Butterfly Effect

 

By Jerry Alt

The days of winging it are long gone for our universe of distressed assets and loss recovery—the result of a chain reaction that inexorably  changed the industry.

The “butterfly effect”—a phenomenon we’ve all likely heard about but perhaps not entirely understood. The most often explanation given is that the beating wings of a butterfly on one side of our world can cause a tsunami on the other. And that is, to a certain extent, what brought the mortgage industry—and its outside counsel networks that handle residential mortgage foreclosures—to our current situation.

The “butterfly” in question was the chronic and rampant overproduction of residential loans in the era ending in the mid-2000s. Without debating the propriety of that trend, in hindsight, many consumers found themselves in marginal mortgage loans—whether because they were steered toward unsuitable products for which they weren’t qualified or because they chose to “game the system” and take 100 percent or more of the equity out of their homes is immaterial for this discussion. When the refi boom of the late 1990s and early 2000s imploded, the “beating of the wings” slowly but inexorably changed the life of mortgage servicers and their foreclosure counsels forever.

In the decades preceding this meltdown, the management of attorneys who regularly represented lenders and servicers in processing routine mortgage foreclosures and consumer bankruptcies was relegated to low-level servicing personnel, often ignored entirely by the legal departments of that financial institution.

These counsel worked for modest flat fees prescribed by HUD, the Department of Veterans Affairs, or one of the GSEs the risks associated with that type of work were generally limited to compliance with time frames and the relatively minor penalties associated with running over those time frames—which were generally passed back to the attorney so to little-or-no identifiable risk of loss remained with the servicer. Because the work was so routine in nature and the cost per loan was modest (by internal legal counsel standards), those firms that could deploy technology and process improvements to consistently hit agencies’ defined time frames gained a large share of the business.

The GSEs took an active role in managing these attorney relationships much earlier than anyone else. While Fannie Mae approved counsel in its earliest iteration of the program, it wasn’t until 2008 that the use of its “retained attorney network” (RAN) was mandated. Freddie Mac, on the other hand, dictated from the beginning that only approved counsel could represent servicers on loans where Freddie was the investor. Despite this supervision, the actual practice of law by these firms was still largely a “black box” other than an increased level of reporting. How the firms processed that work and what internal controls or policies and training they had in place (if any) was seldom if ever earnestly questioned. All that changed in 2010 with the advent of what became known as the robo-signing crisis.

 

Settlements with the Office of the Comptroller of the Currency and Department of Justice include a significantly higher degree of oversight not only for the internal workings of the affected servicers, but also for their vendors.

As the Office of the Comptroller of the Currency and Department of Justice investigations progressed, the settlements from each included, among other things, a significantly higher degree of oversight not only for the internal workings of the affected servicers, but also for their vendors.
Servicers initially struggled with developing audit protocols for their foreclosure law firms, in particular. Wells Fargo was one of the first major servicers to move oversight and management of its law firm relationships to its legal department—an unprecedented and unforeseen (remember the butterfly effect?) consequence of the regulators’ and Justice Department’s findings.

Initially, many of the law firms were exposed to back-to-back client team audits that were, in many cases, repetitive. In one case, a servicer did three sequential audits of the same law firms where no one member of the audit teams was the same and they had not shared their findings with the others. As a consequence, the same questions and the same reviews were imposed on the law firms. Fortuitously, many foreclosures were on hold during this time period, so at least this uncompensated expenditure of effort by the firms did not seriously impact production. It did, however, result in mixed results and, in some instances, inconsistent findings.

More frustrating were legal audits conducted by outside law firms that knew little, if anything, about the foreclosure process, learning as they went at the expense of the servicers they represented. Countless hours were spent educating auditors that had not yet determined how to evaluate these firms or had yet to develop different standards for small law firms versus the larger “mills.”

Eventually the larger and more sophisticated servicers streamlined audit procedures and from that has come a level of consistency. In 2012, an ad hoc committee of the Mortgage Bankers Association consisting of servicing representatives, major law firms, and auditors proposed a uniform audit standard to the FHFA for use by the GSEs that suggested, among other points, a different standard for large and small law firms. All of these efforts continue to refine the process.

While the first level of audits inquired if the law firm had policies (which most did not, but they were designed and implemented), the second level of audits delved into the training of employees on those policies. The third level—where we are now in this continuum—requires each law firm to create an internal audit and compliance function.

