen Dynan, Andreas Lehn-ert, Nellie Liang, & Eileen Mauskopf, Fed. Reserve Bd. Fin. &Econ. Discussion Series Div. Research & Statistical Affairs,The Incentives of Mortgage Servicers: Myths and Realities22 (Working Paper No. 2008–46) (reporting that of 500 dif-ferent PSAs under which a large servicer operated, 48% hadno limitations on modifications other than that they maxi-mize investor return; only 7.5% of the PSAs had meaningfullimits on the types of modifications a servicer could author-ize); Credit Suisse, The Day After Tomorrow: Payment Shockand Loan Modifications (2007), available at http://www.credit-suisee.com/researchandanalytics (finding that 65% of sur-veyed PSAs contain no meaningful restrictions on ability tomodify loans); American Securitization Forum, Statement ofPrinciples, Recommendations, and Guidelines for the Modi-fication of Securitized Subprime Residential MortgageLoans 2 (June 2007) (“Most subprime transactions author-ize the servicer to modify loans that are either in default orfor which default is either imminent or reasonably foresee-able.”).26 Investor Committee of the American SecuritizationForum, Mortgage Investors Endorse Treasury Department’sGuidance on Accounting Treatment of Forborne Principal 2(Aug. 13, 2009).27 Hunt, supra note 25, at 7 (discussing various limitationsand quantifying the frequency of limitations); American Secu-ritization Forum, supra note 25, at 3; see also Mason, Servicer Re-porting Can Do More, supra note 17, at 55 (discussingreasons for 5% limitation).

28 Hunt, supra note 25, at 9–10; Mason, Servicer ReportingCan Do More, supra note 17, at 55.29 See, e.g., Prospectus Supplement, IndyMac, et al., supra note11, at 72:

Notwithstanding the foregoing, in connection with a de-faulted mortgage loan, the servicer, consistent with thestandards set forth in the pooling and servicing agree-ment, sale and servicing agreement or servicing agree-ment, as applicable, may waive, modify or vary any termof that mortgage loan (including modifications thatchange the mortgage rate, forgive the payment of princi-pal or interest or extend the final maturity date of thatmortgage loan), accept payment from the related mort-gagor of an amount less than the stated principal bal-ance in final satisfaction of that mortgage loan, orconsent to the postponement of strict compliance withany such term or otherwise grant indulgence to anymortgagor if in the servicer’s determination such waiver,modification, postponement or indulgence is not materi-ally adverse to the interests of the securityholders (takinginto account any estimated loss that might result absentsuch action).

30 Hunt, supra note 25, at 7.31 Morgan Stanley Omnibus Amendment (Aug. 23, 2007)(on file with the author). The securitization’s sponsor in thiscase likely held some equity interest in the securitization.32 Congressional Oversight Panel, supra note 22.33 Moody’s Investor Service, No Negative Ratings Impactfrom RFC Loan Modification Limits Increases (May 25,2008). 34 Monica Perelmuter & Waqas Shaikh, Standard & Poor’s,Criteria: Revised Guidelines for U.S. RMBS Loan Modifica-tion and Capitalization Reimbursement Amounts 3 (Oct.11, 2007).35 See Gretchen Morgenson, Assurances on Buybacks May Cost aLender, N.Y. Times, Aug. 23, 2007, at C1 (reporting that as ofApril 1, 2007, Countrywide’s securitization agreements re-moved the buyback requirement). See text accompanyingfootnotes 83–90, infra for a discussion of the troubled debtrestructuring rules. 36 Cordell, et al., supra note 25, at 9.37 See generally Michael Laidlaw, Stephanie Whited, MaryKelsch, Fitch Ratings, U.S. Residential Mortgage ServicerBankruptcies, Defaults, Terminations, and Transfers 2 (2007).38 Cordell, et al., supra note 25, at 22.39 See id. at 19 (reporting that, despite loss severity rates inexcess of 50%, many investors remain unconcerned aboutwhether the servicer is pursuing loss mitigation appropri-ately and uninterested in encouraging more loss mitigationactivity).40 Cf. Maurna Desmond, The Next Mortgage Mess: Loan Servic-ing? Claims of Fraud in the Subprime Mortgage Market Illuminatea Murky World, Forbes.com, Mar. 20, 2009, available athttp://www.forbes.com/2009/03/20/subprime-mortgages-carrington-capital-business-wall-street-servicers.html (not-ing that delaying foreclosures and concealing default helpsjunior investors but hurts senior investors).41 See Complaint at 6, Carrington Asset Holding Co., L.L.C.


v. American Home Mortgage Servicing, Inc., No. FST-CV09–5012095-S (Conn. Super. Ct., Stamford, Feb. 9, 2009)(noting that information on the disposition of foreclosedproperty was available to junior investor only because of“special rights” bargained for by institutional investor).42 Goodman, Lucrative Fees, supra note 15.43 See, e.g., Prospectus Supplement, Asset-Backed Pass-Through Certificates, Series 2002–2, Ameriquest MortgageSecurities Inc., Depositor, Ameriquest Mortgage Company,Originator and Master Servicer 44–45 (June 3, 2002) (agree-ment of 51% of certificate holders required); cf. Complaint at6, Carrington Asset Holding, supra note 41 (describing “specialrights” Carrington allegedly bargained for as holder of themost junior certificates to direct the disposition of propertyafter foreclosure and stating that certificate holders nor-mally have no power to direct the actions of the servicer inproperty disposition).44 Cf. Cordell, et al., supra note 25, at 18 (reporting that ser-vicers of private label securitizations receive little guidancefrom investors regarding loss mitigation). Once a pool is upand running, investors are usually constrained from givingactive direction on the management of the assets under taxand accounting rules. Id. at 19.45 Indeed, PSAs usually allow a trustee to increase its moni-toring of a servicer only in the case of a narrowly circum-scribed list of triggering events, primarily financial defaults.Laidlaw, et al., supra note 37, at 2. Advances are discussed indetail below in text accompanying footnotes 151–162.46 See, e.g., Mason, Servicer Reporting Can Do More, supranote 17, at 14 (“The point is, the investor has to completelytrust the servicer to act in their behalf, often in substantiallyunverifiable dimensions.”).47 See Rod Dubitsky, Larry Yang, Stevan Stevanovic, ThomasSuer, Credit Suisse, Subprime Loan Modifications Update 8(2008) (reporting opposition from AAA rated tranches toprincipal reduction modifications when losses from princi-pal reduction spread evenly through all tranches).48 A copy of the complaint in the high-profile suit broughtby investors against Countrywide is available at http://www.housingwire.com/wp-content/uploads/2008/12/countrywide-class-action-complaint.pdf. The complaint was filed in anattempt to force Countrywide to repurchase loans modifiedpursuant to its settlement with several state attorneys gen-eral. The complaint explicitly states that it is not opposed tothe settlement with the attorneys general but believes thatCountrywide is required to repurchase those modifiedloans. Complaint at ¶ 3, Greenwich Fin. Servs. DistressMortgage Fund 3, L.L.C. v. Countrywide Fin. Corp., No.650474 (N.Y. Sup. Ct., N.Y. Cty. Apr. 2008). The argument inthis case is strengthened because Countrywide was, in mostcases, the originator of the loans, and the attorneys generalalleged deceptive acts and practices in origination. See alsoAdelino et al., supra note 21, at 4 (reporting that of morethan 800 suits filed by investors by the end of 2008 not a sin-gle one questioned the right of a servicer to make a loanmodification); Cordell, et al., supra note 25, at 23 (“servicersadmitted that investors have rarely questioned a workout, orasked to see NPV worksheets, or threatened a lawsuit in the

