Federal Deposit Insurance Corp. Chairman Sheila Bair warned Wednesday that regulators must add new servicing standards to a pending risk retention rule to ensure there is not a double dip in the U.S. housing market.
"Because effective servicing of problem loans is so important to preserving value for investors and preventing systemic instability, it is imperative that the Dodd-Frank risk-retention rules also create financial incentives that promote effective loan servicing," Bair said in a speech to the Mortgage Bankers Association.
The "agencies writing the risk-retention rule have been charged with establishing securitization standards that will align incentives in the securitization process. This task cannot be considered complete unless they have addressed the misaligned incentives in servicing that created the present foreclosure crisis."
Although Bair has previously said she favored including servicing standards in the risk retention proposal — a move other regulators oppose — the speech on Wednesday was her strongest to date.
Under the Dodd-Frank law, regulators must write a rule that requires lenders to retain 5% of a mortgage's risk when they sell it into the secondary market. But the law exempts certain loans considered "qualified residential mortgages" (QRM), a category regulators are still attempting to establish.
With the final risk retention rule due by April, the agencies have yet to release a concrete proposal on how they plan to proceed.
In part, this is due to conflicts between the regulators on whether to include servicing standards as part of the QRM test. Both the Office of the Comptroller of the Currency and the Federal Reserve Board have said they support national servicing standards, but argue the risk retention proposal is not the appropriate place to craft them.
But Bair has said they must be included and has the backing of the Securities and Exchange Commission, among others, sources said.
In her speech, Bair laid out what kind of servicing regulations she would like to see added to the risk retention rules.
For example, servicers should be required to take actions that maximize the value of an entire mortgage pool rather than just the claims of any one asset class of investor, she said.
Bair is also seeking disclosure in cases where the servicer manages both the first and second lien of a mortgage and the establishment of a pre-defined process to address conflicts from second-liens.
Additionally, Bair said regulators should require an independent master servicer to provide oversight and resolve disputes on servicer actions, cap servicer principle and interest advances and provide a means other than a foreclosure for a servicer to be repaid.
She argued that misalignment of servicer incentives are behind much of the current problems.
"Just as misaligned incentives drove the origination of trillions of dollars of unaffordable subprime and Alt-A mortgages that triggered the crisis, the process deficiencies we now see in mortgage servicing show that its basic business model and compensation structure are also fundamentally flawed and in urgent need of reform," Bair said. "Paying servicers a low fixed-fee structure based on volume may be sufficient to ensure that payments are processed and accounts are settled during good times, when most mortgages are performing. But it does not provide sufficient incentives to effectively manage large volumes of problem loans during a period of market distress."
As she has for the past several years, Bair pushed for better loss mitigation policies to address the housing crisis, arguing some foreclosures are occurring needlessly.
"Loss mitigation is not just a socially desirable practice to preserve homeownership where possible," Bair said. "It is wholly consistent with safe and sound banking and has macroeconomic consequences. Fair dealing with borrowers and adherence to the law are not optional. They must be viewed as mandatory if our servicing and foreclosure process is to function in the interest of all parties concerned. The bottom line is that we need more modifications and fewer foreclosures. Only by committing to these principles can we begin to move past the foreclosure crisis and rebuild confidence in our housing and mortgage markets."
Bair acknowledged that a big stumbling block to mortgage modifications has been the refusal of second lien holders to engage in loss mitigation for fear they would end up with no return themselves. She said regulators must take steps to ensure second-lien holders get some payment if they agree to a modification.
"While big banks and big investors can handle themselves, the uncertainty around the treatment of second liens has reduced opportunities for effective foreclosure prevention," Bair said. "As part of any resolution of claims regarding large servicers, a fixed formula should be established to govern the treatment of first and second mortgages when the servicer or its affiliate owns the second lien. At a minimum, this formula should require that the subordinate lien be reduced pro-rata to any change in the first mortgage."
Bair recommended basic rights for borrowers, such as a right to appeal any adverse denial of a loan modification request to an independent party.
She also criticized the Mortgage Electronic Registration System (MERS), that holds the mortgage ownership and servicing rights of many mortgages. She argued that banks should not use MERs as an excuse to foreclose.
"This means that banks and other servicers must foreclose in their own names instead of allowing MERS to foreclose; and provide complete chain of title and note transfer history in the notice of default," she said.
Similarly, Bair said that mortgage servicing contracts should not be used as an excuse not to modify loans. While servicing incentives are often embedded in such contracts, she said there is still wiggle room for some products and incentives to be addressed.
"In addition to holding servicers accountable for past behavior, we cannot restore long-term confidence in the securitization process unless we address the misalignment of servicing incentives that contributed to the present crisis," she said. "That is why regulators must use both their existing authorities and the new authorities granted under the Dodd-Frank Act to establish standards for future securitizations to help assure that as the private securitization market returns, incentives for loss mitigation in mortgage servicing are appropriately aligned."