FDIC Chair Calls for Commission to Settle Foreclosure Errors

Federal Deposit Insurance Corporation (FDIC) Chairman Sheila C. Bair called today for a "foreclosure claims commission" to address complaints from homeowners who have been harmed by flaws in the foreclosure process.  This was one of several improvements suggested by Bair, an outspoken critic of the servicing industry, at a "summit" on Mortgage Servicing for the 21st Century sponsored by the Mortgage Bankers Association (MBA).

Bair said that throughout the mortgage crisis "the most persistent adversary has been inertia in the servicing and foreclosure practices applied to problem loans," and that prompt action to modify unaffordable subprime loans in 2007 could have helped to limit the crisis in its early stages.   Still, 18 months into an economic recovery and with hundreds of thousands of mortgage modifications completed, "mortgage markets remain deeply mired in a cycle of credit distress, securitization markets remain frozen, and now chaos in mortgage servicing and foreclosure is introducing a dangerous new uncertainty into this fragile market."

Bair spoke, as she has several times in recent months, of misaligned incentives in the servicing business model which she said drove the origination of trillions of dollars of unaffordable subprime and Alt-A mortgages that triggered the crisis.  Now, she said, the fixed fee structure based on volume does not provide sufficient incentives to effective manage large volume of problem loans during a period of crisis.  "Mortgage servicers have remained behind the curve as the problem has evolved to include underwater mortgages and, now, foreclosure practices that sow confusion and fear on the part of homeowners and fail to fully conform to state and local legal requirements."

This compensation structure drove automation, cost cutting, and consolidation to the point where the market share of the top five servicers has gone from 32 percent to almost 60 percent since 2000.  "When mortgage defaults began to mount in 2007 and 2008, third-party servicers were left without the expertise, the contractual flexibility, the financial incentive, or the resources they needed to engage in effective loss-mitigation programs."

Responding to the crisis, Bair said, requires all parties involved to recognize that loss mitigation is not just socially desirable, it is wholly consistent with safe and sound banking and has macroeconomic consequences.  "The bottom line is that we need more modifications and fewer foreclosures. When foreclosure is unavoidable, we need it to be done with all fairness to the borrower and in accordance with the law. Only by committing to these principles can we begin to move past the foreclosure crisis and rebuild confidence in our housing and mortgage markets.

The foreclosure claims commission envisioned by Bair would follow the model used to settle claims arising out of the BP oil spill and the events of 9/11.  It would be set up and funded by servicers to address claims submitted by homeowners who have wrongly suffered foreclosure through servicing errors.  Bair said that many in the servicing industry will resist such a settlement because of the immediate financial cost, "but every time servicers have delayed needed changes to minimize their short-term costs, they have seen a deepening of the crisis that has cost them - and the rest of us - even more."

In addition to the commission, Bair outlined a number of other actions and changes she believes should be made.

• Establish enforceable requirements that will improve opportunities for homeowners to avoid foreclosure, including a single well trained and adequately compensated human point of contact for ever borrower; one with access to relevant information and authority to table the foreclosure process while loss-mitigation efforts are going on.

• Require servicers to staff and train for effective less mitigation with industry benchmarks for maximum case load and minimum standards of training.

• Manage conflicts of interest arising out of second-lien situations. She suggests developing a fixed formula to govern the treatment of first and second mortgages when the servicer or its affiliate owns the second lien. The formula would, at a minimum, require the subordinate lien to be reduced pro-rata to any change in the first mortgage.

• Give borrowers the right to appeal any adverse denial of a loan modification request to an independent third party with power to correct erroneous determinations.

• Stop weak practices associated with title documentation including requiring banks and other servicers to foreclose in their own rather than MERS name and provide complete chain of title in the notice of default.

• Address those flaws in financial incentives that are not embedded in contracts and thus alterable. For example, a broad settlement could eliminate incentive payments to law firms for speedy foreclosures, prohibit foreclosures when a loan is in loss mitigation and stop the unwarranted use of lost-note affidavits.

Going forward, Bair said that the misalignment of servicing incentives must be addressed.  Regulators must use their existing powers and new ones granted under the Dodd-Frank Act to establish standards to address incentives as the private securitization market returns.  She cited as examples steps that FDIC has taken such as updating the rule for safe harbor protection with regard to the sale treatment of securitized assets in failed bank receiverships. 

Federal agencies are now working together to develop the Dodd-Frank standards for risk retention including requirements for Qualifying Residential Mortgages (QRMs) that will be exempt from risk retention requirements.  The rulemaking process, she said, provides a unique opportunity to better align servicers incentives with those of mortgage pool investors.  For example, the definition of a QRM could require servicing agreements that:

• Require servicers to take actions that maximize the value of the entire mortgage pool rather than the claims of any one class of investors;

• Require disclosure where a servicer is servicing both first and second mortgages and establish a pre-defined process to address conflicts between these positions;

• Restrict commingling of mortgagors' payments with its own assets;

• Require an independent master servicer to oversee and resolve disputes over servicer actions;

• Cap servicer principal and interest advances and provide for a means other than foreclosure for servicers to be repaid.

Bain concluded her address by saying, "If we fail to act decisively now to deal with the foreclosure crisis, we risk triggering a double-dip in U.S. housing markets that could roll back the progress that has been made to date. The problem is serious, and the need for action is urgent. We cannot afford to wait for Congress to take action on this issue.