Moral Hazard - Residential Mortgage Servicing Policies
- lack of incentive to guard against risk where one is protected from its consequences, e.g. by insurance.
The moral hazard issue regarding mortgage servicing and its primary cause stems from the GAAP accounting ruling FAS-ASC-860-50-25-1.(https://www.wilwinn.com/resource/accounting-regulatory-reporting-for-mortgage-servicing-rights/). This ruling basically means that independent mortgage bankers (“IMB”) must capitalize their MSRs without a readily available low-cost source of funding like a depository institution (bank, credit union, etc.) for the servicing value created at time of origination. Hence, they need to raise additional capital to fund the balance sheet, usually at much higher rates than a depository’s cost of funds. This is multiplied for “excess servicing” since that portion is taxed prior to receiving the future income.
In recent years, we have seen IMBs and REITs gain significant market share compared to depositories. Thus, the problem is most IMBs sell all servicing created with the loan so new cash is not required to finance the asset booked to their balance sheet. While most repurchase and representation and warranty agreements provide some degree of consequences from early payoff exposure, early default risk, and simply sloppy work, the effect of selling servicing concurrent with the mortgage asset reduces the moral hazard because most sellers are thinly capitalized and highly leveraged.
SKIN IN THE GAME?
Although the US mortgage market’s current structure has an increased level of safeguards for producing and selling loans servicing released or retained versus the pre-financial crisis era, the lack of complete moral hazard still exists and can only be fully removed if selling released at origination is disallowed. Given the complex nature of the mortgage business that probably would never be allowed to happen, but some “incentive” for maintaining an ongoing interest in how the loan performs could be considered. Perhaps a tiered payment plan wherein the value produced is paid over several years based on a loan’s performance and longevity? This could also flow downstream to the loan officer compensation level where they could elect to get more later instead of a full commission upfront like the insurance industry.
BACK TO THE FUTURE
Another risk often ignored is the fact that all servicing (its fair market valuation) is booked to the balance sheet in the month of origination whether sold or retained. This creates a valuation imbalance problem wherein the originating and/or retaining IMB must book the value to the balance sheet before ever receiving the cash that will be collected over the estimated life of the loan. In the old days, servicing was not capitalized on the books and the income received monthly was recognized as it came in over time. Our industry should reverse this policy for many reasons, but chief among them is the valuation volatility created by significant market movements, disruptions like the current pandemic, and the increasing ease of refinancing. Also, it would disincentivize the moral hazard created when loans are sold servicing released. More IMBs would keep the servicing thereby strengthening their finances and cash positions and improving conditions for the industry as a whole.
Hence, the idea is to remove the incentive to sell released thereby strengthening the moral hazard. Over time, these two policy changes would stabilize and enhance the ongoing viability of the US Residential Financial Market.
© 2020 Mortgage Capital Management, Inc.