Courtesy of James E. McNulty
Americans have always distrusted monopolies – over a century ago, Teddy Roosevelt gained widespread public approval battling the trusts. Monopolies that continue to exist, like public utilities, are subject to stringent regulation on both the price and quality of their services. Mortgage servicing is one monopolistic industry that has avoided serious regulation – to the detriment of millions of American households. In a recent paper, my co-authors and I demonstrate how serious weaknesses in the regulation of mortgage servicers facilitated monopolistic practices and played a contributing role in the global financial crisis.
The Role of Mortgage Servicers
While mortgage lenders originate home loans, servicers collect payments from individual homeowners; keep records of mortgage balances; pool the payments; remit these in a lump sum (minus servicing and guarantee fees) to investors in mortgage backed securities (MBS); and manage escrow accounts covering property taxes and insurance. Servicing can generate considerable revenue (in a stable economy) and large firms that conduct both mortgage origination and servicing typically establish separate departments and subsidiaries for each activity.
Servicers have virtual monopoly power because homeowners do not choose their servicer and cannot switch to another servicer without refinancing the loan (refinancing is a costly and burdensome process). Put simply, if the institution which holds a loan chooses Institution A to service the loan, the homeowner has little choice but to deal with Institution A. Borrowers have little recourse – absent litigation – if the servicer levies unwarranted fees, misapplies monthly payments, fails to respond to complaints, or commits outright fraud.
Regulation of Mortgage Servicers
Before passage of Dodd-Frank in 2010, regulation of mortgage servicers was split between two federal agencies – the Department of Housing and Urban Development (HUD) and the Federal Trade Commission (FTC). In the wake of the financial crisis, it became apparent that neither agency took their regulatory role seriously.
Dodd-Frank transferred regulatory responsibility for mortgage servicing to the newly created Consumer Financial Protection Bureau (CFPB). Under its first director, the CFPB proactively exercised its regulatory authority over mortgage servicers. For example, in September 2014, the agency prohibited a mortgage servicer it considered to be engaging in abusive practices from acquiring any additional mortgage servicing rights (the legal right to service a certain pool of mortgages and collect the associated fees) until it demonstrated the ability to handle such servicing. The CFPB also levied a $37.5 million fine against the servicer’s parent bank holding company. Under the Trump Administration, the CFPB has adopted a much more hands-off approach.
How Mortgage Finance Works
In the U.S., well over half of mortgage assets are securitized, making mortgage servicing essential for the system to function properly. Investors in mortgage-backed securities (MBS) expect that the servicer of the underlying loans will keep accurate records and perform their other required functions in a competent and ethical manner. Since securitization requires servicing, the market in subprime MBS at the heart of the 20007-09 financial crisis could not have developed without a subprime mortgage servicing industry.
Egregious Mortgage Servicing Practices by Fairbanks Capital Corporation
The pivotal case we analyze in our paper involves the largest US subprime servicer in the pre-crisis period, Fairbanks Capital Corporation (FB). In the period before 2004, FB was the target of class action lawsuits in more than ten states, and in over one thousand individual lawsuits. Allegations included assessing fictitious late fees and other questionable fees, failing to keep accurate records of mortgage balances, misapplication of borrowers’ funds, and other predatory practices. These actions resulted in violations of the Fair Debt Collection Practices Act (FDCPA), the Real Estate Settlement Procedures Act (RESPA), the Truth in Lending Act (TILA), the FTC Act, and various state consumer protection laws.
While the FB litigation revealed egregious practices, a settlement was reached that imposed modest penalties on FB and provided a broad release of liability. Unfortunately, the settlement did not prevent further consumer abuses by FB and regulators were forced to restructure a new agreement in 2007.
One common allegation was that FB held monthly payment checks until after the 15-day grace period to impose a late fee (generally five percent of the monthly payment). Unpaid late fees cause the next monthly payment to be insufficient, triggering a pyramiding of late fees. FB was also accused of misapplication of funds, placing money in “suspense accounts” at no interest for over a year, charging borrowers for insurance they did not request or need, charging improper prepayment penalties, and a variety of other predatory practices. FB’s parent company, the PMI Group – traded on the NYSE and one of the nation’s largest private mortgage insurance companies – discussed its FB litigation risk extensively in its 2004 Annual Report. The report also discussed criminal investigations by both the U.S. Department of Housing and Urban Development (HUD) and the US Department of Justice, as well as a possible credit rating downgrade.
The weaknesses in FBs operations are revealed in many documents, but perhaps none are more colorful or revealing as several depositions in a Florida case, Gullo v. Fairbanks (2003), in which I served as an expert witness in 2008. The plaintiff argued that FB repeatedly quoted seriously incorrect mortgage balances and assessed improper late fees. The servicer could not account for substantial sums that it had received. FB then sent a letter threatening to foreclose. When the borrower called FB to discuss these issues, FB servicing staff said they did not know who he was because they could not find his file.
When did Problems First Emerge?
