Sarah Bloom Raskin: Putting the low road behind us
Speech by Ms Sarah Bloom Raskin, member of the Board of Governors of the Federal
Reserve System, at the 2011 Midwinter Housing Finance Conference, Park City, Utah,
11 February 2011.
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Good evening. I would like to thank the sponsors of the Midwinter Housing Finance
Conference for kindly inviting me to join you. Tonight, I'm going to share with you some
thoughts about the powerful impact the housing and mortgage markets have on the nation's
economic recovery, present some ideas to effect positive change in the mortgage servicing
industry, and finally impart a guiding principle that should help us find our way through the
current struggles and drive the way our industry operates in the future.
Speaking strictly in an economic sense, the recession that emerged in 2008 is over. But I
know that the millions of Americans still looking for work, living in cars or motels, or trying to
keep their businesses out of bankruptcy would beg to disagree. Our economy is growing, but
the pace of recovery is agonizingly slow, well behind the pace of recovery in prior recessions.
There are several causes for this lethargy, but, in my view, the critically important drag on the
economy is the absence of any substantial recovery in the housing sector. Traditionally,
housing is the first sector to recover after a recession, buoyed by low interest rates and
pentup demand. The increase in housing sales and construction usually is followed by a robust
increase in consumer expenditures on durable goods, like furniture and appliances, which
magnifies and multiplies the effect of the housing recovery.
Yet today, demand for housing is weighted down by the enormous losses in income and net
worth that households suffered in the recession. In addition, the persistent high rate of
unemployment is further depressing housing demand, creating uncertainty about housing
prices, and impeding that robust recovery in the housing sector that we generally see. With a
pipeline full of distressed properties, the unfortunate consensus is that we should expect
even more downward pressure on house prices. Potential buyers seem inclined to wait and
see if they can get a better buy in the future. Builders, too, are deterred by the additional
competition lurking in this reservoir of vacant and distressed properties.
Significantly, uncertainty about house prices destabilizes expectations outside of the housing
sector. When banks have troubled mortgages on their books, they may be required to
increase their loss provisioning and implement troubled debt restructuring, which in turn
reduces the amount of funds they have to lend. Uncertainty about house prices also clearly
undermines consumer confidence and undercuts consumers' willingness to spend.
According to the Census Bureau, homeownership rates have fallen so significantly in recent
years that they have more than wiped out the increase in homeownership that had taken
place between 2000 and 2007. When I think about this statistic, I see not only the drag on
the nation's already-tepid recovery, but the millions of American families who have lost their
homes and their hopes.
When people lose their homes, the impact is felt not only by the homeowners, but by the
broader community: the bonds of community are weakened, business investment is
undermined, homelessness increases, children are uprooted, unemployment deepens, and
even health problems multiply.
I emphasize all this bad news not to dampen the dinner mood here tonight, but to underscore
the importance of the work that you do and to reiterate what we already know: The recovery
of the housing sector is critical to the robust and sustainable recovery of the American
economy. To see the kind of economic recovery we want, we need to revive our housing
sector and restore the communities that were shaken by its collapse.
So what needs to happen now? To begin with, we should start at the ground level and work
with troubled borrowers to prevent additional foreclosures that will further weaken the market.
We need to make certain that foreclosures take place only when there is no option available
that would be preferable to both the borrower and the investor. It is critical for servicers to
review all options on any given delinquent loan before deciding that foreclosure is the best
course of action. Certainly foreclosure cannot be avoided in every case. However, servicers
must identify those instances where both the borrower and the investor would be better off
modifying the loan than foreclosing on it. Some distressed borrowers should be able to
qualify for a modification through Treasury's Home Affordable Mortgage Program (HAMP). If
the HAMP evaluation has been properly done and the borrower still does not qualify, the
servicer should consider all other reasonable alternatives, ranging from proprietary
before
modifications to short sales to deeds-in-lieu-of-foreclosure, filing for foreclosure. And,
for homeowners whose financial distress is the result of job loss, something as simple as
payment forbearance while the homeowner is unemployed could prevent the loan from going
to foreclosure.
