Sarah Bloom Raskin: Legal opportunities and challenges in crafting a
foreclosure response
Speech by Ms Sarah Bloom Raskin, Member of the Board of Governors of the Federal
Reserve System, at the Maryland State Bar Association Advanced Real Property Institute,
Columbia, Maryland, 4 October 2011.
* * *
Good morning. It's a great pleasure to be with you, and I want to thank the Real Property
section for inviting me to speak at the Advanced Real Property Institute. I have been
immersed at the Federal Reserve in economic analysis, but my first professional language is
the law, so it's a special treat to be before this audience of lawyers today where I can speak
in my native tongue. I'm also excited to be with you this morning because I began my time as
commissioner of financial regulation for the state of Maryland in the heat of the financial
crisis, and I am keenly aware that Maryland's lawyers came together in a show of massive
pro bono strength to help homeowners confronting unprecedented numbers of foreclosures
in the state. I want to recognize the impressive, timely, and trend-setting work that was
performed during the foreclosure crisis here in Maryland. This work continues in various
ways, including most recently the announcement that the state of Maryland will be
participating in the launch of HOPE Loan Port, the country's first web-based foreclosure
mediation portal. Lawyers in Maryland consistently have been on the forefront in supporting
mediation systems to resolve issues between homeowners and servicers.
During my first week as a Federal Reserve governor, the set of mortgage servicing problems
and inequities related to robo-signing hit the national news. While many were surprised by
the news, this is something that we had been dealing with here in Maryland more than three
years ago; as many of you know from having worked on these issues, we had identified
serious servicing problems as early as 2008 in Maryland, had analyzed them quite
extensively, and had crafted some effective legal, administrative, and legislative early
responses. Being rather dismayed that the federal folks believed this to be a new problem,
and concerned that problems with servicing nationwide would hinder the revival of the
housing market and our recovery from recession, I gave a speech advocating a series of
measures at the national and state levels to contain the damage to homeowners in
November 2010. To my dismay, here we are in 2011, with a recovery that is still being
dragged down by serious housing problems that will require not just economic talent - but,
significantly, legal talent - to address.
I want to talk this morning about a couple of those legal challenges. Of course, these
remarks are intended to express my own views, and they do not necessarily reflect the
opinions of my colleagues on the Federal Reserve Board or the Federal Open Market
Committee.
Housing market conditions
Six years after house prices first began to fall, we are still dealing with the aftermath of the
housing bubble. Nationally, house prices have fallen by nearly one-third since their peak in
the first quarter of 2006, and total homeowners' equity in the United States has shrunk by
more than one-half - a loss of more than $7 trillion. This is a shocking and enormous decline.
The drop in house prices has had far-reaching effects on families and the economy, in part
because so many American families - nearly 70 percent - own their homes.1 In contrast,
only about one-half of American families hold any stocks, either directly or through accounts
such as Individual Retirement Accounts, 401(k)s, or mutual funds.2 The fall in house prices
has caused families to cut back on their spending and has prevented families from using
their home equity to fund education expenses or start small businesses. An estimated
3 million families are not able to refinance their mortgages at today's historically low interest
rates because they are underwater on their mortgages.3 And many borrowers have lost their
homes to foreclosure: More than 4 percent of all mortgages in the United States were in
foreclosure, and an additional 3 percent or so were delinquent by 90 days or more in the
second quarter of this year. Initially, when I was commissioner of financial regulation,
foreclosures were concentrated among borrowers with subprime mortgages. But today,
because of the magnitude of the economic downturn and the high level of unemployment,
the typical borrower in foreclosure has a prime or Federal Housing Administration mortgage.
As all of you know, the drop in house prices has put considerable pressure on the legal
system. Of course, the huge wave of foreclosures has strained and sometimes overwhelmed
the courts, particularly in states with judicial foreclosure processes. But in a deeper sense,
the standard contracts that govern mortgage lending, servicing, and securitization did not
account for a potential collapse of this magnitude in the housing sector. As the bubble
expanded, securitization contracts did not provide enough incentive to discourage shoddy
underwriting practices. In the aftermath, the inadequacies of servicing contracts have
contributed to the agonizingly slow pace of mortgage modifications and repeated
breakdowns in the foreclosure process.
Prior to the crisis, the nation's mortgage finance system developed into an extensive set of
specialized industry players with a complex set of linkages operating not just at the lender
and borrower level, but also with an extensive secondary market that was intended to diffuse
risk. All of these relationships were governed by contracts. The promissory note, for
example, lays out the terms under which the borrower will repay the loan, while the mortgage
reflects the lender's security interest in the property. But there are also contracts between the
borrower and third parties and between the lender and third parties. For example, the
borrower likely will enter agreements for title, flood, or private mortgage insurance, while the
lender may enter an agreement with another institution to service the loan. Add mortgage
securitization to the mix, and the number of contractual relationships snowballs. For a
private-label securitization, a crucial contract is the pooling and servicing agreement, or PSA,
which specifies matters such as the characteristics of the mortgages in the pool, how these
mortgages will be serviced, and how the money generated from the loans will be distributed
to investors. At nearly every linkage of our mortgage finance system there is a contractual
relationship, and at nearly every contractual linkage there has been legal challenge and
litigation.
