In recent months, servicing failures have led to executive mea culpas, Washington drubbings and a 50-state investigation of the country's biggest banks. As unpleasant as all of those things were, they have only dented large servicers' profitability.
Despite the drag of the housing crisis, the underlying economics of the servicing business remain strong, especially for large banks operating on a grand scale. This is because the higher costs associated with defaulted loans, while real, are outweighed by servicer profits from efficient collection of on-time mortgage payments, industry data and interviews suggest.
Because the lion's share of compensation is derived from loans that cause no problems, competently handling nonperforming loans is not a compelling business model. Being big is.
This incentive structure is not new, nor was it designed by mortgage servicers, who say they are doing the best job they can. But after several months in which servicing flubs have dominated the headlines, servicing fee structures are being re-examined.
"Servicers are not incented to go above and beyond, and they're not going above and beyond," said Tony Ettinger, who founded C-BASS, a servicer of nonperforming loans, in the 1990s. "They're being paid well for what they're doing."
Many numbers must be taken into account when calculating mortgage servicing economics, but one holds precedence: 25 basis points, or 0.25%.
That's the standard percentage of a performing loan's face value that Fannie Mae and Freddie Mac pay servicers for collecting mortgage payments and tending to a loan on their behalf.
Bonuses and other incentives can expand that fee, and other mortgage investors and guarantors pay different amounts. The Federal Housing Administration offers 44 basis points on its loans, for example, and private-label MBS trusts pay amounts that generally escalate according to loan size and expected difficulty of administration. But 25 basis points is the benchmark.
That margin doesn't sound especially lucrative — on Wells Fargo & Co.'s third-quarter earnings call, a Deutsche Bank analyst badgered Wells Fargo executives about whether it was too paltry to justify the expense of operating in a high-delinquency environment.
"[Y]ou have to look at it from portfolio perspective," Chief Financial Officer Howard Atkins replied. And from that perspective the servicing business still looks pretty good.
Unchanged since the 1980s, that 25-basis-point rate allows for a robust operating margin on performing loans for big servicers, as collecting and processing payments lends itself to a high degree of automation and vast economies of scale. Data on servicer expenses is patchy, but the direct costs of handling a performing loan can drop as low as $60, or about 3 to 4 basis points, per year for the largest players, people familiar with the industry say. That's compared with revenues of $450 (or 25 basis points) on an $180,000 loan, for example.
"In good times, if you had 100,000 Fannie and Freddie loans, you might have a couple hundred people servicing that," said Dave Stephens, CFO of United Capital Markets, who worked for Lomas Mortgage USA for years before moving into hedging for servicers. "If you add another 100,000 loans, all you have to do is add another five people in customer service."
The advantage of those economies of scale drove the consolidation of the servicing industry, and they remain easy to see in the country's two biggest servicers. Bank of America Corp. reported $1.6 billion of "servicing fee and ancillary income" in the third quarter, and Wells reported $1.2 billion on a portfolio of 12 million mortgages.
Of course, even in good times a servicer isn't dealing solely with performing loans. When mortgages get squirrelly, costs shoot up and economies of scale diminish. Though consumer advocates have sometimes alleged that banks profit by pushing borrowers into default, industry data contradicts this overall.
The Mortgage Bankers Association's Quarterly Mortgage Bankers Performance Reports, a barometer of small to midsize servicers, shows that over the last year and a half the rise in expenses has outpaced servicing fee growth. Megaservicers' filings with the Securities and Exchange Commission report the same trend. According to Bank of America's most recent quarterly filing, "elevated servicing costs reduced expected cash flows."
Late fees, modification bonuses and other charges cushion the blow, but missed payments and defaults are money losers no matter how they are handled, with Ettinger and others benchmarking the cost at roughly 75 basis points per loan.
There is a case to be made that the industry's failings in handling defaults stems from being unprepared for a housing crisis of unprecedented scale. Pat Lawler, chief economist for the Federal Housing Finance Agency, said that "some servicers might have been willing to spend more if they had realized fully what was coming."
Still, Lawler said, nonperforming loans are a cost center in the current compensation structure, and accounting considerations make investing in servicing troubled loans even less attractive. Because the value of servicing fee income is booked as a mortgage-servicing-right asset, higher costs don't just mean lower margins. They can force writedowns.
"Part of the problem is that you book your profits up front, as mortgage servicing rights, and increased spending on [nonperforming loans] can lead to a re-evaluation of those profit projections," Lawler said.
That better default servicing would produce worse financial results for a servicer is an unfortunate side effect of that system. Unlike investments in performing loan servicing, sinking money into default-servicing infrastructure does not generally bring down costs unless specifically geared toward speeding up the foreclosure process. Better information systems require better ground-level employees, people who can pick up the phone and quickly make decisions worth tens of thousands of dollars. At C-BASS, Ettinger said, this wasn't a problem — the company bought the loans it serviced, making the basis-point cost of each loan largely irrelevant in the context of recovering the maximum value.
"All the big servicers have added mod modules, and short-sale modules. But they haven't reinvented the process with a focus on curing," Ettinger said. "Nobody put the rocket scientists on collections."
And in the current environment, there may be no economic rationale for them to do so. Higher margins on performing loans make them better equipped to weather high delinquencies. And if the current drive to increase servicer regulation adds new operating costs to everyone in the servicing business, some fear that smaller servicers will have a harder time with the burden.
"A normal servicing fee of 25 basis points can barely cover the costs of servicing and compliance for many of the smaller mortgage loan servicers," said Laura Pephens, a residential servicing consultant. She said she fears that further legal and regulatory burdens will make the problem worse for her clients.
Some industry participants cite the decreasing margin of servicer profitability as evidence that servicers of all sizes do the best job they can on troubled loans — regardless of whether they're being compensated for it.
Dave Miller, head of business acquisition for Cenlar, which charges a per-loan fee to service mortgages on subcontract basis, said that over the last three years his company's loss mitigation department had swelled from just a few people to more than 50.
"Legal support, underwriters for modifications — you didn't have that kind of talent built into your default department in the past," he said. "And we're not getting paid any more money."
Miller said that he believes neither Cenlar nor larger servicing industry peers would intentionally cut corners to save money on default servicing. Fannie and Freddie's incentive payments for helping borrowers achieve modifications or short sales have helped, he said. But, he added, the overall economics of handling troubled loans were still not good.
"What has occurred is a misalignment of what the servicer has been asked to do and is compensated for and what the investor needs to achieve," he said.