After This American Life recently removed the mystery from the New York Federal Reserve’s cozy relationship with Goldman Sachs, multiple writers have offered their take on what financial regulators in America do wrong. But this week, we got an example of a regulator getting something right. If others follow their lead, we could finally get a more stable financial system.
The Consumer Financial Protection Bureau’s new rules on mortgage servicing took effect this year. Servicers collect monthly payments from homeowners, and make decisions on loan modifications and foreclosures. And they happen to be universally terrible at it, for reasons I’ll explain later.
On Monday, CFPB cited Michigan-based Flagstar Bank with violating the new rules. And it violated them in earnest. In 2011, years after the start of the foreclosure crisis, Flagstar had 13,000 active loan modification applications, but only 25 full-time workers and an application review center in India. The backlog became unbearable, taking up to nine months to assess an application. And Flagstar would deal with applications that contained outdated information by simply throwing them out. These actions continued to the present day.
Flagstar frequently failed to tell borrowers their applications were incomplete. It prolonged the decision-making process, despite specific CFPB deadlines for telling a borrower if it would modify their loan. Flagstar illegally denied loan modifications when borrowers qualified under its rules. It gave no explanation for the denials, a violation of CFPB rules. And it lied to customers about their rights to appeal the denials, another violation.
“Struggling homeowners paid a heavy price, including losing the opportunity to save their homes, as a result of Flagstar’s illegal actions,” said CFPB director Richard Cordray, who announced the enforcement action.
CFPB has in the past sanctioned mortgage servicers for similar violations, with limited success. This time, in addition to fining the bank $37.5 million (the bulk of which will go to victims of Flagstar’s bad servicing, who also must be offered new loan modifications), CFPB banned the company from acquiring new mortgage servicing rights, particularly for defaulted loans, until it can demonstrate its ability to comply with the law.
This is enormous. There’s a healthy trade in the right to service loans in default, because new capital rules make them less attractive to large banks, and because CFPB’s regulations are costly to follow. Because servicers don’t originate a massive amount of loans themselves, and because consumers constantly refinance, pay off, or lose a loan to foreclosure, servicers must constantly purchase new servicing rights to refresh their supply and stay in business.
But CFPB ordered Flagstar to not purchase any more default loan servicing until it figures out how to do it properly. This “benching remedy,” as Georgetown law professor Adam Levitin calls it, can change the calculations for financial institutions over whether to commit a fraud, where the potential penalty is usually less than the profit they can make. In this case, Levitin writes, “compliance can be costly, and being taken out of the market can really squeeze the firm's market position and potentially even its cashflow.”
Imagine applying this model to other parts of the financial services industry. Firms guilty of securities fraud could be barred from issuing that set of securities. Companies making high-risk corporate loans outside regulatory guidelines could be stopped from making corporate loans entirely. Banks caught laundering money for sanctioned organizations could be barred from U.S. dollar clearing operations, or from taking new deposits. The message would come through clearly: Violate the law and you no longer get to participate in the business until you prove you can do it legally.
Unfortunately, federal financial fraud sanctions typically follow a different path. Take the Justice Department’s vaunted settlements with big banks for mortgage-backed securities violations. This week, a monitor released the latest review of how JPMorgan Chase has complied with the “consumer relief” section of the settlement.
At the time of the deal, prosecutors touted consumer relief as a way to deliver principal reductions for struggling homeowners. But of the 46,404 borrowers helped by the settlement as of June 30, only 2,633 got principal reductions. JPMorgan satisfied most of its punishment by making 39,445 loans to low- and moderate-income borrowers, and borrowers in disaster areas. Of the $7.6 billion in gross “relief,” $7.1 billion came through lending.
Expanding lending may assist the economy. But banks make loans to make money. And for some reason, the Justice Department allows JPMorgan and other sanctioned banks to pay off penalties for illegal conduct through a profit-making activity. It’s like sentencing a shoplifter to opening a lemonade stand.
This is a depressingly common occurrence. As one Democratic Congressional aide told me, regulators often permit a broad range of activities for credit in settlements, on the theory that they can then obtain “a larger amount of total relief.” But this turns the idea of relief into a farce, with any routine activity qualifying. The regulators can boast about a big amount of relief in the end, but the victims won’t necessarily fare any better.
On top of that, financial regulators are often too concerned with keeping the firms they regulate profitable, no matter how the institutions gain those profits. CFPB’s benching order changes that dynamic dramatically. In fact, it may force the mortgage servicing industry to overhaul itself.
The reason so many mortgage servicers run into these problems comes from their compensation model. They get paid a small percentage of unpaid principal balance, and the margins are so thin that servicers can only make money if they never need to make contact with borrowers. Cutting principal would eat into their profits. The real money, though, comes from fees triggered by delinquent loans, meaning it benefits servicers to put their customers into default. In short, they profit from foreclosures, not modifications.
If CFPB continues to ban companies that can’t service loans properly, pretty soon there won’t be any, because the compensation model literally cannot allow proper servicing. That will chill an entire market in mortgage servicing rights. After New York banking regulator Ben Lawsky halted a servicing transfer in February between Wells Fargo and Ocwen due to fears that the latter had no capacity to service properly, this market has slowed to a standstill.
Many of the horrors of the foreclosure crisis can be laid at servicers’ feet. A consistent move by CFPB to kick bad servicing companies out of the business will force the industry to change the model for compensating servicers. That could fix the bad incentives that make it more profitable to foreclose.
The best way to clean up this broken industry would be through a complete overhaul. I would have preferred it if CFPB simply changed the compensation model unilaterally. Instead, the agency may be doing that in an indirect way — but if successful, it will have significantly improved the experience of owning a home.
CFPB’s counterparts in financial regulation should take note.
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