The default servicing space is narrowing under new legislated regulations.
“The bottom line is that doing the necessary work of protecting our financial system and its customers comes with a cost.”Those words were spoken by Federal Reserve Governor Elizabeth Duke at a California Bankers Association seminar back in January 2012. At that time, the magnitude of the costs that come with compliance in this new era of austere rules and heightened scrutiny was just beginning to present itself.
“Every point where you touch a consumer has had to change over the last year or two to ensure compliance with the CFPB’s [Consumer Financial Protection Bureau’s] new rules,” according to Dave Worrall, president of RoundPoint Mortgage Servicing Corporation.
Worrall says smaller players are not only dealing with a declining number of distressed loans, but they’re also getting crushed by the cost of complying with new regulations. “It’s not just needing to expand infrastructure to be in compliance, but it’s also the cost of needing to prove that you’re compliant and monitor compliance,” Worrall explained. “Small companies are struggling because of this environmental change. A lot can’t, or are going to have a hard time surviving.”
He says just the cost associated with proving compliance adds significant fixed costs to a servicer’s infrastructure. The size of RoundPoint’s compliance area is four times what it was in 2012, according to Worrall. The additional expense that comes with compliance is diametrically opposed to the idea of economies of scale servicing, Worrall notes.
Economies of Scale
In a “Housing Insights” report published last month, the economics team at Fannie Mae noted that the “mortgage servicing business provides perhaps the clearest example of the benefits of scale economies in the primary mortgage market.” The GSE’s economists cite data published by the Mortgage Bankers Association for the period between the second quarter of 2012 and the second quarter of 2013, which shows that direct servicing expenses for servicers of fewer than 2,500 mortgage loans were 13 percent higher per loan than direct servicing expenses for servicers of more than 50,000 loans.
This pre-2007 cost-of-service model just isn’t going to work in the post-2014 era because of the cost to comply, according to Worrall, who says that may not necessarily be a bad thing. “I’m not an advocate of the economies of scale model because I think that type of thinking got us into this situation in the first place,” Worrall said. “Large servicers had built businesses to service lots and lots of loans and had not built in the capabilities to handle a default event like what occurred in 2007 and 2008.”
The pre-2007 cost-of-service model just isn’t going to work in the post-2014 era because of the cost to comply.
It’s the same age-old problem with all companies, according to Bill Glasgow, president of Glasgow Management, Inc., and a former servicing executive with OneWest, JPMorgan Chase, Bear Stearns, and IndyMac. “If you expand too fast, you end up finding out that it costs a multiple, several times over, to fix the problems you create, as opposed to growing in a more sustained, methodical way,” said Glasgow, whose consulting firm specializes in improvements in mortgage servicing operations.
According to Glasgow, the servicing business is changing hands in direct relation to capital structures. Until now, it’s always been the big national banks that were the primary providers, not only of lending but also the servicing side of the business, Glagsow explains. “And now you see them, in many respects, exiting at least a percentage of that business, and some of them clearly want to get out of managing the default side of the business, which is spawning an avenue of growth for nonbanking companies such as Green Tree, Ocwen, and Nationstar,” he said.
In a commentary note released November 18, the analysts at FBR Capital Markets addressed this very topic. “As a result of the current capital and regulatory environment, larger banks are stepping back from the origination and servicing market,” they wrote. “This bodes well for smaller banks and nonbank originator/servicers, as they can step into the hole left by the big, money center banks, allowing them to gain significant market share.”
FBR’s analysts went on to say, “Nonbank market share in both the origination and servicing sectors has risen meaningfully during the past four years.
Many banks have announced their departure from and lessening involvement in different origination channels and have disclosed layoffs as they have decreased capacity. This trend should continue as Basel III capital standards, headline risk, and tighter regulations discourage banks from maintaining a strong presence in the mortgage market.”
Risks of Untethered Expansion
Glasgow, however, worries about the pace of this shift within the marketplace. “If, and only if, the Ocwens, Nationstars, and the Green Trees of this world—and this is a big if—if they can demonstrate that they can grow at the level and pace they are growing today without getting themselves into compliance issues and adversely impacting the consumer, then I would imagine this model will survive for at least the next five years, though a lot will depend on the position or future of the GSEs,” he said.
The industry witnessed the ramifications of such maneuvers just last month with the actions taken by federal and state officials against Ocwen Loan Servicing. The CFPB and 49 state attorneys general filed a consent order in federal court requiring $2.125 billion in restitution to remedy what CFPB Director Richard Cordray described as “systemic misconduct.” On a press call with reporters, Cordray noted that Ocwen “has been greatly expanding its business in the years since the housing collapse.” Today, Ocwen is the nation’s fourth-largest mortgage servicer and the largest nonbank servicer.
“It has acquired smaller competitors such as Homeward Residential and Litton Loan Servicing. And it has taken on servicing duties for some of the big banks. Today its customers number in the millions,” Cordray said. “Because Ocwen bought the mortgage servicing rights to millions of existing accounts, for many borrowers Ocwen was not their first servicer.
For these struggling homeowners, the Consumer Bureau believes that too often trouble began as soon as a loan transferred to Ocwen, with Ocwen failing to honor trial modifications that were agreed upon by previous servicers.”
“There’s been consolidation for the past 10, 20, 30 years but nothing like what we’ve seen here in just the last few years,” Glasgow said.
Squeezing the Business Model
“[W]hile the effects of the economic crisis are receding, bankers are now facing a wave of increased regulatory requirements,” Federal Reserve Governor Duke said in that speech back in January 2012. “For the most part, the new regulations are directed at the largest institutions, whose failure would pose the greatest risk to the financial system, or at the lending practices that led to the crisis. Even so, the changes are so sweeping that many industry analysts have questioned whether the overall weight of regulation poses a threat to the future of the community bank model.”
