Press reports this week note that financial regulators are split about whether and how to create new consumer protection rules for mortgage servicers—those companies that collect monthly mortgage payments from homeowners and forward the payments to investors in those mortgages. The debate also prompted 52 prominent economists and industry experts this week to write an open letter to federal regulators calling for new national standards for mortgage servicing. That key recommendation in the open letter is correct—reforms are badly needed in this area.
This column introduces a simple analogy in support of that recommendation. My analogy shows a large market failure at the heart of the current system of mortgage servicing akin to the one that Congress corrected four decades ago in the credit reporting business. The central problem for consumers today is that their needs are left out of mortgage servicers’ business calculations just as consumers suffered at the hands of credit reporting agencies until the passage of the Fair Credit Reporting Act in 1970. (see table)
A key disconnect
At present, the Fair Credit Reporting Act does not apply to mortgage servicing companies
|Fair Credit Reporting Act
|The companies that affect consumers
|Credit reporting agencies
|The clients of those companies
|Lenders, insurers, etc.
|Investors in mortgages
|Protections for consumers
|Fair Credit Reporting Act
Let’s consider the parallels. Today, the three major credit reporting agencies, Equifax, Experian, and Trans Union, dominate the market for consumers’ credit histories. Mistakes and decisions about credit history can have a large impact on a family, whether a mortgage or auto loan is approved, for instance, and on what terms. The clients of these three credit agencies, however, are not consumers. Instead, the agencies make their money by selling credit reports to lenders, insurers, employers, and others. The market incentives for Equifax, Experian, and Trans Union are to give their corporate clients what they want rather than to worry about how a mistake affects an individual consumer.
Consumer protection laws about credit histories came into force when the credit reporting industry consolidated greatly during the 1960s. A series of congressional hearings showed that individual consumers often had serious mistakes in their credit histories, but the credit reporting agencies had no good procedures to handle consumer complaints. For instance, the hearings showed that consumers lacked any protection when a lender incorrectly reported they had paid late, and individuals were turned down for loans and jobs as a result.
In addition, the hearings emphasized that consumers have no choice about whether to participate in the credit reporting system. The data about anyone who gets a loan goes into the systems for the three big agencies whether consumers like it or not. In light of these problems, Congress passed the Fair Credit Reporting Act of 1970, which gave individuals the right to see their credit history and to correct mistakes. Over time, Congress strengthened these consumer protections under the FCRA, notably in overhauls in 1996 and 2004.
The market structure of mortgage servicing is parallel to that of the credit reporting agencies. First of all, there’s been consolidation. The ten largest servicers had an 11 percent market share in 1989, which climbed to 40 percent a decade later, according to The Handbook of Mortgage-Backed Securities. Today, the top four servicers have over 70 percent of the market. As a result, the policies of a small number of financial giants now govern how most homeowners are treated if there is any difficulty in paying the mortgage.
Secondly, these mortgage servicers make vital decisions about consumers, such as whether to forgive a late payment, modify a mortgage, or foreclose on the house, and with (often large) fees paid by the homeowners. The servicers also can have a major impact on consumers through mistakes. There have been numerous stories about lost documents and incorrect crediting to homeowners’ accounts. The servicers’ clients, however, are financial corporations, such as investors or mortgage guarantors. These clients have their own complaints about the current system, as discussed in the open letter this week. The clients, however, at least have protection by contracts that say the servicers are supposed to act on the clients’ behalf.
Consumers have no similar protections. They are simply “third parties,” or people who are affected by the contract between the investor and the servicer but play no part in drafting the contract. As with the credit reporting agencies, consumers have no choice about which servicer handles their mortgage. Consumers choose a mortgage originator when they get a mortgage, usually a commercial bank or home mortgage broker, but the originator now routinely sells that mortgage to institutional investors who rely on an outside servicer to collect the monthly mortgage payments, with no choice in the matter for the homeowner.