past.”); Mason, Servicer Reporting Can Do More, supra note17, at 15–16 (discussing legal hurdles for investors to re-cover from servicers).49 See Complaint at 17–19, Carrington Asset Holding, supra note41 (detailing the difficulties a junior certificate holder hadobtaining the names of other investors and the trustee andmaster servicer’s refusal to act) (25% of the investors mustagree to suit); Complaint at ¶ 19, Greenwich Fin. Servs. Dis-tress Mortgage Fund 3, LLC v. Countrywide Fin. Corp., No.65047 (N.Y. Sup. Ct., N.Y. Cty. Apr. 2008) (25% of investorsmust agree before litigation pursued). Other PSAs require amajority or super-majority of investors to agree before anyaction can be instituted against a servicer. See, e.g., Prospec-tus Supplement, Asset-Backed Pass-Through Certificates,supra note 43, at 44–45 (agreement of 51% of certificateholders required).50 See, e.g., 15 U.S.C. § 1639a (Pub. L. No. 111–22, div. A, tit.II, § 201(b) (May 20, 2009)). This provision rewrote an ear-lier servicer safe harbor provision contained in the HOPEfor Homeowners Act of 2008, Pub. L. No. 110–289, div. A,tit. IV, § 1403 (July 30, 2008).51 Adelino et al., supra note 21, at 4 (reporting that of morethan 800 suits filed by investors by the end of 2008 not a sin-gle one questioned the right of a servicer to make a loanmodification).52 Letter from Charles E. Schumer, U.S. Senator, to DanielMudd, CEO of Fannie Mae, and Richard Syron, CEO ofFreddie Mac (Feb. 6, 2008).53 GSEs stands for government sponsored entities. The GSEscreate liquidity in the credit markets—and set the terms onwhich credit is issued, in many instances—through theirpurchase of debt instruments and securities on the secondarymarket. The Federal National Mortgage Association (FannieMae) and the Federal Home Loan Mortgage Corporation(Freddie Mac) are the principal actors in the secondary mar-ket for prime and near-prime rate home mortgage loans.54 See Freddie Mac Bulletin (July 31, 2008) ($800 for loanmodifications and $2,200 for short sales); Fannie Mae, An-nouncement 08–20 (Aug. 11, 2008) ($700 for loan modifica-tions and $1,000 to $1,500 for short sales). 55 State Foreclosure Prevention Working Group, Analysis ofSubprime Mortgage Servicing Performance, Data Report No.1, at 23 (2008), available at http://www.csbs.org/Content/NavigationMenu/Home/StateForeclosurePreventionWork-GroupDataReport.pdf (44.9% by number of loans, 42.85%by dollar volume).56 Adelino et al., supra note 21, at 6.57 The IRS regulations provide a safe harbor: anything withan adjusted basis of 1% or less the aggregate adjusted basisof the trust is de minimis per se. 26 C.F.R. § 1.860D-1.58 26 C.F.R. § 1.860G-2(f)(1).59 26 C.F.R. § 1.860G-2(f)(2).60 See, e.g., Thomas A. Humphreys, Tales from the Credit Crunch:Selected Issues in the Taxation of Financial Instruments and PooledInvestment Vehicles, 7 J. Tax’n Fin. Products 33, 41–42 (2008).61 26 C.F.R. § 1.860G-2(b)(3)(i).62 Rev. Proc. 2008–28, Rev. Proc. 2007–72.63 FASB recently completed a five year project of codifying all


