A whole new ballgame: much of the industry's attention throughout the refinance boom was on the origination side. Lenders sought endless ways to maximize loan closings for as many borrowers as they could in as little time as possible. Now, conditions have changed and servicers are looking at the default potential of all those new loans in the portfolio.

WHILE MORTGAGE ORIGINATORS NOW ARE FOCUSED on managing the decline in production, the servicing sector is bracing for potential "default fallout" from the explosion of loans written in the last three years. [??] Yet in spite of the new awareness that more defaults are likely to be on the horizon, there are opportunities today for servicers (and investors) to increase profitability and stabilize and secure their market position. [??] As a result of an effective national campaign promoting widespread homeownership and the exponential popularity of new and old kinds of nonconforming mortgage loans, homeownership levels are currently at an all-time high. One byproduct of the drive to qualify more homeowners, however, has been that some of those new homeowners were not fully financially prepared to be homeowners when they signed their loan. Others, due to an uncertain economy, may find themselves unemployed--or earning less now than when they bought their home. [??] Homeownership is not the answer for everyone. Nonetheless, when technology improves efficiencies in origination processes, a national homeownership campaign proves effective. And when the market experiences the lowest residential mortgage interest rates in decades, origination volumes are bound to remain high. But with those increased originations comes the inevitable byproduct--increased numbers of distressed properties, real estate-owned (REO) disposition loans, defaults and, eventually, foreclosures.

A look at the mortgage delinquency data will help to illustrate the picture better. A natural seasoning effect has been evident for a long time in the servicing business. Mortgages tend to reach peak delinquencies after seasoning for roughly three to four years in a portfolio. The massive volume of originations during the refi boom of the last few years will start to hit its default-prone years in the next few years. This alone will produce an uptick in delinquencies.

While overall national delinquency rates have been declining across the board since the third quarter of 2001 (with a few minor blips in the second quarters of 2002, 2003 and 2004), the string of good numbers may be about to hit some bumps in the road. A small signal that some rougher times may lie ahead for delinquencies appeared in the data for subprime loans in the third quarter of 2004.

The Mortgage Bankers Association's (MBA's) third-quarter 2004 National Delinquency Survey (NDS) released on Dec. 9, 2004, showed a modest decline in the national mortgage loan delinquency rate to 4.41 percent versus 4.49 percent in the third quarter of 2003.

The third quarter of 2004 also saw no increase in the rate of foreclosures started in the quarter compared with the rate in the second quarter of 2004. The rate of new foreclosures in 2004's third quarter (0.39 percent) was down slightly from the rate in the year earlier period (0.44 percent).

Both of these sets of numbers suggest that all is well on the default front. But when the survey results are examined at a more detailed level, specifically reviewing subprime and Federal Housing Administration (FHA) loan activity, the implications for the servicing industry are far less optimistic. Admittedly, one set of quarterly numbers does not define a trend. Yet, the numbers are worth examining.

[FIGURE 1 OMITTED]

The NDS delinquency rate for subprime loans has been bouncing around a bit over the last few quarters (see Figure 1). Over the last four reported quarters it has gone from a high of 11.53 percent (fourth quarter 2003) to a low of 10.04 percent (second quarter 2004). But significantly, the numbers had been declining for eight straight quarters until the third quarter 2004, when they kicked back up by 35 basis points.

The numbers on new subprime foreclosures started also staged a modest rise in the third quarter 2004 NDS report. After hitting a new low for the subprime delinquency series in the second quarter of 2004, they jumped by 18 basis points in the third quarter last year.

What the NDS reveals, in my view, is that the backlash of high loan volumes is beginning to take effect. Investors and servicers are now faced with the challenge of how best to prepare for what I see as an inevitable rise in distressed properties.

Getting prepared

Are the right systems in place today for servicers to optimally manage their servicing portfolios and protect their overall profitability? More important, what are the options for servicers that want to be best prepared for the pending influx of defaults?

