Mortgage Foreclosures: Documentation Problems Reveal Need for Ongoing Regulatory Oversight
Released: 2011-05-12T00:00:00

Letter

Background

The origination, securitization, and servicing of mortgage loans involve multiple entities. In recent years, originating lenders generally have sold or assigned their interest in loans to other financial institutions to securitize the mortgages. Through securitization, the purchasers of these mortgages then package them into pools and issue securities for which the mortgages serve as collateral. These mortgage-backed securities (MBS) pay interest and principal to their investors, such as other financial institutions, pension funds, or mutual funds. After an originator sells its loans, another entity is usually appointed as the servicer. Servicing duties can involve sending borrowers monthly account statements, answering customer service inquiries, collecting mortgage payments, maintaining escrow accounts for taxes and insurance, and forwarding payments to the mortgage owners. If a borrower becomes delinquent on loan payments, servicers also initiate and conduct a foreclosure in order to obtain the proceeds from the sale of the property on behalf of the owner of the loan. Any legal action such as foreclosure that a servicer takes generally may be brought in the name and on behalf of the securitization trust, which is the legal owner of record of the mortgage loans.

Several federal agencies share responsibility for regulating activities of the banking industry that relate to the originating and servicing of mortgage loans (see table 1). Upon assumption of its full authorities on July 21, 2011, CFPB also will have authority to regulate mortgage servicers with respect to federal consumer financial law. Other agencies also oversee certain aspects of U.S. mortgage markets but do not have supervisory authority over mortgage servicers.

Federal Laws Generally Do Not Address the Foreclosure Process, and Past Federal Oversight of Foreclosure Activities Has Been Limited and Fragmented

Because state laws primarily govern foreclosure, federal laws related to mortgage lending focus on protecting consumers at mortgage origination and during the life of a loan but not necessarily during foreclosure. Federal consumer protection laws, such as the Truth in Lending Act (TILA) and the Real Estate Settlement Procedures Act of 1974 (RESPA), address some aspects of servicers’ interactions with borrowers. For example, these laws require servicers to provide certain notifications and disclosures to borrowers or respond to certain written requests for information within specified times, but they do not include specific requirements for servicers to follow when executing a foreclosure. According to Federal Reserve officials, in addition to federal bankruptcy laws, federal laws that address foreclosure processing specifically are the Protecting Tenants at Foreclosure Act of 2009, which protects certain tenants from immediate eviction by new owners who acquire residential property through foreclosure, and the Servicemembers Civil Relief Act, which restricts foreclosure of properties owned by active duty members of the military.

Banking regulators oversee most entities that conduct mortgage servicing, but their oversight of foreclosure activities generally has been limited. As part of their mission to ensure the safety and soundness of these institutions, the regulators have the authority to review any aspect of their activities, including mortgage servicing and compliance with applicable state laws. However, the extent to which regulators have reviewed the foreclosure activities of banks or banking subsidiaries that perform mortgage servicing has been limited because these practices generally were not considered as posing a high risk to safety and soundness. According to OCC and Federal Reserve staff, they conduct risk-based examinations that focus on areas of greatest risk to their institutions’ financial positions, as well as some other areas of potential concern, such as consumer complaints. Servicers generally manage loans that other entities own or hold, and are not exposed to significant losses if these loans become delinquent. Because regulators generally determined that the safety and soundness risks from mortgage servicing were low, they have not regularly examined servicers’ foreclosure practices on a loan- level basis.

