Subprime-Mortgage Servicing Regulation and the Financial Crisis

Scholars are attempting to fully understand all the causes of the 2007-09 U.S. financial crisis, hoping their efforts will ensure that something like this will not happen again. Nonetheless, in this research, weaknesses in mortgage servicing regulation have been largely ignored. Servicers collect payments from homeowners, keep records of mortgage balances, pool the payments and remit them to investors, and manage escrow accounts. In a world where mortgage assets are securitized, mortgage servicing is essential to the functioning of the financial system. Investors in mortgage-backed securities routinely 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 mortgage-backed securities at the heart of the crisis could not have developed without a subprime mortgage servicing industry.

In a recent article, I and my co-authors analyze a pivotal case against the largest U.S. subprime servicer in the pre-crisis period, Fairbanks Capital Corporation (FB). FB was the target of class action lawsuits in more than 10 major states and in over 1,000 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. The two federal agencies responsible for regulating mortgage servicers, and negotiating the settlement, were the Department of Housing and Urban Development (HUD) and the Federal Trade Commission (FTC). The PMI Group, traded on the NYSE and one of the nation’s largest private mortgage insurance companies, owned 57 percent of FB’s common stock at the end of 2002. PMI acknowledged risks from the FB litigation in its Annual 10K Reports.

The litigation revealed egregious practices but was settled quickly for a nominal amount and provided the servicer a very broad release of liability, despite the large volume of complaints about its practices. The settlement, and this release of liability, provided major benefits to FB but allowed very serious weaknesses in consumer protection to continue uncorrected, permitted FB to continue to expand, and created significant wealth gains for the parent firm. Regulators then structured a new agreement in 2007 that largely restated the earlier agreement, a completely unnecessary step if the servicer had complied with the 2003 agreement.

FB was accused of numerous violations of state and federal law in class action lawsuits in California, Florida, Georgia, Illinois, Massachusetts, Michigan, Ohio, Pennsylvania, Texas, and other states, as well as in several thousand individual lawsuits. State attorneys general also launched investigations and filed lawsuits for alleged 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, and for allegedly deceptive, unfair, and unconscionable debt collection practices and assessing fictitious fees.

One common allegation was that FB held monthly payment checks until after the 15-day grace period to impose a late fee (generally 5 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. PMI discussed its FB litigation risk extensively in its 2004 Annual Report on Form 10K, indicating PMI management considered the FB litigation significant. The report also discusses criminal investigations by both HUD and the U.S. Department of Justice, and a possible credit rating downgrade. Clearly, continued problems at FB would have a substantial negative effect on PMI.

On November 12, 2003, in USA v. Fairbanks, the federal government sued Fairbanks 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.” (p. 4).

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, Thomas Basmajian, 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 became irrelevant at that point. The settlement was contingent upon the final order of the Federal District Court in Massachusetts, and became effective on May 4, 2004. The $40 million amount is very small in comparison with recent settlements for mortgage market abuses, many of which are for amounts over $10 billion. On May 4, 2004 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 earlier 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. Though $40 million distributed equally among 500,000 borrowers (the total noted above) is $80 per borrower, 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 those of most other members 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.

We test the hypothesis that the settlement benefited both PMI and the nation’s largest mortgage lender before the financial crisis, Countrywide Financial. 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 percent, using traditional event study methods, but range from 5 percent to 20 percent, 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.

Countrywide is often considered one of the worst predatory lenders; it nearly imploded during the crisis before being acquired by Bank of America. 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 percent

What were the alternatives? FB could have been prevented from purchasing additional servicing until it had clearly demonstrated the ability to handle its existing servicing. Regulatory resources are limited, so regulators should identify the worst financial practices, publicize them, and penalize the firms. In September 2014, the Consumer Financial Protection Bureau followed this approach when it prevented a mortgage servicer engaged in allegedly abusive practices from acquiring any additional mortgage servicing rights until it demonstrated the ability to handle such servicing, and levied a $37.5 million fine. This could have been done with FB. The FB case reveals that considerable operational risk can be created when servicers expand rapidly. We conclude that servicers must be held to a high standard, and regulatory authority should not be split between agencies.

Why did two federal agencies settle these important cases so quickly at such a nominal cost, and provide this broad release of liability without addressing the problems? What was the reason for the secrecy? Students of regulatory capture may be interested in one fact and some questions I raise personally. (These are not mentioned in the article and do not necessarily represent the views of my co-authors who have not fully considered the argument.) While the letters stood for Private Mortgage Insurance, PMI was known informally in the industry as Preston Martin Incorporated. Preston Martin (1923-2007) was President Nixon’s chairman of the Federal Home Loan Bank Board and later President Reagan’s vice chair of the Federal Reserve Board; he was Reagan’s first appointee to the Fed. The Wall Street Journal reported in 2007 that Martin expected to succeed Paul Volcker as Fed chair in the mid-1980s, so this was an extremely influential businessman and political figure. Did officials in the extremely business-friendly, anti-regulation George W. Bush Administration in 2003 take these actions because this was Martin’s company? Can powerful companies use the resources of the federal government to dismiss thousands of claims against the firm because they have influence? Is this the way our legal system works, sometimes? The public will never know all the details, but one can certainly wonder. In any event, we conclude that if subprime mortgage servicers had been held to a higher standard, this market could have developed on a sounder footing, and the crisis might have been less severe.

This post comes to us from Professor James E. McNulty at Florida Atlantic University. It is based on his and Luis Garcia-Feijoo and Ariel Viale’s recent article, “The Regulation of Mortgage Servicing: Lessons from the Financial Crisis,” available here.