It is possible that the market forces and industry cycles that traditionally challenged mortgage managers have been fundamentally altered. Endless waves of new buyers supported by strong immigration patterns and other positive economic developments could make demand continue to outstrip supply and keep house price appreciation stoked. If this is the case, then consumer debt could remain comfortably below the asset value of homes. This, unfortunately, is likely not a sustainable state of affairs for the industry. So, in my view, the question becomes what should investors be considering in order to best protect their interests moving forward?

First and foremost, the constant march toward increased productivity in loan servicing departments should increase, because it is a proven strategy for success. This is the most effective method for creating "true" value within the marketplace.

Regardless of whatever other market forces are afoot, an increasingly productive servicing shop will simply be better-positioned to ride out downturns in the market, and be best-positioned to take the greatest advantage of the upswings. This bears repeating, because it seems that it is often forgotten--especially in the midst of robust volumes and heady forecasts.

Now is the time for servicers and investors (those not already doing so) to get back to the basics: to polish and improve the processes already in place in their servicing departments that address reducing costs and risks. With subprime delinquencies on the rise, servicers and investors need to look more closely at the processes for managing default. They need to reduce the time it takes to return REO properties to market and investigate new systems that facilitate and enable them to consistently improve the way they do business.

Second, servicers must directly confront the worst-case scenarios and most troublesome issues, head-on. In servicing, the worst-case scenario is a default on a loan. It is easy to ignore this because it is the least-attractive aspect of mortgage financing. And it generally has been ignored for the last 10 years. Foreclosure rates, as documented by MBA's NDS, in recent times have remained relatively low on a national level--making them easy to ignore as minor blemishes on the otherwise attractive face of loan activity.

A costly part of the business

"Default management accounts for around 30 percent of direct servicing costs," explains Mary Hunter, chief executive officer of Chicago-based ACEX LLC, a company that offers a collaborative contact and business information-management solution to mortgage servicers.

"While the mortgage industry as a whole has adopted the mantra of 'increasing efficiencies,' the default sector seems a bit reluctant to jump on the bandwagon. Because servicing defaulted loans requires the meticulous participation of many partners to manage the process in order to ensure maximum communication at any point in the cycle, collaborative commerce should be at the top of servicers' minds as a way to safeguard against inefficient processes and procedures. The impact of this issue extends far beyond default servicing and affects the industry at large," says Hunter.

Dawn Gibbs, president and chief executive officer of Financial Industry Computer Systems Inc. (FICS), a Dallas-based provider of mortgage servicing technology solutions, agrees. "Servicing companies need to be proactively considering what resources already are--or will need to be--directed toward handling a potentially sizable increase in residential mortgage loan defaults in 2005," says Gibbs.

"They need to be taking a hard look at their existing portfolios and what percentage of those portfolios are comprised of adjustable-rate mortgages, interest-only type loans and 80/20 loans--all of which are projected to be the loans most affected by higher interest rates and, thus, potential distressed status. Servicers must then evaluate their infrastructure, from staff to technology, and determine what they have in place and what level of volume they are truly prepared to manage effectively. Those that plan effectively will be much more likely to weather the storm," she says.

What makes it so difficult for servicers is that the raw number of fore-closures remains one of the more elusive pieces of data to obtain, because it remains enigmatic to most in the industry. Many know--or think they know--that foreclosures number in the tens of thousands per month. Every servicer needs to evaluate the marketing and holding costs of the actual properties. The cost is far greater than the "raw" number indicative of credit loss. For example, what are the effects of foreclosed and vacant properties on the surrounding properties?

And just because foreclosures as a percentage of loans remain comfortably low, this may not exactly correlate to the actual "costs" of each raw foreclosure in the overall marketplace. By definition, with foreclosures we are talking about vacant homes for sale. These are not "positives" for anyone, especially when coupled with the daily challenges to servicers of simply managing defaulted loans within their portfolio.