previously issued Financial Accounting Statements. Thecodification is effective September 15, 2009. For our pur-poses, we will refer to the pre-codification Statements.64 Roles of the SEC and FASB in Establishing GAAP: Hearing Beforethe Subcomm. on Capital Markets, Insurance, and GovernmentSponsored Enterprises of the H. Comm. on Fin. Servs., 107thCong. (2002) (statement of Robert K. Herdman, Chief Ac-countant, U.S. Securities & Exchange Commission).65 Mortgage Banker’s Ass’n, FAS 140 Implications of Re-structurings of Certain Securitized Residential MortgageLoans 2, available at http://www.mortgagebankers.org/files/News/InternalResource/55315_MBAPositionPaperonFAS140Restructurtings.pdf.66 FAS 140 is 102 pages long; the REMIC rules, by compari-son, are easily read at one sitting.67 Fin. Accounting Standards Bd., Accounting for Transfersand Servicing of Financial Assets and Extinguishments ofLiabilities, Statement of Fin. Accounting Standards No.140, § 35, 42–43 (2000); Stephen G. Ryan, Accounting forand in the Subprime Crisis 37 (Mar. 2008).68 Fin. Accounting Standards Bd., Accounting for Transfersof Financial Assets-An Amendment of FASB Statement No.140, Statement of Fin. Accounting Standards No. 166 § A29(2009). See generally Fitch Ratings, Off-Balance Sheet Ac-counting Changes: SFAS 166 and SFAS 167 (June 22, 2009).69 Letter from Office of the Chief Accountant, Securities andExchange Commission, to Arnold Hanish & Sam Ranzilla(Jan. 8, 2008) [hereinafter Office of the Chief AccountantLetter], available at http://www.sec.gov/info/accountants/staffletters/hanish010808.pdf; Letter from Christopher Cox,Chairman, Securities and Exchange Commission, to BarneyFrank, Chairman of House Financial Services Committee(July 24, 2007), available at http://www.house.gov/apps/list/press/financialsvcs_dem/press072507.shtml. 70 See Mortgage Banker’s Ass’n, supra note 65.71 Office of the Chief Accountant Letter, supra note 69.72 American Securitization Forum, Streamlined Foreclosureand Loss Avoidance Framework for Securitized SubprimeAdjustable Rate Mortgage Loans (updated July 8, 2008),available at http://www.americansecuritization.com/uploadedFiles/ASFStreamlinedFramework7.8.08.pdf.73 See Mortgage Banker’s Ass’n, supra note 65, at 5 n.13 (not-ing that the accounting standards for default are consistentwith the REMIC definition).74 This restriction on modification builds on the AmericanSecuritization Forum’s definition of “reasonably foresee-able.” Ryan, supra note 67.75 Adelino et al., supra note 21, at 4.76 This discussion focuses on the rules governing loss recog-nition after a modification. We do not here consider the ac-counting rules requiring that the value of loans and otherassets be reflected at market value, or the mark-to-marketrules. Such rules and their implications are beyond thescope of this piece.77 Fin. Accounting Standards Bd., Accounting by Debtorsand Creditors for Troubled Debt Restructurings, Statementof Fin. Accounting Standards No. 15 (1977).

78 See American Securitization Forum, Discussion Paper,supra note 8, at 3–6.79 See infra, text accompanying notes 134-137, for a discus-sion of how servicer’s incentives to perform loan modifica-tions are influenced by a common type of junior interest,residuals.80 Generally and simplistically speaking, in an over-collateral -ization structure, each class receives a predeterminedamount of interest in a specified waterfall, followed by a pre-determined amount of principal payments. The most juniorlevels, often held by the servicer, can retain any interest leftover after the first round of interest payments are made. Inprime securitizations, in general, the distribution is basedon predetermined percentage shares of the cash flow, and soeven senior tranches may see their income fluctuate depend-ing on the income from the pool. See American Securitiza-tion Forum, Discussion Paper, supra note 8, at 4–7. 81 The junior tranches in most subprime securitizations arecurrently cut off from receiving any principal payments, dueto the accumulated losses in the pool as a whole. For primesecuritizations, where the distribution is based on cash flowand is not predetermined, subordinate and senior tranchesmay share equally in the reduction of principal payments,although subordinate tranches will continue to take thefirst hit on interest losses. See American SecuritizationForum, Discussion Paper, supra note 8, at 3–6. 82 See, e.g., Investor Committee of the American Securitiza-tion Forum, supra note 26, at 2; Monica Perelmuter & JeremySchneider, Standard & Poor’s, Criteria: Structured Finance:RMBS: Methodology for Loan Modifications That IncludeForbearance Plans for U.S. RMBS 2 (July 23, 2009).83 Fin. Accounting Standards Bd., supra note 77, at § 2.84 Fin. Accounting Standards Bd., Accounting by Creditorsfor Impairment of Loans, An Amendment of FASB State-ment No. 5 and 15, Statement of Fin. Accounting StandardsNo. 114 (1993). These accounting rules require an immedi-ate recognition of loss and a cessation of interest paymentsin favor of principal payments. Adelino et al., supra note 21,at 23–24.85 FASB has recently altered the rules protecting the bank-ruptcy-remote status of the trust. Instead of qualifying as aSpecial Purpose Entity, all “variable interest entities” nowmust be reviewed to determine the extent to which thetransferring entity maintains control and appropriate dis-closures provided. This is unlikely to impact the weight ofthe TDR rules directly, but it does change the formal mecha-nism by which bankruptcy-remote status is achieved andevaluated. See Transfers of Financial Assets, An Amendmentto FASB Statement No. 140, Statement of Fin. AccountingStandards No. 166 (2009).86 Fin. Accounting Standards Bd., supra note 77, at § 7.87 Adelino et al., supra note 21, at 23–24.88 In reality, of course, the interest is likely to change month-to-month, and the servicer would be eyeing a bottom line ofthe combined expected interest on all the loans in the pool.89 This assumes that the servicer is required to make ad-vances on the principal and interest payments. Advances are


discussed in detail below in text accompanying footnotes150–162.90 Assuming that the servicer holds a surplus interest in-come strip and ignoring the cost of financing the advances.91 Investor Committee of the American SecuritizationForum, supra note 26, at 3 (investor committee of ASF citingpotential rating agency downgrades as proof of the “intentand expectations of parties to the securitization.”).92 See, e.g., American Securitization Forum, Statement ofPrinciples, Recommendations, and Guidelines for the Modi-fication of Securitized Subprime Residential MortgageLoans 3 (June 2007) (reporting that limits contained in thePSA on loan modifications may usually be waived either bybond insurers or credit rating agencies; only in rare cases isinvestor consent required to waive the cap and in no case isinvestor consent required to approve an individual loanmodification otherwise permitted by the PSA).93 See, e.g., Kurt Eggert, Limiting Abuse and Opportunism byMortgage Servicers, 15 Housing Pol’y Debate 753, 763–66(2004) (chronicling the involvement of the ratings agenciesin the reform of servicing practices at Fairbanks CapitalCorporation).94 Diane Pendley, Kathleen Tillwitz, Karen Eissner, ThomasCrowe, Stephanie Whited, Fitch Ratings, Rating U.S. Resi-dential Mortgage Servicers 2–3 (2006); cf. Mason, ServicerReporting Can Do More, supra note 17, at 25–26 (pools serv-iced by higher-rated servicers require less credit enhance-ment).95 After an investigation by the Federal Trade Commissioninto the servicing practices of Fairbanks Capital Corp. (cur-rently known as Select Portfolio Servicing), Moody’s In-vestors Service and Standard & Poor’s Corp. downgradedFairbank’s servicer rating to “below average,” making it im-possible for the servicer to bid on new contracts. Fairbankswas later able to resume bidding for new business when itsservicer rating was changed to “average.” See Fairbanks CEOEager to Reenter Servicing Market, Am. Banker, May 14, 2004.96 Moody’s Investor Service, supra note 33 (stating that it willnot downgrade ratings on several pools with increased lim-its on the number of modifications since Moody’s believes“that the judicious use of loan modifications can be benefi-cial to securitization trusts as a whole.”).97 Pendley, et al., supra note 94, at 8.98 Id. at 11, 15; see also Michael Guttierez, Michael S. Mer-riam, Richard Koch, Mark I. Goldberg, Standard & Poors,Structured Finance: Servicer Evaluations 15–16 (2004).99 Pendley, et al., supra note 94, at 9.100 See Katherine Porter, Misbehavior and Mistake in BankruptcyMortgage Claims, 87 Tex. L. Rev. 121 (2008) (reporting that ser-vicers appear to be imposing often improper default-relatedfees on borrowers in bankruptcy proceedings).101 Pendley, et al., supra note 94, at 11–12.102 Advances are discussed in detail below in text accompany-ing footnotes 150–162.103 Perelmuter et al., supra note 34, at 3.104 See, e.g., Perelmuter et al., supra note 34.105 See text accompanying footnotes 134–137, infra (dis-cussing residual interests).