Oversight also has been fragmented, and not all servicers have been overseen by federal banking regulators. At the federal level, multiple agencies—including OCC, the Federal Reserve, OTS, and FDIC—have regulatory responsibility for most of the institutions that conduct mortgage servicing, but until recently, some nonbank institutions have not had a primary federal or state regulator. Many federally regulated bank holding companies that have insured depository subsidiaries, such as national or state-chartered banks, may have nonbank subsidiaries such as mortgage finance companies. Under the Bank Holding Company Act of 1956, as amended, the Federal Reserve has jurisdiction over such bank holding companies and their nonbank subsidiaries that are not regulated by another functional regulator. Until recently the Federal Reserve generally had not included the nonbank subsidiaries in its examination activity because their activities were not considered to pose material risks to the bank holding companies. In some cases, nonbank entities that service mortgage loans are not affiliated with financial institutions at all, and therefore were not subject to oversight by one of the federal banking regulators. In our 2009 report on how the U.S. financial regulatory system had not kept pace with the major developments in recent decades, we noted that the varying levels or lack of oversight for nonbank institutions that originated mortgages created problems for consumers or posed risks to regulated institutions.

While Federal Regulators Conducted Reviews in Response to Reported Problems, Future Oversight and Servicing Standards Have Yet to Be Determined

In response to disclosed problems with foreclosure documentation, banking regulators conducted coordinated on-site reviews of foreclosure processes at 14 mortgage servicers. Generally, these examinations revealed severe deficiencies in the preparation of foreclosure documentation and with the oversight of internal foreclosure processes and the activities of external third-party vendors. Examiners generally found in the files they reviewed that borrowers were seriously delinquent on the payments on their loans and that the servicers had the documents necessary to demonstrate their authority to foreclose. However, examiners or internal servicer reviews of foreclosure loan files identified a limited number of cases in which foreclosures should not have proceeded even though the borrower was seriously delinquent. These cases include foreclosure proceedings against a borrower who had received a loan modification or against military service members on active duty, in violation of the Servicemembers Civil Relief Act.

As a result of these reviews, the regulators issued enforcement actions requiring servicers to improve foreclosure practices. Regulators plan to assess compliance but have not fully developed plans for the extent of future oversight. According to the regulators’ report on their coordinated review, they help ensure that servicers take corrective actions and fully implement enforcement orders. While regulatory staff recognized that additional oversight of foreclosure activities would likely be necessary in the future, as of April 2011 they had not determined what changes would be made to guidance or to the extent and frequency of examinations. Moreover, regulators with whom we spoke expressed uncertainty about how their organizations would interact and share responsibility with the newly created CFPB regarding oversight of mortgage servicing activities. According to regulatory staff and the staff setting up CFPB, the agencies intend to coordinate oversight of mortgage servicing activities as CFPB assumes its authorities in the coming months. CFPB staff added that supervision of mortgage servicing will be a priority for the new agency. However, as of April 2011 CFPB’s oversight plans had not been finalized. As we stated in our report, fragmentation among the various entities responsible for overseeing mortgage servicers heightens the importance of coordinating plans for future oversight. Until such plans are developed, the potential for continued fragmentation and gaps in oversight remains.

In our report, we recommend that the regulators and CFPB develop and coordinate plans for ongoing oversight and establish clear goals, roles, and timelines for overseeing mortgage servicers under their respective jurisdiction. In written comments on the report, the agencies generally agreed with our recommendation and said that they would continue to oversee servicers’ foreclosure processes. In addition, CFPB noted that it has already been engaged in discussions with various federal agencies to coordinate oversight responsibilities.

As part of addressing the problems associated with mortgage servicing, including those relating to customer service, loan modifications, and other issues, various market participants and federal agencies have begun calling for the creation of national servicing standards, but the extent to which any final standards would address foreclosure documentation and processing is unclear. A December 2010 letter from a group of academics, industry association representatives, and others to the financial regulators noted that such standards are needed to ensure appropriate servicing for all loans, including in MBS issuances and those held in portfolios of the originating institution or by other owners. This letter outlined various areas that such standards could address, including those requirements that servicers attest that foreclosure processes comply with applicable laws and pursue loan modifications whenever economically feasible.

