A California thrift's experience with mortgage servicing could give banks a reason to reconsider plans to ditch the business despite concerns about new regulations.

Simplicity Bancorp (SMPL) in Covina, Calif., largely credits a decision to bring servicing in-house for its improved asset quality. Delinquencies made up 1.4% of the $867 million-asset company's total mortgages at June 30, compared with 2.5% a year earlier.

Net chargeoffs for Simplicity's fiscal year that ended June 30 were half those of the prior year, at $2.1 million. Nonperforming assets fell 40% at mid-2013 from a year earlier, to $16 million.

Reining in credit is critical to Simplicity, where returns are under pressure as the thrift shrinks its balance sheet. Simplicity's fiscal 2013 earnings fell 14% from a year earlier, to $6.2 million.

Taking over mortgage servicing proved to be the biggest factor behind the thrift's asset quality improvement. Management began to bring those operations in-house after realizing they could do a better job working with borrowers on payments.

"We had a big issue with the collection efforts," Duston Luton, Simplicity's president and chief executive, says. The servicers "were just not collecting."

Servicing is about as basic a task as there is in banking, focusing on collecting payments, paying real estate taxes and making sure borrowers stay current on insurance. It is a low-margin business.

Looming regulatory changes from Basel III, along with rules from the Consumer Financial Protection Bureau set to take effect in January, have motivated a number of banks to sell mortgage-servicing rights.

Formerly Kaiser Federal Financial Group, Simplicity is one of a handful of community banks that have moved in the opposite direction. And the thrift, which was formed in the 1950s as a credit union for employees of the Kaiser Foundation Hospitals in Los Angeles, had to fight to take over its servicing.

As recently as early last year, third parties serviced most of Simplicity's mortgages. Management noticed an alarming trend — nonperforming loans in its mortgage book jumped to 3.3% in 2011 from 1.8% two years earlier.

Outsiders were handling the lion's share of those bad loans. Simplicity decided it wanted to bring those operations in-house, offering to pay fair market value for the servicing rights. But Citigroup (NYSE: C) unit CitiMortgage and Bank of America (BAC) rejected the proposal, Luton says.

In 2010, with delinquencies and credit costs rising, Simplicity filed a lawsuit in against the servicers in an effort to push the issue. In May and November, the servicers independently agreed to sell Simplicity servicing rights on mortgages valued at $128.5 million.

Simplicity did not disclose the transactions' terms. Representatives for Citi and B of A declined to comment.

Simplicity has not yet figured out why Citi and Bank of America fought so strenuously to hold on to a relatively small pool of servicing rights.

"It baffled us," Luton says. The servicers "were just overwhelmed. I think it was costing them more to service the loans than we were paying."

Once it obtained the servicing rights, Simplicity moved quickly to tackle credit issues. It contacted borrowers to collect overdue payments or make alternative arrangements.

In some cases, homeowners who were behind on payments had the funds to bring the accounts current and were eager to pay, but were unable to get in touch with the servicers. "They were just waiting for someone to talk to them," Luton says.

Simplicity also initiated foreclosure proceedings when collection efforts stalled. Over time, asset quality improved.

"The decrease in delinquent loans 60 days or more was primarily due to short sales and pay-offs," Simplicity said in its annual report filed Sept. 10. The filing attributes the improvement to the thrift's ability to wrest servicing from the third-party providers.

To be sure, Simplicity helped dig its own hole. Until 2009, the thrift bought a fair share of loans on the secondary market. It has since started originating most of its mortgages, retaining servicing rights of all of those loans. At June 30, servicers handled just 14% of Simplicity's mortgages, compared to 59% two years earlier.

Simplicity has learned its lesson. For the thrift, servicing is a critical link in its ability to maintain relationship with mortgage customers, Luton says. Most bankers probably agree, but many are being forced to weigh the benefits over handling servicing against rising costs of regulation.

Regulation "is doing nothing but push the costs up," says James Powell, chief executive of Liberty Savings Bank in Wilmington, Ohio. The $577.2 million-asset thrift recently sold servicing rights to 4,600 mortgages to a unit of Taylor Capital Group (TAYC), in part, because Liberty was reluctant to increase its servicing budget.

"We thought we were doing a good job as a servicer," Powell says. "But we felt the investment we were willing to make was going to limit our ability to be efficient going forward."

A number of other banks are making similar choices.

OneWest Bank in Pasadena, Calif., and Ally Financial in Midvale, Utah, have each sold big portfolios of mortgage servicing rights this year, and Wells Fargo (WFC), the nation's biggest mortgage lender, is reported to be looking at selling some servicing.

Basel III and the CFPB have roiled the waters considerably for servicers. Basel III would limit the amount of mortgage servicing rights that can be counted as capital, while new rules issued by the CFPB require, among other things, that servicers notify borrowers at least two months in advance of an interest rate adjustment that would lead to higher payments.

The CFPB's rules also make it more difficult to arrange force-placed insurance coverage when a borrowers' coverage lapses.

The rising cost of compliance is on Luton's mind, though he says that Simplicity has no plans to exit servicing. "We've set ourselves up to be able to do it efficiently," he says.

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