106 Laidlaw, et al., supra note 37, at 2 (bond insurers may beinvolved in oversight of the servicer), at 3 (bond insurersmust be notified in the event of servicer default or termina-tion), at 5 (bond insurer can initiate servicer termination).107 See, e.g., Prospectus Supplement, IndyMac, et al., supranote 11, at S-113 (authorizing the bond insurers to enforcethe PSA and to waive limitations on modifications con-tained in the PSA).108 See American Securitization Forum, Discussion Paper,supra note 8, at 1.109 Dubitsky, et al., supra note 47, at 8.110 See generally In re Stewart, 391 B.R. 327, 336 (Bankr. E.D.La. 2008) (overviewing servicer compensation), aff ’d, 2009WL 2448054 (E.D. La. Aug. 7, 2009).111 See, e.g., Prospectus, CWALT, INC., Depositor, Country-wide Home Loans, Seller, Countrywide Home Loans Servic-ing L.P., Master Servicer, Alternative Loan Trust 2005-J12,Issuer 56 (Oct. 25, 2005) (“In addition, generally the masterservicer or a sub-servicer will retain all prepayment charges,assumption fees and late payment charges, to the extent col-lected from mortgagors). But see Prospectus Supplement, In-dyMac, et al., supra note 11, at S-11 (late payment fees arepayable to a certificate holder in the securitization).112 See, e.g., Prospectus Supplement, IndyMac, et al., supranote 11, at S-73:

Default Management ServicesIn connection with the servicing of defaulted MortgageLoans, the Servicer may perform certain default manage-ment and other similar services (including, but not lim-ited to, appraisal services) and may act as a broker in thesale of mortgaged properties related to those MortgageLoans. The Servicer will be entitled to reasonable com-pensation for providing those services, in addition to theservicing compensation described in this prospectus sup-plement.

113 See In re Stewart, 391 B.R. 327, 343, n.34 (Bankr. E.D. La.2008) (“While a $15.00 inspection charge might be minor inan individual case, if the 7.7 million home mortgage loansWells Fargo services are inspected just once per year, the rev-enue generated will exceed $115,000,000.00.”), aff ’d, 2009WL 2448054 (E.D. La. Aug. 7, 2009).114 Goodman, Lucrative Fees, supra note 15. 115 See, e.g., Ocwen Fin. Corp., supra note 16, at 34 (revenuefrom late charges reported as $46 million in 2008); Eggert,supra note 93, at 758; Gretchen Morgenson, Dubious Fees HitBorrowers in Foreclosures, N.Y. Times, Nov. 6, 2007 (reportingthat Countrywide received $285 million in revenue fromlate fees in 2006).116 Ocwen Fin. Corp., supra note 16, at 34.117 See Porter, supra note 100. Under the Department of theTreasury’s Home Affordable Modification Program, ser-vicers are required to waive unpaid late fees for eligible bor-rowers, but all other foreclosure related fees, including,presumably, paid late fees, remain recoverable and are capi-talized as part of the new principal amount of the modifiedloan. See Home Affordable Modification Program, Supple-mental Directive 09–01 (Apr. 6, 2009).118 See, e.g., Prospectus Supplement, Chase Funding Loan Ac-


quisition Trust, Mortgage Loan Asset-Backed Certificates,Series 2004-AQ1, at 34, (June 24, 2004), available at http://www.sec.gov/Archives/edgar/data/825309/000095011604003012/four24b5.txt (“[T]he Servicer will be entitled todeduct from related liquidation proceeds all expenses rea-sonably incurred in attempting to recover amounts due ondefaulted loans and not yet repaid, including payments tosenior lienholders, legal fees and costs of legal action, real es-tate taxes and maintenance and preservation expenses.”). 119 Adelino et al., supra note 21, at 6 (“In addition, the rulesby which servicers are reimbursed for expenses may providea perverse incentive to foreclose rather than modify.”).120 Goodman, Lucrative Fees, supra note 15 (“So the longerborrowers remain delinquent, the greater the opportunitiesfor these mortgage companies to extract revenue—fees forinsurance, appraisals, title searches and legal services.”).121 See In re Stewart, 391 B.R. 327, 346 (Bankr. E.D. La. 2008),aff’d, 2009 WL 2448054 (E.D. La. Aug. 7, 2009).122 See Peter S. Goodman, Homeowners and Investors May Lose,But the Bank Wins, N.Y. Times, July 30, 2009 [hereinafterGoodman, Homeowners and Investors May Lose]; Goodman,Lucrative Fees, supra note 15.123 See Goodman, Homeowners and Investors May Lose, supranote 122 (describing Bank of America’s refusal to entertainthree separate short sale offers during two years of non-pay-ment while its affiliate continues to assess property inspec-tion fees).124 See, e.g., Prospectus Supplement, IndyMac, et al., supranote 11, at S-73 (noting that the servicer is entitled to retainthe costs of managing the REO property, including the saleof the REO property).125 See Freddie Mac Bulletin, supra note 54 ($800 for loanmodifications and $2200 for short sales); Fannie Mae, supranote 54 ($700 for loan modifications and $1000 to $1500for short sales).126 In 2006, one of the nation’s largest subprime servicers re-ported an additional $48 million in revenue from float in-come which made up 15% of its servicing income. Due to adecline in both the average float balance and yield, Ocwen’sfloat income went down to $29 million in 2007 and $11 mil-lion in 2008. See Ocwen Fin. Corp., supra note 16, at 34; Eggert,supra note 93, at 761; Follow the Money: How Servicers Get Paid,26 NCLC REPORTS Bankruptcy and Foreclosures Ed. 27 (2008).127 Ocwen Fin. Corp., Annual Report (Form 10-K), at 7 (Mar.17, 2008).128 See, e.g., Prospectus Supplement, Deutsche Alt-A Securi-ties Mortgage Loan Trust, Series 2006-AR6, Issuing Entity,DB Structured Products, Inc., Sponsor, Deutsche Alt-A Securities, Inc., Depositor, Wells Fargo Bank, N.A., Securi-ties Administrator and Master Servicer (Dec. 14, 2006) (ser-vicer must remit as compensating interest any interestshortfall on loans prepaid in the first 16 days of the month).129 See, e.g., Ocwen Fin. Corp., supra note 127, at 3 (typicallyreceive 50 basis points annually on the total outstandingprincipal balance of the pool).130 See, e.g., Prospectus Supplement, IndyMac, et al., supranote 11, at 71.131 Anthony Pennington-Cross & Giang Ho, Fed. Res. Bank