Servicing shops need to be diligent in pursuing these options, and investors need to be
supportive of efforts to find net-positive alternatives to foreclosure. These actions will have a
far-reaching positive impact: A lower inventory of distressed properties for sale results in
higher house prices, which leads to a healthier pace of recovery in the housing market and
the broader economy. I can't emphasize enough how important it is that servicers be willing
and diligent in offering assistance to troubled homeowners: It is key to the pace of economic
recovery.
For those in the housing and mortgage fields, making needed changes will not be easy. In
particular, for those in the mortgage servicing industry, it means difficult changes and
significant investments to rectify broken systems. For those servicers who are subsidiaries or
affiliates of a broader parent financial institution, the responsibility for change and further
investment absolutely extends up to that parent company, many of which have enjoyed
substantial profits while their servicing arms have been run on the cheap.
In November, I spoke about the problems in residential mortgage servicing operations that
were undermining the performance of this industry. These problems existed before
November and as far as I can tell they remain unaddressed. How do I know this? Late last
year, the federal banking agencies began a targeted review of loan servicing practices at
large financial institutions that had significant market concentrations in mortgage servicing.
The preliminary results from this review indicate that widespread weaknesses exist in the
servicing industry. The agencies intend to report more specific findings to the public soon,
but I can tell you that these deficiencies pose significant risk to mortgage servicing and
foreclosure processes, impair the functioning of mortgage markets, and diminish overall
accountability to homeowners.
I'm sure this has been said, but I'll say it again because I have seen little to no evidence of
improvement in the operational performance of servicers since the onset of the crisis in 2007:
Until these operational problems are addressed once and for all, the foreclosure crisis will
continue and the housing sector will languish.
What is needed is strong corporate governance procedures for servicers that are
established, monitored, and enforced enterprise-wide in order to prevent process
breakdowns. Servicers need sound policies and procedures that outline the rules, laws,
standards, and processes by which internal operations are assessed. Senior executives
need to emphasize compliance and qualitative measures over short-run cost efficiency, and
need to articulate the presence of adequate quality controls and audit processes to identify
risks and take timely, corrective actions where needed. Corporate leadership needs to
communicate performance expectations that hold all business lines accountable to strong
procedural controls.
If errors occur or internal processes become challenged, servicers must act swiftly and
responsibly to contain the damage to consumers and markets. Going forward, the servicing
industry must foster an operational environment that reflects safe and sound banking
principles and compliance with applicable state and federal law. This is a primary
responsibility of the servicing industry, but regulators now have to be prepared to monitor
servicing functions on an ongoing basis to ensure confidence is restored and take
enforcement actions, when necessary, to address significant failures.
I'm not going to outline for you the consequences of these failures. You know them all too
well. Suffice it to say that when servicers misapply payments, lose paperwork, file incorrect
foreclosure affidavits, or simply do not answer the phone or make available knowledgeable
staffpersons, there are consequences to the consumer. With few adequate remedies to
provide meaningful recourse in the event errors occur - after all, it's not as if consumers
have a choice regarding who does their servicing - many consumers find themselves captive
to practices that have emphasized speed and aggressive timeframes over responsiveness,
accuracy, and completeness.
So something is wrong. Here we are in 2011, looking at high levels of foreclosures on the
horizon, looking at significant failures in process, and nothing much has changed since 2007.
I always thought this dysfunction was going on for too long - but I'm someone who thought
the successive waves of foreclosures in 2007 amounted to a virtual tsunami. In my mind,
massive foreclosures were always a sign of an equally massive market failure. Well, now it
seems to me we have reached a point where this sign of failure is hindering our economy's
ability to rebound.
In addition to improvements that individual servicers need to make, we also have to find a
way to fix broader problems in the industry and make it functional.
In my November remarks, I began the conversation about a flawed business model that
creates misaligned incentives in ways that are more difficult for any one company to change
on its own. So let's talk now a little bit about how a better-functioning servicing industry would
be structured.