In short, consumers exert no market pressure on servicers. A servicer can provide lousy service and the homeowner has no way to exit. Even if the consumer tries to refinance the mortgage, the new originator can sell the servicing rights to the same lousy servicer as before.
This simple point has not been part of the public debate to date about mortgage servicing. The United States has long required effective consumer protection rules under the Fair Credit Reporting Act, but the same sorts of problems in mortgage servicing currently lack any similar consumer law. Quite simply, there is a large market failure. Consumers can suffer from bad service and large losses, with no effective market checks or legal redress in place.
Once this gaping market failure is recognized, the intellectual case for significant consumer protection laws in the mortgage servicing arena is easy to grasp. Those protections should likely come from the federal agencies charged with responsibilities to implement housing pieces of the Dodd-Frank Act—the recently enacted financial services reform law—as the Federal Deposit Insurance Corporation is now reportedly proposing.
Similarly, consumer protection rules can be built into any settlement that the state attorneys general may reach soon with servicers as part of the recent robo-signing scandal, in which many mortgage services companies have been found complicit in shoddy handling of the legal requirements for foreclosure. If not enough progress is made elsewhere, new consumer protection laws could usefully be part of the reform of the housing finance system that Congress is scheduled to consider next year.
Wherever improvement comes from, however, there needs to be an effective new path for handling mortgage payments before the financial markets will resume providing major liquidity to the housing markets. So in terms of specific consumer protection laws, the open letter provides a good list of reforms to consider, including basic protections that consumers get their accounts credited properly. Here are three traditional categories of consumer protections to consider:
- Conflict of interest
Let’s look at each in turn.
Mortgage servicers should disclose their fee schedule, including for the contractors they hire in the foreclosure process. For credit and debit cards, we have seen new consumer protection laws around transaction and late fees. The risk of problems is even greater in mortgage servicing when consumers have no option to exit from an abusive servicer.
Servicer fees are often paid out of the proceeds of a foreclosure, and a recurring complaint has been that such fees give too great an incentive to foreclose rather than work out a modification. Disclosure of a servicer’s fees, perhaps both to the homeowner and to consumer protection enforcers, is an important first step toward reducing abuse.
A new lawsuit against Bank of America alleges that employees were trained to mislead consumers who called with complaints about mortgage servicing. Regulators already have general powers to enforce against “unfair and deceptive practices” by servicers, but more needs to be done.
More specific rules about common categories of deception are worth considering. As with the Fair Credit Reporting Act, consumers could be entitled to moderate-sized statutory damages where a mortgage servicer has engaged in a pattern of deception.
Conflict of interest
Most mortgage servicing today is done within the largest financial holding companies. One major concern about the current system is that the large servicers may be protecting affiliates who hold second liens on homes in the form of home equity loans, at the expense of the first-lien holders—the investors—who they supposedly work for. When conflicts of interest exist, consumers come third, after the investors and servicers, and the servicer has no legal duty to act in the consumers’ best interest.
Other aspects of banking regulation have strict conflict-of-interest disclosures and regulations, such as the limits on transactions between an FDIC-insured bank and its affiliates. New measures should be considered to ensure that servicers are acting on behalf of investors and consumers, rather than for the benefit of their lending affiliates.
The way forward
Mortgage servicers grew enormously during the credit and housing bubble in the 2000s. The flaws of the system became visible only after house prices began to fall nationally in 2006, when mortgage servicers proved unable to meet the legitimate needs of investors and consumers. Since then, the problem has only gotten worse.
Only rarely does such a large, concentrated industry arise in ways that can have such important negative effects on millions of consumers. There is little reason to think that the system that developed during the housing bubble is the correct system going forward. The Fair Credit Reporting Act provides a model for showing that the rights and needs of consumers should not continue to be ignored in our system for mortgage servicing.
Peter Swire is the C. William O’Neill Professor of Law at the Ohio State University and a Senior Fellow at the Center for American Progress. Until this August, he served as Special Assistant to the President for Economic Policy, and worked extensively on housing policy.