of St. Louis, Loan Servicer Heterogeneity & The Termina-tion of Subprime Mortgages 2 (Working Paper No. 2006–024A); Follow the Money: How Servicers Get Paid, 26 NCLCREPORTS Bankruptcy and Foreclosures Ed. 27 (2008); Cordell,et al., supra note 25, at 16. 132 See, e.g., Investor Committee of the American Securitiza-tion Forum, supra note 26, at 2; Perelmuter, et al., supra note82, at 2.133 See American Securitization Forum, Discussion Paper,supra note 8, at 8–9.134 See, e.g., Ocwen Fin. Corp., supra note 127, at 20; Joseph R.Mason, Mortgage Loan Modification: Promises and Pitfalls8 (Oct. 2007) (servicers who own residual interests always losemoney when loans are modified). In some cases, the servicermay even bet against itself, by purchasing a credit defaultswap on the pool, in which case it makes money if there is aforeclosure. See Patricia A. McCoy & Elizabeth Renuart, TheLegal Infrastructure of Subprime and Nontraditional HomeMortgages 36 (2008), available at http://www.jchs.harvard.edu/publications/finance/understanding_consumer_credit.135 Perelmuter, et al., supra note 82, at 2. 136 Kurt Eggert, Comment on Michael A. Stegman et al.’s “Preven-tive Servicing Is Good for Business and Affordable HomeownershipPolicy”: What Prevents Loan Modifications, 18 Housing Pol’y De-bate 279, 282 (2007); Mason, supra note 134, at 14 (servicersin a first-loss position delay instituting and completing fore-closures compared to servicers in a junior loss position);Mason, Servicer Reporting Can Do More, supra note 17, at 45(servicers who hold residuals or interest only strips resistmaking loan modifications).137 Dubitsky, et al., supra note 47, at 7–8.138 See, e.g., Ocwen Fin. Corp., supra note 127, at 22.139 See, e.g., id. at 7–8.140 Mason, supra note 134, at 4.141 Cf. Mason, Servicer Reporting Can Do More, supra note17, at 6–12 (noting that it is “generally recognized” thatgood servicing cannot improve the quality of a loan pooland may in fact only mask problems in valuation and ana-lyzing three case studies of failed servicers); Eggert, supranote 93, at 769 (“Servicer’s reputation among borrowersdoes not, therefore, directly affect the ability to obtain newcontracts or retain existing ones.”).142 David Moline, Servicing Gets a Tune Up: FASB Amends Guid-ance on Servicing of Financial Assets, Deloitte Heads Up (Mar.20, 2006).143 Cf. Marina Walsh, Servicing Performance in 2007, MortgageBanking 75 (Sept. 2008) (noting that “[m]anaging the MSRasset was a significant challenge for the high-default ser-vicers” in 2007). 144 Perelmuter, et al., supra note 82, at 2. See text accompany-ing footnotes 104–105, supra.145 Mason, supra note 134, at 13–14.146 Ocwen Fin. Corp., supra note 16, at 30.147 Walsh, supra note 143, at 71.148 See Mason, Servicer Reporting Can Do More, supra note17, at 8–12 (reviewing case studies of several failed servicers).149 Vikas Bajaj & John Leland, Modifying Mortgages Can BeTricky, N.Y. Times, Feb. 18, 2009 (reporting views of Credit


Suisse analyst that “[s]maller companies . . . that are undermore financial pressure and have more experience in dealingwith higher-cost loans have been most aggressive in lower-ing payments” than larger companies, who offer weakermodifications).150 Cordell, et al., supra note 25, at 16.151 See, e.g., Ocwen Fin. Corp., supra note 127, at 4 (advancesinclude principal payments); Brendan J. Keane, Moody’s In-vestor Services, Structural Nuances in Residential MBSTransactions: Advances 4 (June 10, 1994) (stating thatCountrywide was in some circumstances only advancing in-terest, not principal).152 Brian Rosenlund, Metropolitan West Asset ManagementRMBS Research 3 (Winter 2009).153 Id.154 Keane, supra note 151, at 3.155 See, e.g., Prospectus Supplement, IndyMac, et al., supranote 11, at 71.156 Rosenlund, supra note 152.157 Mary Kelsch, Stephanie Whited, Karen Eissner, VincentArscott, Fitch Ratings, Impact of Financial Condition onU.S. Residential Mortgage Servicer Ratings 2 (2007).158 See Complaint at 11–15, Carrington Asset Holding, supranote 41 (alleging that servicer conducted “fire sales” ofhomes in order to avoid its obligation to make advances andto speed its recovery of advances already made).159 Early accounting treatment of principal reductions mayhave given some servicers an incentive to do principal reduc-tions over rate reductions. Most PSAs do not specify thetreatment of losses from principal reduction. As a result,some trustees ascribed the entire amount of losses due toprincipal reductions against servicers’ interest advance re-quirements. Industry practice has now moved to treatingprincipal reductions as a “realized loss,” as are rate reduc-tions. Realized losses are allocated to each tranche as pro-scribed in the securitization documents, but usually inascending order, from the most junior interests on up. SeeDubitsky, et al., supra note 47, at 7–8.160 American Securitization Forum, Discussion Paper, supranote 8, at 1.161 See, e.g., Perelmuter et al., supra note 34, at 3.162 Ocwen Fin. Corp., supra note 16, at 5.163 Cordell, et al., supra note 25, at 17; cf. American Securitiza-tion Forum, Operational Guidelines for Reimbursement ofCounseling Expenses in Residential Mortgage-Backed Securitizations (May 20, 2008), available at http://www.americansecuritization.com/uploadedFiles/ASF_Counseling_Funding_Guidelines%20_5%20_20_08.pdf (stating thatpayments of $150 for housing counseling for borrowers indefault or at imminent risk of default should be treated asservicing advances and recoverable from the general securiti-zation proceeds).164 See, e.g., Ocwen Fin. Corp., supra note 127, at 4.165 Cordell, et al., supra note 25, at 11; Ocwen Fin. Corp.,supra note 127, at 4 (advances are “top of the waterfall” andget paid first); Wen Hsu, Christine Yan, Roelof Slump,FitchRatings, U.S. Residential Mortgage Servicer Advance