One step the industry could take that would have an enormous payoff for consumers and
market participants would be to change its pricing model. The economic incentives and
pressure points of the current servicing model cause problems at multiple levels.
In addition to float income and ancillary fees, servicers earn money through an annual fee on
each loan. This annual servicing fee is an important income source that has to cover some
wildly varying costs. On a performing loan for which costs to servicers are minimal, the
revenue stream from ancillary fees and float may itself be nearly enough to fairly compensate
servicers. But when a loan becomes non-performing, costs start climbing. Costs associated
with collections, loss mitigation, foreclosure, the maintenance and disposition of real-estate
owned properties, and so on, are lumpy and can be high. The current model is structured
with the hope that, over a given period of time, there are enough of the low-touch performing
loans to cross-subsidize the high-touch non-performing ones, so that the overall pool of
servicing fee revenue is sufficient to cover expenses and return a reasonable profit. But if
that doesn't happen, servicers are either being paid too much for their efforts or not enough.
The current model also rests on the expectation that, in good times, servicers are using
some of the residual income to build out systems and procedures to handle the pressures
that come with worse times. Unfortunately, as we have seen, this has not happened.
A better business model - one that might attract more entrants and increase competition -
would more closely tie expenses with compensation and reduce many of the principal-agent
problems that currently exist. Rather than rolling most of the compensation into one annual
fee that covers performing and delinquent loans alike, servicers could be compensated quite
modestly for the routine processing of payments involved with performing assets. They would
be required to have either significant capacity for loss mitigation and the other work involved
with non-performing loans, or business relationships with third parties, such as specialty
servicers, that do. Contracts could spell out a structure wherein the investor would pay
significantly higher and more direct compensation for the more labor-intensive work involved
in delinquent loans, though they would need to be careful not to create perverse incentives to
encourage such delinquencies. There would also need to be much more clarity and
specificity about loss mitigation standards and systems for auditing internal procedures. Such
a system could more appropriately compensate servicers and sub-servicers for the level of
work involved in servicing very different types of loans. Specialists could emerge who focus
primarily on the routine performing loans or the more involved non-performing ones. If the
non-performing specialist was a third party, the existing servicer could either transfer the
servicing rights once a loan hits a certain delinquency trigger, or simply have the loans
subserviced - of course with high levels of accountability - on a fee-for-services basis until
the delinquency is resolved. One structure along these general lines has recently been
proposed by Fannie Mae, Freddie Mac, and Ginnie Mae. While many details would need to
be worked out and possible implications thought through, I believe it is a promising start.
Another structural change that would help would be a limit on the extent to which servicers
have to advance principal and interest on non-performing loans. In times of high delinquency,
this can put considerable financial strain on servicers, which can lead to negative
consequences for consumers trying to work with those stressed servicers. This could be
addressed by changing secondary market standards so that servicers only have to advance
mortgage principal and interest up to, say, 60 or 90 days beyond delinquency. Alternatively,
they could advance principal and interest payments only as they come in - a so-called
"actual/actual" schedule. Either change would affect the payment streams to investors, but I
would imagine that participants in the secondary markets would be able to model with some
confidence how this would affect the value of securities and adjust pricing accordingly.
This means that future pooling and servicing agreements will need to look different than
those of the past. They will need to be much more detailed and provide clarity about what the
servicer can and cannot do. They should explicitly allow for loan modifications and other
nonforeclosure workout actions when they are determined to lead to a smaller loss to the
investor than would a foreclosure. There also needs to be clarity that the servicer is expected
to work in the aggregate best interests of the investor, regardless of tranche. And we need to
find ways to deal with the problems that arise from the conflicting interests of senior and
junior lien interests that can hold up workable alternatives to foreclosure.
Too many of the practices in the mortgage servicing industry have been developed and
defended solely on the basis of "standard industry practice," but many practices were not
only standard but shoddy. This has proven true, I might add, on the underwriting and
secondary market sides of the house, and we are now seeing courts reject some of those
practices. More explicit rules and procedures need to replace standard practices. And these
rules and procedures need to be incorporated into the deals with investors, who will factor
them in to the value they see in the securities.
