Post-financial crisis regulatory changes have impacted the financial services industry in various and significant ways. But perhaps the sectors most affected are those that are consumer facing. Mortgage originators and servicers took much of the blame during the financial crisis as loan defaults skyrocketed. The backlash from regulators and politicians was immediate and material with a flood of new regulations and guidelines. The Dodd-Frank Wall Street Reform and Consumer Protection Act, intended to protect consumers and the stability of the financial system, is highly complex with multiple key rules still not finalized. While many would agree that the Act is only partially effective, the Dodd-Frank Act did lead to the creation of the Consumer Financial Protection Bureau (CFPB). The CFPB has been highly focused on origination and servicing issues that affect consumers across all spectrums of lending from credit cards and student loans to mortgage servicers and debt collectors and payday lenders. To further complicate matters, there have been a number of settlements with Attorneys General and regulators over origination and servicing practices. While much of this activity has been concentrated on residential mortgage loans at the largest banks and servicers, there have also been significant allegations or settlements with respect to other types of consumer loans and with respect to smaller financial institutions.
Portfolio managers tasked with managing non-securitized consumer assets often rely on third party service providers. This is often the case for non-depositories like hedge funds, private equity funds and REITs but may also hold true for those working in a depository setting. While it might be tempting to leave these complicated compliance matters to the service providers, a developing standard ingrained in the Dodd-Frank Act, as well as in other regulatory settlements and pronouncements, holds a financial institution accountable for its service providers’ actions. While it is unclear what liability that would legally create for a non-depository, a negative Office of the Comptroller of the Currency (OCC) or CFPB review of a loan servicer, for example, could have multiple negative consequences such as the servicer becoming distracted by on-going regulatory review issues, negative public relations issues and, in a worst case scenario, investor redemption calls to withdraw funds.
Portfolio management teams at private equity firms, hedge funds, and REITs seeking to invest in residential mortgage loans prefer to focus on maximizing their total return through smart acquisitions and positioning portfolios for different market conditions and have less time to spend on compliance monitoring. Hence these entities often employ specialized advisory firms offering cost-effective loan servicing oversight and hands-on asset management services. These services include the creation and implementation of policies and procedures and ongoing oversight of asset due diligence and loan servicing. Banks’ residential mortgage loan servicing operations seeking cost-effective compliant servicing solutions also use specialized advisors to assist in monitoring and properly documenting compliance with evolving new rules.
The costs of non-compliance
The costs of non-compliance can be quite severe especially when you consider that the actions of your third-party service providers can have material negative consequences for your operations.
The most obvious cost of non-compliance at the service provider level is the expenses involved in a settlement with regulators which often involve a combination of borrower relief, fines payable to the regulators and legal costs. In large servicing organizations, designing, implementing and monitoring real time compliance processes to handle evolving and complex new rules can be very challenging and prone to unintended violations. One of the most highly publicized settlements was the $25 billion National Mortgage Settlement over alleged abusive foreclosure practices by the servicing divisions of the nation’s five largest banks. Unfortunately, a recent survey of mortgage counselors in California alleges that the largest banks could still be in violation of the main terms of the National Mortgage Settlement, such as dual tracking issues or failing to provide borrowers with a Single Point of Contact (SPOC), and has led to calls for an investigation. New York Attorney General Eric Schneiderman has also announced his intention to sue two of the largest banks for purportedly violating the terms of the National Mortgage Settlement. Separately, Capital One recently agreed to a $210 million settlement for allegations of deceptive marketing practices made by their third-party marketing contractors which the bank allegedly failed to monitor adequately.
Of course, given all the regulatory compliance challenges and regulatory capital requirements facing the largest bank servicers, there is not likely to be a good match for the largest banks to service portfolios for non-depositories. But other servicing operations aren’t getting a pass just because they aren’t the largest and most publicly visible. The CFPB has stated its intent to review all servicers regardless of size and to pursue violators rigorously where consumers have been harmed. So even if your servicer is a smaller operation focused on a special servicing approach to resolving consumer delinquencies, you can expect that they will be reviewed closely for, among other things, issues involving fair debt collection, fair servicing standards, modifications, dual tracking and their handling of consumer complaints. So private equity firms, hedge funds and REITs without their own servicing operation would be wise to hire third-party servicers who are compliant with your program and with all legal and regulatory requirements. These servicing operations should be able to monitor their compliance and should be open to an independent oversight review from an unaffiliated third-party.