Receivables Securitization Rating Criteria 1 (Sep. 10, 2009)(same).166 Prospectus, CWALT, INC., et al., supra note 111, at 47(limiting right of reimbursement from trust account toamounts received representing late recoveries of the pay-ments for which the advances were made).167 Walsh, supra note 143, at 72.168 Servicers under HAMP are not permitted to require anup-front payment of fee advances to obtain a loan modifica-tion, though they will be capitalized and paid by the bor-rower as part of the modified principal loan amount. SeeHome Affordable Modification Program, Supplemental Di-rective 09–01, at 6, 9, available at https://www.hmpadmin.com/portal/programs/directives.html.169 See, e.g., Prospectus Supplement, IndyMac, et al., supranote 11, at 71. 170 The subprime servicer Ocwen stated in its annual reportthat its increase in late charges for 2008 “reflects higherdelinquencies and collections of previously assessed latecharges primarily on loans that have returned to performingstatus. The increase in late charges lags the increase in delin-quencies because late charges are not earned and thereforenot recognized as revenue until they are collected.” OcwenFin. Corp., supra note 16, at 34.171 See Complaint at 11–15, Carrington Asset Holding, supranote 41 (alleging that servicer conducted “fire sales” of fore-closed properties in order to avoid future advances and re-cover previously made advances); Goodman, Lucrative Fees,supra note 15.172 Mason, supra note 134, at 4. A large subprime servicernoted in its 2007 annual report that although “the col-lectibility of advances generally is not an issue, we do incursignificant costs to finance those advances. We utilize bothsecuritization, (i.e., match funded liabilities) and revolvingcredit facilities to finance our advances. As a result, in-creased delinquencies result in increased interest expense.”Ocwen Fin. Corp., supra note 127, at 18; see also Wen Hsu,supra note 165 (“Servicer advance receivables are typicallypaid at the top of the cash flow waterfall, and therefore, re-covery is fairly certain. However, . . . there is risk in thesetransactions relating to the timing of the ultimate collectionof recoveries.”).173 Tomasz Piskorski, Amit Seru & Vikrant Vig, Securitiza-tion and Distressed Loan Renegotiation: Evidence from theSubprime Mortgage Crisis 5 (Dec. 2008), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1321646 (find-ing increased numbers of modifications when the foreclo-sure process is delayed); see also Eggert, supra note 93, at 757(reporting that servicers sometimes rush through a foreclo-sure without pursuing a modification or improperly fore-close in order to collect advances).174 Cf. Hsu, et al., supra note 165, at 4 (finding that modifica-tions do not appear to accelerate the rate of recovery of ad-vances, in part because of high rates of redefault).175 Rosenlund, supra note 152, at 1.176 See, e.g., Ocwen Fin. Corp., supra note 127, at 7–8.177 Posting of Alan White to Consumer Law & Policy Blog,


http://pubcit.typepad.com/clpblog (Nov. 17, 2008, 10:15CST).178 Perelmuter et al., supra note 34, at 3.179 Wen Hsu, supra note 165, at 4.180 See, e.g., Ocwen Fin. Corp., supra note 16, at 4–5, 12.181 Piskorski, et al., supra note 173, at 2 n.2; see also Mason,supra note 134, at 7 (citing a range of $500–$600 to completea modification); cf. American Securitization Forum, supranote 163 (stating that payments of $150 for housing coun-seling for borrowers in default or at imminent risk of de-fault should be treated as servicing advances and recoverablefrom the general securitization proceeds).182 National Consumer Law Center, Foreclosures §§ 2.6, 2.7(2d ed. 2007 and Supp. 2008) (reviewing GSE modificationoptions) (reviewing HUD, VA, and RHS modification op-tions); Cordell, et al., supra note 25, at 20. 183 Cordell, et al., supra note 25, at 10, 17 (reporting that ser-vicers of private label securitizations do not get paid for con-tacts with delinquent borrowers, unlike servicers for FannieMae or Freddie Mac loans).184 See id. at 20 (reporting that Freddie historically “paid feesof $250 for a repayment plan, $400 for a modification, $275for a deed in lieu of foreclosure, and $1,100 for a short sale”;most of these numbers were doubled in July 2008). 185 See Freddie Mac Bulletin, supra note 54 (for loan modifi-cations, increase from $400 to $800; for repayment plans,increase from $250 to $500; for short sales, increase from$1100 to $2200; for deed-in-lieu, to remain at current levelof $275); Fannie Mae, Announcement 08–20, August 11,2008 (for loan modifications, $700; for repayment plans,$400; for short sales, range from $1000 to $1500; for deed-in-lieu, $1000, plus up to $350 in expenses). The Fannie MaeAnnouncement 08–20 also provides that servicers may nolonger charge the borrower $500 to cover administrativecosts incurred in connection with a modification, thoughcertain out-of-pocket expenses such as credit reports andtitle searches may continue to be charged to the borrower. 186 Preserving Homeownership: Progress Needed to Prevent Foreclo-sures: Hearing Before the Senate Comm. on Banking, Housing &Urban Affairs, 111th Cong. (July 16, 2009), at 25 (testimonyof Diane E. Thompson).187 Cordell, et al., supra note 25, at 30–31. 188 Morgenson, supra note 21; California ReinvestmentCoalition, The Ongoing Chasm Between Words and Deeds:Abusive Practices Continue to Harm Families and Commu-nities in California (2009) (reporting observations by hous-ing counselors that loan modifications declined in thesecond quarter); cf. Nocera, supra note 5 (reporting thatmany servicers find the incentives “meaningless”).189 See generally National Consumer Law Center, Foreclosures§§ 3.2.2, 6.4.5 (2d ed. 2007 and Supp.).190 See generally National Consumer Law Center, Foreclosures§ 2.7.3 (2d ed. 2007 and Supp.).191 Michael A. Stegman, Roberto G. Quercia, Janneke Rat-cliffe, Lei Ding, & Walter R. Davis, Preventive Servicing Is Goodfor Business and Affordable Homeownership Policy, 18 HousingPol’y Debate 243, 270–273 (2007) (reporting on the staff levelsof 8 servicers; servicers universally employed more collectors