As one servicer said to me recently on a call, “Now you know what we go through with our investors and regulators. Welcome to our new reality.” This isn’t to say this paradigm shift was unwarranted, but it was not contemplated in the staffing or pricing models and was created at breakneck speed by constantly evolving standards imposed on the firms. (We’ll return to the issue of fee structures in a moment.)

So where did all this effort lead? How has it changed the landscape of the formerly unimportant and sometimes trivialized practice of foreclosure law? First, based on anecdotal evidence, a high percentage of law firms failed the initial audits in areas such as compliance, training, written policies and procedures, data security, and technology. This forced firms already struggling to meet the increased challenges of prosecuting foreclosure cases in an environment of consumer activism to expend additional time and capital to develop the level of sophistication that was by 2012 becoming the minimally accepted level to continue in the business.

More than a few firms decided to exit this line of business rather than comply or found themselves and their historical practices so deficient that they lost client share. A very small number of firms were driven out of the industry entirely, but far more were exposed to scrutiny formerly reserved for riskier vendors (cash and check processing, customer service, property management companies, etc.).

The good news for the industry is most of the firms they utilize are in fact very good at what they do and are committed to spending the human and capital resources to meet these changing expectations. The other potentially good news for these law firms is that the majority of all new mortgage loans originated today are GSE-backed. That means a standardization of sorts has emerged for the future conduct of these players.

In November 2012, both Fannie Mae and Freddie Mac announced they were, at the behest of the Federal Housing Finance Agency, getting out of the business of directly managing law firm relationships and putting that burden on the servicers. In the wake of that, the GSEs created an approval process that imposed on the servicers (and, by implication, their law firms) a minimum set of standards for any law firm handling a GSE loan. The old retained attorney networks are being phased out in a sunset fashion, so only those firms that meet these minimum standards—as certified by the servicers—can process new foreclosure or bankruptcy matters referred after June 1, 2013.

If a firm wants to stay in this business, it has no choice but to establish the requisite training, audit, compliance, and technology (specifically intrusion detection, perimeter security, protection of non-public personal information [NPPI], and document retention) required to satisfy the GSE-mandated standards. Also, minimum financial stability requirements are imposed on firms to ensure they can operate efficiently and still retain profitability while being robust enough to withstand these challenges.

Another consequence of this level of scrutiny is legal services agreements submitted to law firms contain higher levels of indemnity for their acts or omissions, effectively making the foreclosure firm a guarantor not only for its own activity, but also for that of its third-party vendors—including title companies, service of process companies, and auctioneers. This, in turn, forces the law firms to ensure those vendors comply with similar standards of their own, thus subjecting what are, in many instances, small local vendors to these same rigorous requirements. The standards are forcing some smaller vendors out of the business—the ultimate unintended consequence of that first fluttering of the butterfly wings when servicers were subjected to introspection by their regulators.

The first complaint many law firms made when exposed to these increased servicer and investor performance requirements was insufficiency of fees. At the same time, state law changes dramatically increased the workload on those firms and imposed new legal procedures related to prosecuting foreclosures. In response to these changing conditions, Fannie Mae increased fees across the board with Freddie Mac and HUD expected to adjust their compensation levels about the time this article goes to press.

These pay adjustments, while deserved and overdue, are not the long-term solution. Essentially, the entire landscape has changed and foreclosure is increasingly recognized as a higher-risk and more important legal function than in the past. The pertinent and more appropriate approach to this change would be for all participants in the process to, first, define the tasks that are expected of counsel in prosecuting these loan foreclosures; second, agree on uniform industry standards of compliance and conduct; and, third, only when the first two have been defined, should a suitable fee structure that fairly compensates counsel for the work be established that is commensurate with the effort and the risk associated with handling distressed assets in today’s marketplace.

It is indeed a brave new world for all participants in the default process. In that world, increased compliance is the standard. But it also comes with a level of intolerance for performance short of perfection, a standard that is impossible to sustain without reassessing the industry as a whole. And that is a challenge that must be met, or else who will survive to protect the collateral that sustains the entire mortgage industry?

Jerry Alt is president of LOGS Network, where he leads a team of nearly 2,000 legal and business process outsourcing professionals serving the residential mortgage and financial services industry.