Editor’s Note: It seems that we can’t go three months without hearing about yet another species of misconduct by mortgage servicers that shifts losses onto the lienholders they are supposed to protect. We’ve read reports about force-placed insurance, inflated appraisal and maintenance fees, robosigning and other foreclosure irregularities, interference with loan mods and short sales due to second lien holdings, and, most recently, reports of the ongoing collection of fees by servicers for loans that have already been liquidated. Why do we seem to be facing a near-constant stream of news stories about mortgage servicers behaving badly? It turns out that this problem is nothing new, and traces back to a fundamental issue that we discuss at length in Way Too Big to Fail – misalignment of incentives. In this revealing guest post, former insider Steve Ruterman draws on his experiences to illustrate the roots of this fundamental problem. – IMG
By Steve Ruterman, guest blogger
The Principal – Agent Problem: Part I – RMBS Data Integrity
Back near the dawn of time when I was in business school, and the faculty was hard-pressed to find topics to fill up the curriculum, they introduced the Principal – Agent Problem. As future corporate managers and agents of the stockholders, I suppose they wanted to explain to us that our economic interests were not identical to those of the owners. This wasn’t exactly the most shocking news we had ever received, but that was all that was said about the issue, back then.
Of course, there is considerably more to this multi-faceted problem. According to Wikipedia, “The principal–agent problem arises when a principal compensates an agent for performing certain acts that are useful to the principal and costly to the agent, and where there are elements of the performance that are costly to observe,” primarily due to asymmetric information, uncertainty and risk.
Let’s look at the relationship between the RMBS bondholder (principal) and the mortgage loan servicer (agent) in this context. The bondholder relies completely on the servicer to collect principal and interest each month, remit cash collections to the trust, report monthly collateral performance data accurately, send out monthly bills to borrowers, encourage borrowers to pay on time, persuade them to catch up if they fall behind, and foreclose and sell the underlying property if all else fails. For these services the bondholder pays the servicer a fee which is a flat percentage of the aggregate unpaid balances of the loans owned by the trust.
Like all businesses, the goal of a servicer is to maximize its profits from the flat fee which is its revenue. The main route to this goal is to minimize its expenses, of which labor comprises approximately 80%.
The owner of the servicer has its own subset of Principal – Agent issues with respect to its employees. The incentives it provides its employees add several layers of complexity to the bondholder – servicer relationship. In this first part, I am going to discuss the effects of Principal – Agent and Owner – Employee relationships on the integrity of the data reported to the bondholder each month, using examples from my past experiences.
By 2001, MBIA, my former employer had about $3 billion of exposure to ten manufactured housing (“MH”) loan pools serviced by an affiliate of the bond issuer. We’ll call it MH Servicer I. In January 2002, MH Servicer I’s parent, had concluded from the rapidly increasing delinquency levels in the MH loan pools that it wanted to be out of the MH financing business. They present-valued MH Servicer I’s assets and liabilities over their remaining 25- to 30-year lives, and carried the net asset value as the residual value of the now discontinued business.
The parent had a problem to solve. How could it retain the management of MH Servicer I over an extended period of time, and how could it motivate the servicer to increase the value of a large run-off pool of badly performing MH loans? The solution was reasonably simple: the management team was awarded above-market base salaries, together with incentive compensation which paid them attractive bonuses if they could increase MH Servicer I’s residual value. If the residual value went up each year, they stood to make a lot of money.
Calculation of the residual value each quarter was performed by an outside vendor, and the methodology was based on delinquency trends. If delinquency went down, the value went up. Because MBIA was at risk if principal and interest collections of the ten trusts were inadequate to pay bondholders, we were delighted to see the elevated delinquency levels go down in 2002. We were happy, that is, until we found out why they were going down.
During a visit to MH Servicer I’s main collection site, I noticed a white message board which was posted with following two suggestions to the collections staff:
- Ask for the payment in full.
- If you can’t get it, offer an extension.
“What’s an extension?” I asked.
“Oh, if a borrower is 90 days past due, offer to extend the next due date by, say, 60 days,” responded a member of MH Servicer I’s staff.
“How is the resulting delinquency reported?”
“Extended borrowers are reported as current until they miss their next payment on the next due date.”
Extensions certainly brought reported delinquency down, while MH Servicer I’s residual value and management’s incentive compensation went up. Extensions also increased the amount of the trust’s non-earning assets without reducing the par value of the trust’s liabilities. This dynamic crushed the credit enhancement of each deal in accelerated fashion, and rendered delinquency reporting useless from an analytic perspective.
We had another $600 million of MH exposure coming from 11 trusts involved in the 2003 bankruptcy of another MH servicer we’ll call MH Servicer II. In this case, the delinquency situation was the reverse of the MH Servicer I story. These trusts issued bonds which were 3- to 5-years old at the time of the filing. Despite a vintage profile similar to the MH Servicer I trusts, the Conseco trusts consistently reported 30+ day delinquency in the 3% range. At least they did so until the month after the bankruptcy filing.
From that point on, delinquency increased each month for over a year, ultimately reaching peaks in the 18% range. I was not privy to the incentive compensation plans provided to MH Servicer II’s management and employees, but it is easy to infer that reported delinquency trends were somehow suppressed (i.e., held down) for several years. Once the bankruptcy filing occurred, delinquency increased to MH Servicer I levels and beyond, until a new management team came on board and began to exert control over the loan pools beginning in late 2003.
The point of these two examples is to illustrate how the Principal – Agent Problem, or its subset, the Owner – Employee Problem, can destroy the integrity of reported collateral performance data over extended periods of time.