per loan than loss mitigators; the ratio between collectorsand loss mitigators ranged from a low of 1.25 to a high of25; the ratio of loss mitigators to loans ranged from one per20,000 loans to one per 100,000 loans). If we assume a de-fault rate of 10%, a conservative estimate for today’s subprimeloans, the best case scenario would be one loss mitigation spe-cialist for every two thousand loans in default. 192 Cordell, et al., supra note 25, at 16; Ocwen Fin. Corp.,supra note 127, at 19.193 Cordell, et al., supra note 25, at 15.194 Dubitsky, et al., supra note 47, at 5 (listing staff increasesat several large subprime servicers from 2007 to 2008; ser-vicers had year-to-year increases ranging from 20% to 100%);Peter S. Goodman, Paper Avalanche Buries Plan to Stem Foreclo-sures, N.Y. Times, June 29, 2009 (reporting that J. P. MorganChase added 950 “counselors” in the first six months of2009, bringing the total to 3500). 195 Goodman, supra note 194 (quoting Michael Barr, Asst.Sec’y of the Treasury for Fin. Institutions, “They need to doa much better job on the basic management and operationalside of their firms.”); Cordell, et al., supra note 25, at 9–10;State Foreclosure Prevention Working Group, Analysis ofSubprime Mortgage Servicing Performance, Data ReportNo. 3 at 8 (2008), available at http://www.csbs.org/Con-tent/NavigationMenu/Home/SFPWGReport3.pdf; PrestonDuFauchard, California Department of Corporations, LossMitigation Survey Results 4 (Dec. 11, 2007); cf. Aashish Mar-fatia, Moody’s, U.S. Subprime Market Update November2007, at 3 (2008) (expressing concern as to servicers’ abilitiesto meet staffing needs).196 Mason, supra note 134, at 2.197 Mortgage Banker’s Ass’n, National Delinquency SurveyQ3 2008, (foreclosure inventory increased from 0.79% to1.58% of outstanding loans third-quarter 2007 to thirdquarter 2008).198 Walsh, supra note 143, at 73 (subprime servicers reportthat the ratio of staff to foreclosure fell during 2007; report-ing a servicer as saying, “We simply could not hire defaultand loss mitigation staff fast enough.”).199 Kelsch, et al., supra note 157, at 3; see also Eggert, supranote 93, at 768–69 (arguing that servicers can increase theirprofitability by cutting staff both because they save directexpenses on staff and because understaffing is more likely to lead to ancillary fees, such as late fees, that servicers mayretain).200 Bajaj, et al., supra note 149 (reporting views of Credit Su-isse analyst that “[s]maller companies . . . that are undermore financial pressure and have more experience in dealingwith higher-cost loans have been most aggressive in lower-ing payments” and bigger companies “need to be retooled toemphasize modifications over foreclosures”).201 Jack Guttentag, New Plan to Jump-Start Loan Mods: Web Por-tal Would Centralize Communication, Break Logjam, InmanNews, July 20, 2009, available at http://www.inman.com/buyers-sellers/columnists/jackguttentag/new-plan-jump-start-loan-mods (noting that it should take no more than an hourfor a servicer to process a loan modification request; at thatrate, Chase’s 3500 loan modification counselors should be


able to process at least 70,000 loan modifications a week—ap-proximately the number of Making Home Affordable modi-fications that Chase has processed in the first five months ofthe program).202 Cordell, et al., supra note 25, at 15–16; Diane Pendley &Thomas Crowe, FitchRatings, U.S. RMBS Servicers’ LossMitigation and Modification Efforts 9 (May 26, 2009). 203 Stegman, et al., supra note 191, at 271 (only two of eightservicers surveyed provided bonuses for staff successfullycompleting workout agreements with borrowers).204 Guttierez, et al., supra note 98, at 6 (average turnover forall positions for residential mortgage servicers ranges from15% to 25% over a six month period).205 Eggert, supra note 136, at 286; Guttentag, supra note 202.206 Walsh, supra note 143, at 73.207 Eggert, supra note 136, at 285 (“Ironically, servicers maybe demanding far more documentation to modify a loanthan the originator did to make it in the first place.”).208 Nocera, supra note 5.209 Eggert, supra note 136, at 285; cf. John Collins Rudolf,Judges’ Frustration Grows with Mortgage Servicers, N.Y. Times,Sept. 4, 2009, at B1 (reporting Wells Fargo’s admission inone bankruptcy case that it had failed to inform the home-owner of the information she needed to submit, eventhough it denied her application on the basis of the missinginformation, despite her repeated submissions of what thehomeowner believed was a complete packet; judge in casedescribed it as “certainly not an isolated case”).210 Guttierez, et al., supra note 98, at 6.211 See State Foreclosure Prevention Working Group, supranote 195, at 8 (reporting that 23% of closed loss mitigationefforts in May 2008 were either refinancings or reinstate-ments in full by the borrower without any contact from theservicer); Goodman, Lucrative Fees, supra note 15 (reportingthat a former Countrywide employee characterized thebanks’ strategy as waiting to see if the economy improvedand borrowers cured on their own instead of performingmodifications). For a general discussion of the value to a ser-vicer of the possibility of the homeowner’s independent cureof a default, see Adelino et al., supra note 21.212 Cf. Piskorski, et al., supra note 173, at 18 (finding thatforeclosure rate for loans held in portfolio remains roughlyconstant, irregardless of housing price declines, but the fore-closure rate for securitized loans with servicers increases byover 60% when housing price declines, suggesting that ser-vicers of securitized loans rely heavily on refinancing as aloan modification option).213 Dubitsky, et al., supra note 47, at 7–8; Mason, Servicer Re-porting Can Do More, supra note 17, at 57.214 White, supra note 19, at 17–18; see also Marfatia, supra note195, at 5 (reporting that half of all active loans facing resetin the first three-quarters of 2007 refinanced; more thanone-quarter of all remaining loans refinanced after reset);State Foreclosure Prevention Working Group, supra note195, at 8 (reporting that 23% of closed loss mitigation ef-forts in May 2008 were either refinancings or reinstatementsin full by the borrower).