Similarly, some regulators have stated their support of national servicing standards. For example, OCC has developed draft standards, and in his February 2011 testimony, the Acting Comptroller of the Currency expressed support for such standards, noting that they should provide the same safeguards for all consumers and should apply uniformly to all servicers. He further stated that standards should require servicers to have strong foreclosure governance processes that ensure compliance with all legal standards and documentation requirements and establish effective oversight of third-party vendors. A member of the Board of Governors of the Federal Reserve System testified that consideration of national standards for mortgage servicers was warranted, and FDIC’s Chairman urged servicers and federal and state regulators in a recent speech to create national servicing standards. Most of the regulators with whom we spoke indicated that national servicing standards could be beneficial. For example, staff from one of the regulators said that the standards would create clear expectations for all servicers, including nonbank entities not overseen by the banking regulators, and would help establish consistency across the servicing industry. The regulators’ report on the coordinated review also states that such standards would help promote accountability and ways of appropriately dealing with consumers and strengthen the housing finance market.

Although various agencies have begun discussing the development of national servicing standards, the content of such standards and how they would be implemented is yet to be determined. According to CFPB staff, whatever the outcome of the interagency negotiations, CFPB will have substantial rulemaking authority over servicing and under the Dodd-Frank Act is required to issue certain rules on servicing by January 2013. We reported that problems involving financial institutions and consumers could increase when activities are not subject to consistent oversight and regulatory expectations. Including specific expectations regarding foreclosure practices in any standards that are developed could help ensure more uniform practices and oversight in this area. To help ensure strong and robust oversight of all mortgage servicers, we recommended that the banking regulators and CFPB include standards for foreclosure practices if national servicing standards are created.

In written comments on our report, the agencies generally agreed with this recommendation, and most provided additional details about the ongoing interagency efforts to develop servicing standards. For example, OCC noted that ongoing efforts to develop national servicing standards are intended to include provisions covering both foreclosure abeyance and foreclosure governance. OCC added that the standards, although still a work in progress, will emphasize communication with the borrower and compliance with legal requirements, documentation, vendor management, and other controls. The Federal Reserve commented that the intent of the interagency effort was to address the problems found in the servicing industry, including in foreclosure processing, and coordinate the efforts of the multiple regulatory agencies to ensure that consumers will be treated properly and consistently. FDIC noted that the agency successfully proposed the inclusion of loan servicing standards in the proposed rules to implement the securitization risk retention requirements of the Dodd- Frank Act. FDIC also noted that any servicing standards should align incentives between servicers and investors and ensure that appropriate loss mitigation activities are considered when borrowers experience financial difficulties. CFPB said it has effective authority to adopt national mortgage servicing rules for all mortgage servicers, including those for which CFPB does not have supervisory authority. Finally, Treasury said it has been closely engaged with the interagency group reviewing errors in mortgage servicing and that it supports national servicing standards that align incentives and provide clarity and consistency to borrowers and investors for their treatment by servicers.

While Documentation Problems Likely Will Result in Delays in the Foreclosure Process, the Impact on Financial Institutions and Others Is Less Clear

To date, a key impact of the problems relating to affidavits and notarization of mortgage foreclosure documents appears to be delays in the rate at which foreclosures proceed. Despite these initial delays, some regulatory officials, legal academics, and industry officials we interviewed indicated that foreclosure documentation issues were correctable. Once servicers have revised their processes and corrected documentation errors, most delayed foreclosures in states that require court action likely will proceed.