The Principal – Agent Problem: Part II – Asymmetric Information
In this second part, I’m going to discuss a different facet of the Principal – Agent problem: asymmetry of information. It is difficult to imagine a business relationship which features greater information asymmetry than that of an RMBS bond investor (owner) and the mortgage loan servicer (agent). In this case, the servicer is in a position to know everything there is to know about each individual loan in the loan pool and its past and expected future performance. The bondholder gets a monthly remittance report from the servicer via the trustee (another problem for another day), and, in some cases, historical loan level data about loan attributes and payment status from the servicer’s website. If he wants anything over and beyond these basics, he has to buy it from third party vendors (e.g., Intex, Bloomberg, CoreLogic, Lewtan).
At the end of the last subprime crisis (circa 1999 – 2001) MBIA found itself doing business with several new replacement servicers. We had to find new replacement servicers in a hurry because the original servicers were affiliates of the subprime issuers. Each of these issuers was in bankruptcy and ultimately in liquidation. The issuers included ContiMortgage, Delta Funding, First Alliance, Southern Pacific Mortgage and American Business Financial Services. Our new servicers included Litton Loan Servicing, Ocwen Financial Services and Fairbanks.
Before getting into the details of various asymmetric situations, a brief discussion of servicer advances is required. Servicers are generally required by the Pooling and Servicing Agreements (“PSAs”) to advance to the trust delinquent principal and interest payments due from but not paid this month by obligors. The servicer is obliged to continue advancing until he deems that the unpaid note balance plus the cumulative advances will exceed the net liquidation value of the underlying property. When the property is liquidated, the servicer is first in line for reimbursement. If the liquidation proceeds do not cover its advances, the servicer then has access to all funds collected by the entire trust in order to recover its “non-recoverable” advances. In this way, the servicer is not at risk of non-payment for its advances.
For its part, the trust receives the servicer advances and applies them to the monthly cash distribution waterfall. However, the trust does not recognize any new liability or note payable to the servicer, and remittance reports often do not report monthly advances and reimbursements.
In 2002, during a routine visit to subprime servicer Fairbanks (now Select Portfolio Servicing), we asked about an amount being billed to a borrower. We were told that it was for interest on a servicer advance. The following exchange ensued.
MBIA: “You can’t charge borrowers (or anyone else) interest on servicer advances.”
Fairbanks: “Where does the PSA say that we can’t?”
While Fairbanks had a point, and the relevant PSAs were silent on interest on advances, they were also silent on the general topic of imposing new costs on borrowers who were having difficulty meeting their monthly mortgage obligations in the first place. It hadn’t occurred to anyone that servicers might pursue various means of parasitizing borrowers and trusts to the direct detriment of RMBS investors.
In 2003 Fairbanks paid the FTC and HUD $40 million to settle charges that it had engaged in “unfair, deceptive, and illegal practices in the servicing of subprime mortgage loans.” Clearly, Fairbanks employees believed they would be rewarded for thinking up new revenue generating ideas, and they certainly showed great ingenuity in these endeavors.
Years later, as MBIA’s insured subprime loan pools liquidated down to relatively small numbers of remaining loans, another anomaly began to show up in the remittance reports. In some cases, trusts began to report negative principal collections on a monthly basis. It is certainly possible that an older trust supported by a small number of (possibly delinquent) loans might have zero principal collections, but how could collections equal some negative number?
In 2008, this was the question MBIA had regarding the subprime servicer reporting the negative collections. Under what circumstances could a trust experience a negative principal collection amount? Several tortuous weeks later, the answer was finally extracted. The subprime servicer was modifying loans in the following fashion:
- First, it found a delinquent borrower willing to sign a new note with a larger unpaid principal balance and a significantly lower interest rate so that the monthly payment would decrease at least a little.
- The amount of the increase in the note balance was equal to the servicer’s cumulative servicer advances to date.
- Because this transaction had the effect of transferring the servicer’s unsecured loan balance to the trust, the servicer advances to the borrower became “non-recoverable”, and the servicer could be reimbursed in the month of the loan modification from the top of the collections waterfall – that is, from all principal collected that month by the trust from all obligors. In this way, the servicer didn’t have to wait until the loan liquidated for reimbursement of its advances.
This particular servicer was the replacement servicer for several subprime deals insured by MBIA. Some of the related PSAs required the servicer to obtain MBIA’s consent to the modification of any loan in the affected trust. As a result, I noted that approximately two thirds of the borrowers I reviewed for modification consent purposes had negative equity 10 years or more after loan origination, and before the addition of the servicer advances to the modified note balance.
These experiences with servicers have led me to believe that the current mortgage market meltdown, documentation deficiencies, robosigning and related foreclosure problems all stem from the same cause: the collapse of any regime of internal controls at some mortgage originators, sellers and servicers resulting from a misalignment of incentives. Once the loan underwriter sells all of its originations, and expects to do so in the future, it concludes that it can do without the internal control provided by things like underwriting guidelines. In fact, it finds that it can dispense with all of its former internal controls, which only cost it money.
Once all internal controls are dispensed with, management and employees pursue the incentives given them by the owners, and you get the fiasco in the mortgage markets we are living with today.
Steve Ruterman is an independent consultant to institutions and institutional investors with significant RMBS exposures and a fan of The Subprime Shakeout. He recently retired after a 14 year career with MBIA Insurance Corporation, during which he transferred over 20 mortgage loan pools to new servicers. Mr. Ruterman welcomes your comments, and can be reached by email at Steve.Ruterman@yahoo.com.