215 Fitch: Delinquency Cure Rates Worsening for U.S. Prime RMBS,BusinessWire, Aug. 24 2009, http://www.businesswire.com/news/home/20090824005549/en (reporting that cure ratesare now at historical lows for both prime, at 6.6%, and sub-prime, at 5.3%).216 See, e.g., Ocwen Fin. Corp., supra note 16, at 11 (“[I]n themajority of cases, advances in excess of loan proceeds may berecovered from pool level proceeds.”).217 See Adelino et al., supra note 21, at 6 (“In addition, therules by which servicers are reimbursed for expenses may pro-vide a perverse incentive to foreclose rather than modify.”).218 Goodman, Lucrative Fees, supra note 15.219 See Goodman, Lucrative Fees, supra note 15 (describingsuch optimism and consequent delay by one servicer).220 Affiliated servicers holding junior liens may be particu-larly reluctant to agree to a short sale, since the junior lienmust usually be wiped out by a short sale. The junior liencould be erased in a foreclosure, as well, but in that circum-stance the servicer would have at least the possibility of a de-ficiency judgment against the borrower. Additionally, if theforeclosure is delayed, an optimistic servicer may believethat the housing market will recover sufficiently to coverboth the first lien and some of the second lien. 221 See Helping Families Save Their Homes: Hearing, supra note 9(“One thing that I think is not well understood is that be-cause of the complex structure of these securitized mort-gages that are at the root of the financial calamity the nationfinds itself in, voluntary programs to readjust mortgagesmay simply be doomed to failure.”).222 See National Consumer Law Center, Foreclosures Ch. 6(2d ed. 2007 and Supp.) (describing the most commonmortgage servicing abuses).223 Comments of National Consumer Law Center and Na-tional Association of Consumer Advocates to the FederalTrade Commission on Advance Notice of Proposed Rule-making, 16 C.F.R. Parts 317 and 318: Mortgage Acts andPractices Rulemaking (Aug. 4, 2009), available at http://www.consumerlaw.org/issues/predatory_mortgage/content/FTCMortgageCommentsAug09.pdf.224 Bernanke, Speech at Federal Reserve, supra note 1.225 For some descriptions of all too typical bureaucraticbungling by servicers, see Goodman, supra note 194 andGuttentag, supra note 201.226 Preserving Homeownership: Progress Needed to Prevent Foreclo-sures: Hearing Before the Senate Comm. on Banking, Housing &Urban Affairs, 111th Cong., at 4–5 (July 16, 2009) (testimonyof Paul Willen).227 This is especially so since the HAMP modification programdoes not permit a second HAMP modification for any reason,even if there is a subsequent, unavoidable drop in income. SeeMaking Home Affordable, Supplemental Documentation-Frequently Asked Questions-Home Affordable ModificationProgram, Q. 80 (Aug. 19, 2009), available at hmpadmin.com.228 Roberto G. Quercia, Lei Ding, Janneke Ratcliffe, Centerfor Community Capital, Loan Modifications and RedefaultRisk: An Examination of Short-Term Impact (Mar. 2009),available at http://www.ccc.unc.edu/documents/LM_March3


_%202009_final.pdf; Diane Pendley, et al., supra note 202, at2, 10–11 (modifications with principal reductions greaterthan 20% perform better than any other category of modifi-cations, but few modifications with principal reductionsdone and redefault rates, even for loans with a 20% principalreduction, remain at 30%–40% after 12 months).229 See Bernanke, Speech at Federal Reserve, supra note 1(“[P]rincipal write-downs may need to be part of the toolkitthat servicers use to achieve sustainable mortgage modifi-cations.”). 230 See Renae Merle & Dina ElBoghdady, Administration Fills inMortgage Rescue Details, Wash. Post, Mar. 5, 2009 (reportingthat one in five homeowners with a mortgage owe more ontheir mortgages than their home is worth).231 Second liens can be modified if they are, as many are inthe current market, completely unsecured because theamount of the first lien equals or exceeds the market valueof the property.232 Nocera, supra note 5.233 See http://www.fdic.gov/consumers/loans/loanmod/loanmodguide.html (the FDIC web site containing all theinformation on its loan modification program); A Review of

Foreclosure Mitigation Efforts Before the H. Comm. on Fin. Servs.,110th Cong. (2008) (statement of Sheila Bair, Chairman,FDIC) (discussing the importance of streamlined modifica-tions in addressing the foreclosure crisis); see also Pendley, etal., supra note 227, at 9 (discussing the benefits of stream-lined modification programs generally).234 See, e.g., Guttentag, supra note 201.235 Preserving Homeownership: Progress Needed to Prevent Foreclo-sures: Hearing Before the Senate Comm. on Banking, Housing & Urban Affairs, 111th Cong. (July 16, 2009) (testimony ofMary Coffin) (Wells Fargo experiences delays and difficultiesin contacting borrowers).236 Home Foreclosures: Will Voluntary Mortgage Modification HelpFamilies Save Their Homes? Hearing Before the Subcomm. on Com-mercial and Administrative Law of the H. Comm. on the Judiciary,111th Cong. (2009) (testimony of Alan M. White) (65% lossseverity rates on foreclosures in June 2009).237 Id.238 Preserving Homeownership: Progress Needed to Prevent Foreclo-sures: Hearing Before the Senate Comm. on Banking, Housing &Urban Affairs, 111th Cong. (July 16, 2009) (testimony of Cur-tis Glovier, on behalf of the Mortgage Investors Coalition).

why servicers foreclose when they should modify · vi why servicers foreclose when they should...

Documents