The implications for borrowers could be mixed, but delays in the foreclosure process could exacerbate the impacts of vacant properties and affect recovery of housing prices. Borrowers whose mortgage loans are in default may benefit from the delays if the additional time allows them to obtain income that allows them to bring mortgage payments current, cure the default, or work out loan modifications. However, according to legal services attorneys we interviewed, these delays leave borrowers unsure about how long they could remain in their homes. And borrowers still might be subject to new foreclosure proceedings if banks assembled the necessary paperwork and resubmitted the cases. Communities could experience negative impacts from delayed foreclosures as more properties might become vacant. We reported that neighborhood and community problems stemming from vacancies include heightened crime, blight, and declining property values, and increased costs to local governments for policing and securing properties. Delays in the foreclosures process, although temporary, could exacerbate these problems. Various market observers and regulators indicated that the delays could negatively affect the recovery of U.S. housing prices in the long term. According to one rating agency’s analysis, market recovery could be delayed as servicers work through the backlog of homes in foreclosure. Regulators also reported that delays could be an impediment for communities working to stabilize local neighborhoods and housing markets, and could lead to extended periods of depressed home prices.

Impacts on servicers, trusts, and investors because of loan transfer documentation problems were unclear. Some academics and others have argued that the way that mortgage loans were transferred in connection with some MBS issuances could affect servicers’ ability to complete foreclosures and create financial liabilities for other entities, such as those involved in creating securities. According to these academics, a servicer may not be able to prove its right to foreclose on a property if the trust on whose behalf it is servicing the loan is not specifically named in the loan transfer documentation. In addition, we note in our report that stakeholders we interviewed said that investors in the MBS issuance may press legal claims against the creators of the trusts or force reimbursements, or repurchases. Conversely, other market participants argue that mortgages were pooled into securities using standard industry practices that were sufficient to create legal ownership on behalf of MBS trusts. According to these participants, the practices that were typically used to transfer loans into private label MBS trusts comply with the Uniform Commercial Code, which generally has been adopted in every state. As a result, they argue that the transfers were legally sufficient to establish the trusts’ ownership. Although some courts may have addressed transfer practices in certain contexts, the impact of the problems likely will remain uncertain until courts issue definitive, controlling decisions. In the near term, industry observers and regulators noted that these cases and other weaknesses in foreclosure processes could lead to increased litigation and servicing costs for servicers, more foreclosure delays, and investor claims.

Although tasked with overseeing the financial safety and soundness of institutions under their jurisdiction, the banking regulators have not fully assessed the extent to which MBS loan transfer problems could affect their institutions financially. According to staff at one of the regulators, as part of the coordinated review, examiners did not always verify that loan files included accurate documentation of all previous note and mortgage transfers—leaving open the possibility that transfer problems exist in the files they reviewed. The enforcement orders resulting from the coordinated review require servicers to retain an independent firm to assess these risks. Regulators will more frequently monitor these servicers until they have corrected the identified weaknesses; however, the regulators have not definitively determined how transfer problems might financially affect other institutions they regulate, including any of the institutions involved in the creation of private label MBS. With almost $1.3 trillion in private label securities outstanding as of the end of 2010, the institutions and the overall financial system could face significant risks.

To reduce the likelihood that problems with transfer documentation could pose a risk to the financial system, we recommended that the banking regulators assess the risks of potential litigation or repurchases due to improper mortgage loan transfer documentation on institutions under their jurisdiction and require that the institutions act to mitigate the risks, if warranted. Completing the risk assessments and fully ensuring that regulated institutions proactively address the risks could reduce the potential threat to the soundness of these institutions, the deposit insurance fund, and the overall financial system. In written comments on a draft of our report, the regulators generally agreed with or did not comment on this recommendation. For example, FDIC strongly supported this recommendation and noted its particular interest in protecting the deposit insurance fund. In addition, the Federal Reserve said that it has conducted a detailed evaluation of the risk of potential litigation or repurchases to the financial institutions it supervises and will continue to monitor these issues.

Chairman Menendez, Ranking Member DeMint, and members of the subcommittee, this completes my prepared statement. I would be happy to respond to any questions you may have at this time.

Contacts and Staff Acknowledgments

If you or your staff have any questions about matters discussed in this testimony, please contact A. Nicole Clowers at (202) 512-4010 or clowersa@gao.gov. Other key contributors to this testimony include Cody Goebel (Assistant Director), Beth Garcia, Jill Naamane, and Linda Rego.

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