These are some initial thoughts on how to rebuild an important but currently dysfunctional
sector of the housing market. Surely details need to be worked out, costs accounted for, and
potential unintended consequences thought through. This isn't easy, and time is of the
essence because the drag on our recovery is palpable. We need the incentives that permit
us to reengineer this sector of the market and build a business model that actually works.
That model will need to provide adequate and appropriate compensation for servicers,
protect consumers, give investors what they need, and be sufficiently transparent to all
parties and the public. It needs to be transparent and accountable - one that better aligns the
interests and incentives of homeowners, investors, and servicers. And servicers need to
understand that the homeowner is an important constituent, if for no other reason than that it
is the homeowner who is critical to the revitalization of the housing sector.
In the process of rebuilding, we all have a significant and urgent role to play. The Federal
Reserve Board has acted to provide unprecedented levels of liquidity to the market since the
crisis began through the development of an accommodative monetary policy and the
establishment and implementation of back-stop facilities and last-resort lending. We clearly
need to continue thinking about obstacles that exist in the realm of strong mortgage lending.
There is always more that the Federal Reserve can consider in terms of reforms that are
needed for housing finance, mortgage lending, and mortgage service providers.
But the government can only do so much, and relevant private sector actors need to think
beyond their bottom line and focus on how their firms' actions are or are not contributing to
the economic recovery. I am convinced that, in order for our economic reconstruction to
come about, it will be essential for each of us to commit to furthering the good of our nation,
our neighborhoods, and our fellow citizens.
I do not want to revisit all of the sordid events that brought us to economic crisis in 2008 but,
suffice it to say that, in the housing sector, we traveled a very low road that had nothing to do
with looking out for the greater good. On the contrary, there were too many people in all of
the functional component parts - mortgage brokers, loan originators, loan securitizers,
subprime lenders, Wall Street investment bankers, and rating agencies - who were interested
only in making their own fast profits and were indifferent to the consequences of their actions
for homeowners and communities, much less the nation as a whole. This selfish free-for-all
ultimately led to an economic slide the effects of which are still visible in the boarded-up
houses and sheriffs' foreclosure notices posted all over America.
We pulled back from the brink of depression only through a massive and unprecedented
infusion of public dollars in the banking system, and in other systemically important firms, to
prevent collapse. In other words, the public was forced into a position where it had to put a
lot on the line to save the financial system from its own follies and from total ruin. And many
were bitter about having to do so.
Now, it is time to pay back the American citizenry in full, and not just in the literal sense, but
in the sense that there must be reciprocity and mutuality in our structuring of economic policy
so that we do not travel this low road again. Bluntly stated, the government reluctantly
provided the taxpayer funds necessary to unfreeze the financial markets and get our financial
institutions on their feet again, with the expectation that the benefits would be directly
meaningful to those taxpayers in their households and communities.
The financial institutions that have been bolstered directly and indirectly by government
subsidy and aid must now seek to support those who have been buffeted and injured by the
housing crisis. This must go beyond the corrective actions that need to be taken to rectify
current deficiencies. It means that financial institutions need to understand the effects their
actions will have on consumers and the country as a whole, and factor those considerations
in to their business decisions. This is the high road - a moral and economic imperative that
must be the driving purpose that unifies and animates our efforts. Indeed, the high road
demands that we become effective institutional innovators for positive changes in our
communities and for housing practices that promote community well-being. When we
traveled the low road, the only question was: Will this practice make me rich? Taking the high
road means we continually ask: Do our financial and legal arrangements contribute to the
public welfare and the common good?
Yes, our economy has started to rebound, but we need a strong housing market in order to
ensure a complete, stable, and sustainable recovery. The meltdown in the housing sector set
off our economic crisis, and the reconstruction of the housing sector will help bring it to a
close. Each of you has a role to play in this mission, and I urge you to embrace this
challenge and to do your part to contribute to the economic rebuilding of our country.
Thank you.