Several FB employees testified that the problems started with the rapid accumulation of new servicing rights purchased from Citigroup and other lenders. FB customer service employees were required to take a new call every three minutes even if the issue in the previous call had not been resolved. Payments were applied to the wrong account or not applied at all, files were missing, papers were strewn about, and there was significant employee turnover. One former employee testified: “I want to make this as clear as possible. No one in the Hatboro [Pennsylvania] office really knew what was going on. No one was trained properly. No one. It was a circus.” In another case a federal bankruptcy judge stated FB “in a shocking display of corporate irresponsibility, fabricated amounts owed out of thin air” (Maxwell v. Fairbanks, 2002).
On November 12, 2003, in USA v. Fairbanks, the federal government sued FB for engaging in unfair or deceptive acts or practices in violation of the FDCPA, the RESPA, the TILA and the FTC Act. The allegations were essentially those described above. The complaint noted the substantial growth of Fairbanks’ servicing portfolio in the previous three years through acquisitions of subprime servicing from other servicers. The complaint also pointed out that “Fairbanks finished 2002 as the subprime mortgage industry’s largest servicer, managing a portfolio that totaled almost $50 billion. Fairbanks services over 500,000 mortgage loans”.
The USA v. Fairbanks case was settled immediately. On the same day, November 12, 2003, the FTC and HUD announced a settlement with FB. The servicer did not admit any wrongdoing, but the settlement required changes in FB’s operations and the creation of a $40 million redress fund for affected borrowers to remedy the alleged violations of law. The founder and former CEO of FB paid a personal fine of $400,000 into the fund. HUD Secretary Mel Martinez stated that FB had “engaged in a laundry list of predatory loan servicing practices,” and called it a “record settlement.” The state cases were irrelevant at this point as they were incorporated into the federal case; State Attorneys General were powerless to do anything. The settlement was contingent upon the final order of the Federal District Court in Massachusetts which was effective on May 4, 2004.
The $40 million fine is very small compared to recent settlements for mortgage market abuses, many of which are for amounts over $10 billion. On May 4, 2004 with the support of the FTC and HUD, the settlement was approved by the United States District Court for the District of Massachusetts. The Court order approving the settlement was released the same day as the settlement.
Various objections to the settlement were filed with the Massachusetts Court. The objections noted that FB received a very broad release of liability, and that many class members would receive minimal cash payments. One of the objectors argued that many class members would receive cash payments of less than $200. $40 million distributed equally among 500,000 borrowers (the total noted above) is $80 per borrower, but not all borrowers were affected. However, less than $40 million was available for redress because of attorneys’ fees. One borrower with a much larger loan than most of the class (and hence arguably more damages) was offered approximately $3,500 but opted out of the settlement because he considered his damages to be much larger.
The objections also pointed out that many class members entitled to relief would receive nothing if they did not respond to the one notice that was sent, that many class members who had moved (such as those who had lost their homes through foreclosure) would not receive any notice at all, that all discovery in the case was under seal, that class members who accepted the settlement were prohibited from speaking to the press about any aspect of the case, and that the notice provided little financial information to allow borrowers to make an informed judgment about participating.
The Financial Impact of the Settlements
In our paper, we test the hypothesis that the settlement benefited both PMI and Countrywide. We estimate the wealth effects of different announcements from an initial litigation event in July 2002 up to approval by the Court in May 2004. The cumulative abnormal returns over the period are at least 7.59% using traditional event study methods but range from 5% to 20% depending on which announcements are considered unanticipated and hence more informative. These results are consistent with our hypothesis that the $40 million settlement – distributed among a very large number of borrowers – benefited PMI. The cost was nominal, and 1,145 borrowers opted out of the settlement, an indication that informed borrowers considered the amounts offered inadequate in relation to their damages.
As the largest home lender in the US before the crisis, Countrywide is often considered one of the worst predatory lenders. Evidence of contagion effects suggests such lenders benefited from the settlement. This would be expected because the settlement bolstered the subprime mortgage market. Countrywide’s stock price reaction to the first settlement-related announcement is +6.71%.
Alternatives to Settlement
What were the alternatives for financial regulators? Regulatory resources are limited, so regulators should identify the worst financial practices, publicize them, and sanction the firms. As noted, in 2014, the CFPB did precisely that. Certainly, mortgage servicers engaging in abusive and potentially fraudulent practices should not be permitted to acquire additional mortgage servicing rights. At a minimum, this type of restriction could have been imposed on FB.
Mortgage servicers have virtual monopoly power; if they are unregulated, or lightly regulated, they have incentives to abuse their monopoly power to enrich the managers and owners of the firm. Financial regulators need to recognize this fundamental point, which should also be reflected in legislation. The FB case reveals that considerable operational risk can be created when servicers expand rapidly. We conclude that servicers must be held to a higher standard, and regulatory authority should not be split between agencies. If subprime mortgage servicers had been held to such a standard, the mortgage market could have developed on sounder footing, and the crisis might have been less severe.
 Public utilities are natural monopolies. Natural monopolies describe a situation where one firm (because of a unique raw material, technology, or other factors) can supply a market’s entire demand for a good or service at a price lower than two or more firms can.