Mortgage Servicers Make More Money In Foreclosure

Posted on January 17th, 2012

As I had long suspected, mortgage servicers have very strong financial incentives to push for foreclosure instead of modifying a loan. Diane E. Thompson, of counsel to the National Consumer Law Center, recently published an article in the Washington Law Review that analyzes various servicer incentives and how they prompt servicers to select loan modification or foreclosure.

In general, this decision is based on which approach will make the most money for the servicer. Although servicers will claim that an individual investor or group of investors has refused to entertain the idea of a loan modification, more often than not, investors have very little day-to-day involvement with individual loans. These investors are generally owners of mortgage-backed securities. They do not own individual loans, rather, they own an interest in receiving the proceeds from a large pool of loans.

Many investors are entities like pension funds, retirement funds, and other entities that are seeking a stable, long-term investment. In general, it is in an investor’s best interest to keep the pool of loans filled with performing loans. Properties that are sold via foreclosure do not provide long-term income, and in many cases, investors see very little of the funds from the foreclosure. This is due to several factors.

First, given the fact that many properties are underwater, a foreclosure sale very rarely obtains an amount equal to the loan balance. Moreover, a foreclosure sale cuts off long-term gains from interest. A lump sum of $150,000 is worth much less than that same amount paid off over a term of 30 years at 5% interest.

Second, before investors see any return from a foreclosure sale, the servicer is paid. Servicing a loan that is in foreclosure allows servicers to obtain fees for late and missed payments, securing a property, hiring attorneys to process the foreclosure, and other costs. The longer a property spends in default and in foreclosure, the more money a servicer stands to make. Servicers make significantly less money servicing a performing loan over the long-term.

It is also worth noting that when servicers offer loan modifications, they often offer modifications that make economic sense for the servicer, not the investors. Many loan modifications provide for missed payments and the associated penalties by tacking the value onto the loan’s principal balance. This means that many borrowers end up owing more after a modification than they did prior to modifying. Another popular strategy is to set aside the missed payments and fees in a separate line item. This amount can be paid down over time by making pre-payments, or it becomes a balloon amount due at the end of the modified loan’s lifetime. These loans are more likely to default, sending more business back to the servicer.

Most interesting is why servicers don’t generally offer principal reductions — they are normally paid a servicing fee based on the principal balance of the loan. Reducing principal reduces that fee, which is clearly not in the servicer’s interest. Servicers are also rated based upon their efficiency in resolving delinquent loans. Pushing to foreclose can help increase this rating and drive more business to the servicer.

Servicers will also keep borrowers in temporary loan modifications as long as they can. This increases the servicer’s profit as it is entitled to keep the majority of its fees and penalties that relate to servicing the loan. Additionally, when a servicer denies a permanent loan modification, it can apply further fees related to the partial payments made under the trial modification. Keep in mind, trial modifications do not modify the loan, they are essentially a reduced payment period designed to test a borrower’s ability to make reduced payments.

On the whole, the article is worth reading and is accessible to both academics and lay persons. Look for more updates and analysis in the future.

For those looking for a copy of the article on Westlaw or Lexis, the cite is:

Thompson, Diane E., “Foreclosing Modifications: How Servicer Incentives Discoruage Loan Modifications,” 86 WashLRev 0755 (2011).