FHFA Narrows Mortgage Servicing Overhaul to Two Very Different Options

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The Federal Housing Finance Agency offered four options for revamping the economics of mortgage servicing earlier this year. Now it's down to two sharply contrasting plans.

Both were described in a white paper on Tuesday. One would tweak the current system by establishing a piggybank to pay for special servicing in the event that a pool of loans runs into trouble. It is akin to a plan proffered by the Mortgage Bankers Association and The Clearing House Association, a trade group for large banks.

The other plan would alter the fundamentals of servicer compensation by replacing the traditional 0.25 percentage point annual fee with a flat payment, combined with a greater reliance on unspecified financial incentives.

The two plans are geared toward the same objective: motivating servicers to put more resources into servicing troubled loans. As critics of the current servicing system have noted, the current 0.25 percentage point earned is typically highly lucrative in good times but woefully inadequate to cover the high costs of properly servicing defaulted loans during bad ones.

Both approaches "would complement the already announced shift towards a performance-based incentive fee for non-performing loans," the FHFA's report states. "Investigations into servicing practices revealed that certain servicers engaged in activities that did not comport with professional standards or, in some cases, with applicable law, regulations, and local rules. … The incentives inherent in the current servicing compensation model contributed to these problems."

The first option in the FHFA report would likely strip around 0.05 percentage points from a servicer's current annual fee, setting it aside in a reserve account for high-cost periods in which loans needed special attention. In the event that the servicing rights were sold, the reserve would accompany become part of the transfer. This model would alter industry compensation but is unlikely to satisfy the servicing industry's harshest critics.

The second option would bring "fundamental changes" to the servicing market by replacing the percentage-based fee with a stipend of perhaps $10 a month, plus unspecified additional incentives on every loan, the FHFA stated. Government sponsored enterprises would still backstop loans, but the warranties currently provided by the servicer would be split between originators and servicers.

The elimination of the commission based on a set percentage of the principal outstanding would have a sizable impact on servicers' internal operations. Currently the commissions are set at a level that is far higher than the actual cost of servicing a performing loan, with most of the standard 0.25 percentage point fee recorded on the servicer's books as an asset that will pay out as long as the borrower stays current and does not refinance. This creates significant volatility in the value of the asset, because the speed at which borrowers refinance is highly dependent on changes in mortgage rates. To mitigate the volatility in the value of the servicing asset, servicers often engage in complicated and sometimes costly hedging transactions.

The FHFA proposal could potentially reduce the need for such hedging. By replacing the 0.25 point fee with a flat stipend whose value is considerably lower, servicers will have less need to hedge. Although servicing margins would fall, servicers would likely make up for the shortfall by earning more from mortgage originations.

The second approach would greatly enlarge the role of Fannie Mae, Freddie Mac, and their FHFA conservator in determining industry compensation, although the $10 fee proposed could be revised and the tailored performance incentives are not specified in the paper. The possibility of major changes — and the prospect of the industry becoming reliant on the government sponsored entities for updates to the payments structure — is likely to unsettle some industry participants.

"We want certainty, not 'trust me, we'll treat you right,' said David Stephens of United Capital Markets, a Denver based mortgage servicing consulting and hedging firm. "If you invest tens of millions of dollars in a servicing operation, the minimum net worth to get into this business is 10 million. So you want certainty before you do that, and that's not offered at all… Given the history of the government setting flat-rate numbers and then never adjusting them again, that's worrisome."

The paper itself notes potential advantages to the more radical option. Doing away with a percentage-based fee and the associated need to manage mortgage servicing rights through hedging in the capital markets would create a simpler business for smaller servicers.

"The financial risk management skills and capital required for [managing mortgage servicing assets] are not core competencies for providing quality servicing," the paper notes.

While the paper devotes considerably more space to the more drastic of the two options for revamping the mortgage servicing market, it does not overtly endorse either. Instead, it requests another round of public comment. Among the questions specifically raised in the paper are the effects of the proposals' changes on competition in the industry, and whether either would result in greater investments in non-performing loans.

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