For example, let's just zero in on one such contractual relationship and examine how the
legal structure set forth in this relationship has held up. First, let's look at the provisions that
govern mortgage servicing, and second, the provisions that lay out the representations and
warranties about the features and underwriting quality of the loans included in the
securitization. Both sets of provisions exist in the contract that governs the securitization, the
PSA.
Mortgage servicing
The problems in mortgage servicing have been well documented. For example, the federal
banking regulators found significant problems when we looked at mortgage servicing and
foreclosure processing at 14 federally regulated mortgage servicers, which collectively
represent more than two-thirds of all servicing volume nationally. These problems include
critical weaknesses in servicers' foreclosure governance processes, foreclosure document
preparation processes, and oversight and monitoring of third-party law firms and other
vendors. These problems indicate the existence of unsafe and unsound banking practices
and violations of federal and state laws, as well as demonstrated patterns of misconduct and
negligence on the part of servicers. Individual consumers have been harmed by this
negligence, including the negligence of law firms. In addition, the imperative for servicers to
fix their systems, review past decisions, and put in place the internal systems and controls
that they should have had all along has impeded the repair of the overall housing market.
The burden of addressing these issues of repair, review, and implementation of systems and
controls rests with the mortgage servicers, their parent financial institutions, and the law firms
that mishandled the foreclosures. But what do the terms of the PSA, which is the standard
contract governing this work, require in this context? The standard servicing contract
provides disincentives for servicers to act in the best interests of investors and borrowers.
This misalignment of incentives has more profound consequences when defaults are high.
Under the standard contract, servicers receive a flat fee per loan that they service, usually
1/4 to 1/2 percent of the unpaid loan balance annually, depending on the type of loan. The
flat fee is considerably more than is required to service a performing loan and considerably
less than is required to service a delinquent loan. The expectation is that, on average, the fee
will cover the servicer's expenses. Servicers are also reimbursed for some expenses, such
as the cost of a title search when pursuing a foreclosure, but generally not for unanticipated
overhead or labor costs.
The PSA aligns the incentives of borrowers, servicers, and investors reasonably well when
mortgage defaults are low. Under normal circumstances, mortgage servicing is profitable. A
servicer primarily processes mortgage payments and minimizes labor and overhead costs by
harnessing economies of scale and automating the process as much as possible.
The PSA does not perform nearly as well under stressed circumstances. When mortgage
delinquencies are high, mortgage servicing is not profitable, and servicers may feel extra
pressure to cut costs as much as possible. In addition, servicers may not be properly
motivated to perform loan modifications even when such modifications are in the best
interests of borrowers and investors. Servicer compensation is not generally tied to the
performance of the loan, and in most cases a servicer receives no extra payment for
preventing a default. Further, loan modifications are labor intensive, and this extra labor cost
is not reimbursed under the contract. Instead, the PSA provides for the reimbursement of
some foreclosure expenses.
Other language in the contract also does little to encourage loan modifications, particularly in
the case of securitized mortgages. Many PSAs provide minimal guidance about
modifications beyond specifying that servicers should apply "usual and normal" servicing
standards or the same standards that they apply to the loans held in portfolio. With such
vague guidance, servicers assert that they are worried about litigation risk if they employ
servicing approaches that have not been widely adopted throughout the industry.
Furthermore, even when the PSAs provide guidance about loan modifications, it can differ
widely across PSAs, often preventing servicers from designing a uniform modification
program for their entire portfolio.
To borrow from the title of a popular marital advice column, Can this contract be saved? I
think the answer is no - at least not in its current form. This contract might have been
adequate if servicers had followed the age-old advice and used their profits from the fat
years when defaults were low in order to build their capacity for lean years when defaults
were high. But in practice, this does not appear to have happened - and perhaps even the
most knowing servicer a few years ago might not have anticipated the subsequent level of
mortgage defaults.
Given that failure, it is imperative to reconsider the compensation structure so that servicers
have adequate incentives to perform payment processing efficiently on performing
mortgages, and to perform effective loss mitigation on delinquent loans. After the
compensation structure is reconsidered, the PSAs need to be amended or renegotiated in
order to facilitate more workouts. Finally, PSAs should clarify the situations in which loan
modifications and other mitigation strategies should be pursued. One tool that could aid in
providing such clarity, and has received substantial attention over the last few years, is the
net present value model. Requiring servicers to take mitigative actions that are
net-presentvalue positive to the investor could encourage the fair and consistent treatment of borrowers.