Establishing a servicing oversight program
Establishing an effective servicing oversight program requires a commitment from senior management and the selection of individual(s) responsible for defining and implementing the program. Hopefully, you are not starting from scratch, but if you are then consider hiring a compliance manager immediately. Unfortunately, compliance managers are in high demand right now so you can’t expect to do this on the cheap. If your firm is a small hedge fund or servicer, look to expand the role of your general counsel if possible. It’s also probably not a bad idea to interview and possibly engage an outside consultant or attorney firm with compliance experience. In any case, there needs to be a clear commitment from management to define a program and the individual(s) responsible for implementing the program.
A second important step is to draft a set of policies and procedures that will provide guidance for due diligence vendors and servicers that you use in the acquisition and servicing of loans that you acquire and manage. The policies don’t have to be 800-page gorillas, but they need to be more than a one pager as well. The policies are meant to give guidance to your servicer and should speak to acceptable loss mitigation programs and how those programs should work, as well as to related operational issues. For example, my company will customize a standard set of policies for that client. With respect to loss mitigation, our policies typically include a loss mitigation overview and individual policies covering modifications and repayment plans, short sales, deeds-in-lieu, bankruptcy, foreclosure, real estate-owned (REO) and charge-offs. With respect to operational issues, our policies include an advance policy (for escrow and corporate advances), property valuations, inspections and property preservation, escrow administration, compliance with various regulations that affect servicing (such as FDCPA, TILA and RESPA), borrower complaints and quality control reviews. Without this necessary guidance, your servicers will rely on generally acceptable standards which standards may not address your needs and worse may create a liability for you if those standards turn out to be no longer acceptable after regulatory scrutiny.
A third important step is to work with your service providers to ensure that the policies are implemented. While regular face-to-face meetings are always a good idea, asset managers should use some sort of technology solution to assist them with reviewing the portfolio for missing, incomplete or illogical data points that could indicate exceptions to policies.
A fourth step is to conduct regular quality control reviews, which may be based on a simple random selection of loans or on exception queries. The reviews should encompass a deep dive into a file and should be conducted on a regular basis. It is prudent that work product be saved in an easily accessible but secure internal site. Any exceptions should be communicated to the servicer and the exception should either be cured or in some cases the policy amended.
Lastly, there should be at a minimum an annual on-site review of loan servicers and other third parties to ensure that they are providing a compliant type of service. In particular, there should be a focus on regulatory hot issues such as anti-money laundering and how consumers interact with the servicer especially with regard to consumer complaints. Other critical areas to understand are how the servicer manages their training programs and how they have addressed any negative findings from state regulator and CFPB audits.
While there is an obvious cost in implementing a program like this, they pale in comparison to the potential legal costs and penalties in not doing so. For the foreseeable future, portfolio managers who manage non-securitized consumer assets have no choice but to implement a higher level of oversight over third party service providers that are consumer facing.
Staying on top of changes
Many aspects of the Dodd-Frank Act have yet to be interpreted especially with respect to implementation, and the CFPB expects to continue working on rule implementation through the end of 2013. It is incumbent upon portfolio managers and their designated compliance person that they remain on top of changes that are still being implemented.
There are a number of good resources that can help one keep abreast of changes. First, you can sign up for e-mail updates from a number of Web sites that specialize in covering the mortgage industry. Several attorney firms also maintain blogs and conduct Webinars on a regular basis. You can also find good information on the Websites of the GSEs and various regulators including the CFPB, the OCC and the Federal Reserve. Lastly, there are a number of vendors, such as AllRegs, that will provide updates on regulatory changes and information on GSE origination and servicing standards.
James Dooley is managing director at NewOak Capital Advisor LLC. At NewOak James is the head of loan asset management and servicing advisory. James a has more than 17 years of experience trading and managing distressed residential mortgage loans, REO and other distressed consumer assets. He may be reached by phone at (212) 209-0850.