Since the beginning of the recession, the industry has had to deal with paradigm shift after paradigm shift, according to Worrall. As a result, “shops are retooling to performing loans,” he said. Worrall sees the prevailing business model of the future as large loan servicers working with primarily performing mortgages.
Indicative of this transformation within the industry, Roundpoint, which has historically been a special servicer, has begun focusing solely on performing loans. Worrall says Roundpoint got into the MSR market in 2012, but activity was limited. In 2013, it ballooned and pricing almost doubled from what the company was paying for MSRs the year before.
In order to survive in this new marketplace, Worrall says it’s paramount for any company to allocate significant corporate resources for monitoring and complying with the swiftly changing regulatory environment. Secondly, he says it’s important to provide a good experience for the consumer because whether still trying to hang on as a special servicer or executing the economy of scale model, the only way to succeed is with a business model that stresses customer service.
“You look at companies that are truly committed to this business—Wells as an example—that have weathered the storm, and you’re never going to see those types of institutions exit,” Glasgow said. “On the other hand, if we were so worried about the American-US Air merger, then we should be as equally worried about concentrating mortgages with just a handful of servicers.”
Glasgow points to Washington Mutual, Fleet, and even Citi as examples of what happens when a single company tries to become the behemoth, large mortgage company with the largest market share. “There have been more failures than successes, and this is something that we at least have to be careful and mindful of,” Glasgow said.
Bowing to Numerous Interests
With Basel III, eminent domain, lawsuits from municipalities, FHA penalties, and hungry attorneys general looking for ways to raise public opinion among their constituents, there’s a multitude of various interests trying to “intervene in the mortgage lending space without concern as to what it will do, at least in the short- and intermediate-term, to the profitability of this business,” according to Glasgow. If those banks and nonbanks are left in doubt as to what the future holds in this business, he says, it only generates more concern and interest in exiting the mortgage business.
“We as an industry have to get to a point where the intervention by all these various interests is minimized,” Glasgow said. “For example, everyone wants to examine and audit the same company. We have to get to the point where one firm can produce something equivalent to an SAS 70, something that says, ‘I’m in good health and I’m performing in compliance with CFPB requirements.’”
According to Glasgow, there’s too much interruption on the part of these various examiners. They are detracting from both banks’ and nonbanks’ ability to service the consumer. And he says the same is true for vendors; they’re encountering the same interference.
“We’re all audited,” said Caroline Reaves, CEO of Mortgage Contracting Services (MCS), which itself was recently part of a consolidation effort.
In August, Concentric Equity Partners and TDR Capital announced the formation of a new holding company to establish a suite of mortgage field services companies comprising MCS and two of its former competitors, Asset Management Specialists (AMS) and Vacant Property Specialists (VPS).
According to Reaves, there are a number of factors that come into play when considering combining forces with another company. In addition to the other party’s reputation, their management team, and the location of their facilities, chief among the questions to ask is: “Do they have something that will benefit our business?” she said.
Although the pooling of MCS, AMS, and VPS under common ownership just made good business sense, Reaves says compliance is a very big part of all consolidation taking place within the industry today. “Just the sheer volume of new regulations that have come out and the expense of that” is a strong driver, Reaves said.
MCS alone has invested $25 million in its technology since 2007, and Reaves says a lot of that has been recently to ensure compliance with new regulations. “If we’re sharing technology and not having to replicate those efforts, we get the best out of all our technologies and can make sure we’re able to handle all the security, data transfer, data backup, and disaster recovery requirements” that are necessary for this business, she explained.
“I think we will absolutely see more consolidation just because of the sheer expense of remaining compliant with all of the new regulations, along with the benefits related to technology and quality control,” Reaves said. “Consolidation can be very good. When companies are consolidating to gain the strengths of other companies, it helps our industry and helps our clients.”
Todd Mobraten, COO of RES.NET, agrees that it can be a good thing for the industry when vendors consolidate because it tends to align the ratio of suppliers to demand now that the economy is improving and the number of loans in default is declining. These consolidations could essentially represent a reset or a balancing of supply and demand, he explains.
However, Mobraten said, “From a supplier’s viewpoint like mine, when there’s a consolidation of mortgage servicers, there becomes less opportunity. We wind up with a large pool of suppliers and a small customer base.”
“This business has always been about building relationships and understanding the specific pains that your customer base goes through, and you investing time and dollars into solutions for these particular customers,” Mobraten said. “With an immediate acquisition of some kind, now you’re at risk of that customer and all that time and investment going away in a matter of seconds.”
Mobraten said the interesting part to him is that although “every acquisition represents somebody having to sell to survive, it also represents an opportunity for someone else.”
One thing those in the industry can count on, according to Mobraten, is constant change, and it’s important to strategize for that change to endure and remain successful.
Over the last three to four years, regulatory supervision has reached a level that Glasgow can only describe as “ridiculous.” It’s a major distraction and interference with any company performing as it should and working to exceed customer expectations.
“You can’t take managers off the line and have them entertain and educate examiners—which is what we’ve been doing—and at the same time expect them to manage your customer base,” Glasgow said. “It doesn’t work.”
The burden today is being placed on those lenders and servicers that have had the stamina to withstand this “intervention,” Glasgow says, but it’s not something that can continue without companies concluding the risks of this business outweigh the rewards.
“In the next 12 to 24 months, if the extraordinary intervention that has happened in our industry over the last few years doesn’t subside, then this is a business that’s not sustainable based on the servicing fee revenues—it’s just simply not sustainable,” according to Glasgow. “Then you have to ask yourself, ‘Who is going to eventually pay for it? Who is going to have to pay to support today’s broad-based definition of how this business should be conducted?’”