Investors also need tools that will allow them to better monitor servicer performance and take
action accordingly. These tools should be developed and described in the contract.
Currently, metrics that allow investors to measure servicers' execution are not widely
available. Such metrics could include customer satisfaction ratings, delinquency and cure
rates, the average time that a homeowner waits on the phone to talk with the servicer, and
servicer error rates. Indeed, one can even imagine the development of a uniform servicer
scorecard. To be meaningful, the ability to transfer servicing from low-performing servicers to
high-performing ones would have to be enhanced. The creation of common back-office
systems across servicers would make transfer less prone to error and less costly, and any
contractual or legal barriers would need to be reduced to allow investors to "fire" a
lowperforming servicer. A new contractual regime designed along these lines would represent a
significant change from the existing world of servicing, but it could help create a system in
which servicers compete on the quality of their performance and are more accountable to
both investors and consumers.
Representations and warranties
I turn next to the problem of representations and warranties contained in the PSAs.
Underwriting standards declined dramatically in the middle part of the previous decade as
the housing bubble approached its peak. For example, the median combined loan-to-value
ratio on subprime mortgages originated for home purchases rose from 90 percent in 2003 to
100 percent in 2005 - meaning that more than one-half of borrowers who purchased homes
with subprime mortgages put no money down. The share of mortgages in which borrowers
did not document fully their income or assets also increased. In addition, the number of
mortgages that defaulted in the first year after origination - commonly considered a gauge of
poor underwriting - rose appreciably as the bubble approached its peak.4
The "originate to distribute" model of loan origination may have contributed to this decline in
underwriting standards. Under this model, brokers or lenders sell the loan to a third party,
typically a securitizer, who then issues securities collateralized by mortgage loans to
investors. This model technically describes securities guaranteed by Fannie Mae and
Freddie Mac as well as private-label securities sponsored by financial institutions such as
commercial or investment banks, but problems were more acute in the private-label market.
Although the private-label originate-to-distribute model may have worked adequately at first,
this discipline eroded as the securitization boom progressed. Originators and securitizers
were generally able to complete securitization transactions while retaining very little or no
economic stake in the performance of the loan after the sale, although some of these
securities did ultimately make their way back onto the balance sheets of certain financial
conglomerates, much to their dismay. As a result, originators and securitizers had an
increasing incentive to weaken underwriting standards in order to increase the volume of
loan origination, and thereby the volume of securitizations.
As securitization developed and became more prominent as a source of financing for
mortgage lending, representations and warranties were one of the main tools market
participants relied on to align incentives among originators and securitizers on the one hand
and investors on the other. These provisions describe the underwriting standards and other
matters with respect to the assets that are the subject of the securitization. The originator, in
principle, is required to refund at par (less payments received) the value of the loan should it
violate the originator's representations and warranties or in some cases, should it default
within a specified time from origination. In practice, however, representations and warranties
did not function as intended.
First, as in the case of servicing, contracts in private-label mortgage securitizations varied
considerably from deal to deal, and there was no consistent language or standard for
representations and warranties. Therefore, a poorly underwritten mortgage loan could breach
the representations and warranties of one deal's contract but not be a violation of
representations and warranties in another very similar deal; this discrepancy would only be
apparent following a careful reading and nuanced comparison of the differences in drafting
between the two contracts. Given the volume of transactions investors were considering, it is
not surprising that they may not have conducted a thorough analysis of the different risks
each set of representations and warranties presented. Second, the lack of standardization of
representations and warranties gives rise to greater opportunity for parties in a failed
securitization transaction to argue over the interpretation of contract terms, increasing legal
uncertainty and making effective resolution of investor claims more difficult. Finally, in order
to enforce their representations and warranties, investors may need to band together in
groups representing 25 percent or more of the voting rights in order to make certain
demands upon the securitization trustee. Investors may be dispersed and have difficulty
coordinating their actions.
The flaws in the representations and warranties provisions of the PSAs appear to be widely
recognized. For example, many key players in the securitization industry have worked
through Project RESTART, an initiative of the American Securitization Forum (ASF), to
create an industry standard for representations and warranties that covers prudent practices
and is commonly understood by all market participants.5 The ASF has also published model
principles for repurchasing mortgage loans that breach representation warranties to provide
a standard industry PSA enforcement mechanism.6 I believe that these are useful
developments and should promote greater consistency in governing contracts of mortgage
securitizations in the future, thereby facilitating investor monitoring of underwriting standards
and setting common expectations for resolution of breaches of representations and
warranties when they occur.
Nevertheless, standard representations and warranties, no matter how well drafted, are
unlikely on their own, or even in combination with a well-constructed enforcement standard,
to go far enough to resolve the crucial problems of misaligned incentives and disparities in
access to information in the securitization process. During lending and asset booms, there is
a temptation for market participants to collectively allow underwriting standards to weaken in
order to meet a market demand for increased lending. When a crisis then occurs,
bankruptcies of originators and securitizers of mortgages may prevent investors in practice
from obtaining restitution for breaches of representations and warranties.
Thus, other contractual mechanisms are also required to promote a healthy and properly
aligned securitization market. For instance, comprehensive disclosures about the mortgage
loans being securitized are vital to ensure that investors are able to conduct meaningful due
diligence prior to making a decision to invest in a securitization. They are also vital to
investors' ongoing monitoring of the servicing and administration of securitization
transactions. The work of the Securities and Exchange Commission to revise securitization
disclosures is particularly important and should significantly contribute to improving the flow
of information in securitization markets.7
Conclusion
The period since the onset of the financial crisis has been described as one of the worst
economic episodes since the Great Depression, which was another time of tremendous
strain on the housing market. House prices declined about 30 percent from peak to trough,
and the homeownership rate, as recorded by the decennial census, fell from 48 percent in
1930 to 44 percent in 1940. Nonfarm mortgage foreclosures reached a thousand per day in
1933, and, in fact, foreclosures were so widespread that 28 states imposed foreclosure
moratoriums. Mortgage lending was disrupted, and private mortgage insurance companies
and private mortgage securitization collapsed.
One factor in the upheaval in mortgage lending was the mortgage contract. Before the Great
Depression, the long-term fully amortized contract had not yet been widely adopted. Instead,
one common contract featured a short maturity, generally five years or less, and often did not
call for any regular payments on the principal. A borrower was likely to default at the end of
the loan term if he was not able to roll over the loan or obtain a new loan to pay off the
existing balance. This contract also made it difficult to assess the health of financial
institutions, as lenders booked the loans as short-term exposures when the risk was actually
much longer term. One contemporary source called the contract "a menace."8
After the Great Depression, fully amortizing loans with maturities of 15 years or longer
became the standard. Federal policy appears to have been a key factor in this transition.
First, the Home Owners' Loan Corporation - a sort of precursor to today's Making Home
Affordable program - purchased distressed mortgages and modified them into loans that
amortized for 15 years or longer.9 Second, the newly created Federal Housing Administration
sold insurance on 20-year fully amortizing loans. Third, savings and loans with new federal
charters were required to make fully amortizing loans except when state law forbade it.
The challenge for us today, as I see it, is to emulate our predecessors from the 1930s who
dealt with a comparable crisis. We need to consider our current array of mortgage contracts
with a dispassionate eye and open mind. If the contracts today are not working - and the
7
See Disclosure of Asset-Backed Securities Required by Section 943 of the Dodd-Frank Wall Street Reform
and Consumer Protection Act, 76 Fed. Reg. 4489 (Jan. 26, 2011) (to be codified at 17 C.F.R. pts. 229, 232,
240, and 249). In addition, the risk retention requirements of section 941 of the Dodd-Frank Wall Street
Reform and Consumer Protection Act are also important to a comprehensive effort to align incentives in the
securitization markets in order to promote sound underwriting. By requiring securitizers to retain a share of the
economic risk in the mortgages they securitize from the outset of the transaction, the requirement creates
incentives for securitizers to better monitor the credit quality of assets they securitize and ultimately
discourages unsafe and unsound underwriting practices by originators.
8
See Morton Bodfish and A.D. Theobald (1938), Savings and Loan Principles (New York: Prentice-Hall),
p. 175.
9
See Jonathan D. Rose (2011), "The Incredible HOLC? Mortgage Relief during the Great Depression," Journal
of Money, Credit and Banking, vol. 43 (6), pp. 1073-107.
evidence seems clear to me that, along some dimensions, they are not - we as lawyers
should be working on ways to improve them. Without such improvements you may not be
serving your clients, and from the perspective of the macroeconomy, none of us will be
contributing to a reconstruction of the legal framework in the crucial context of mortgage
finance. Lawyers have a singular responsibility and exceptional ability to help rebuild this
framework, and I urge you to consider how you can contribute to the effort of renegotiating
these relationships and how the terms of such a renegotiation might become memorialized in
contracts. This is a massive challenge for lawyers who practice in the field of mortgage
finance and your country needs you to tackle it with the same vigor and energy that you have
brought to other legal challenges in this housing crisis.
Cicero said that "the safety of the people should be the highest law." Our people will not be
financially safe until we re-examine and re-set the terms that define relationships in the
housing market. So we have a serious challenge ahead of us. It's a challenge that I have
confidence we can meet with your help.
Thank you, and I'm happy to take your questions and hear your comments.