The complications of FHA delinquent loans

"Presently, five basic tools are at a servicing company's disposal related to the management of FHA-insured, distressed mortgage loans. Three allow borrowers to stay in their home [repayment plan, partial claim and rate modification] and two allow borrowers to dispose of their home [borrower accepts fair market value and difference is forgiven, and if property doesn't sell, servicers accept a voluntary deed]," says Harold Wright, vice president of Standard Mortgage Corporation, New Orleans, a mortgage servicing company.

"The big challenge for servicing companies remains [qualifying] borrowers for the correct strategy to help them," Wright says. "Often, borrowers will provide misleading information to servicing companies to either make their situation look better or worse than it is, and this negatively impacts the likelihood of a timely resolution of the problem."

In addition to any increase in default volume, another significant issue facing servicing companies in 2005 surrounds the involvement of the Department of Housing and Urban Development (HUD) and pending regulation on the handling of distressed FHA loans. While FHA delinquency rates peaked at 12.59 percent in the second quarter of 2003, they have inched down more recently to 12.22 percent in the third quarter of 2004, according to the NDS. New FHA foreclosures hit a peak of 1 percent in the third quarter of 2003, and have stayed at roughly that level (0.98 percent) in the third quarter of 2004.

"The FHA currently gives incentives to servicers for every loss-mitigation option they put into place, but with the old assignment program done away with, servicers are now authorized to put loss-mitigation options in place without HUD involvement," Wright explains.

"This places a large degree of responsibility directly on the servicer now. HUD pushes servicers to do loss-mitigation options for borrowers, but at the same time HUD still can come in and second-guess servicers' decisions to do so."

This year, the FHA will implement its Accelerated Claim Disposition program, in which the FHA asks that servicers refer delinquent loans that meet specific criteria to FHA at the 120-day mark, at which point the servicers immediately receive a claim for the delinquent loans. However, servicers, to some degree, are still in the dark about the impact of this new program on the marketplace.

"Once the loans have been referred to the FHA, it then works with a partner that takes the properties and continues to service them [through loss mitigation, foreclosure or whatever the end result], markets the properties and delivers the money to HUD," says Wright.

"This will effectively knock servicers out of that portion of servicing, but we are not sure of the total impact because the criteria that determine which delinquent loans qualify for the Accelerated Claim Disposition [have] not yet been released," explains Wright. "The big problem for servicers is that they can potentially lose a loan with this process since, oftentimes, borrowers reinstate after 120 days. As a result, this could greatly impact the value of FHA servicing, staffing for servicers, foreclosure attorneys and everyone right down the line."

Hard lessons ahead

For those who work in servicing and have not dealt heavily with the default process, a hard lesson awaits many of them. The process in place for the basic management of defaulted loans is archaic and inefficient. It is extremely time-consuming for all parties involved--from servicer and investor to attorney to borrower.

"A major problem for servicing companies might be the management of communication between all of the disparate parties that become involved if a mortgage loan slips into default status," says FICS' Gibbs. "Currently, this is mostly handled through a paper-based, fax and/or overnight-delivery-facilitated process. From a technology standpoint, document imaging is poised to potentially have the biggest impact on how servicing companies manage default scenarios by enabling the formation of an electronic document archive.... [This could] greatly improve the efficiency of the communication process that goes into effect [among] the servicing company, the investor, the borrower and attorneys when a loan goes into default."

A role for technology

There exists an immediate need--perhaps more than in any other sector of the mortgage industry--for a more collaborative approach to handling defaulted loans.

"The need is for a central database repository where all the parties can send and receive data in real time," says Leilani Allen of Summer Point Consulting, Mundelein, Illinois. "That way, all the participants in the default process [servicer, attorney and investor] can know what is happening with the borrower and/or property."

Allen summarizes how this might work: "Once a loan goes into default, the servicer sends a subset of the loan file to the repository. This includes the loan terms, borrower and property information, as well as contact information for the involved parties. Then, as each negotiation occurs, or as documents are sent and received, the repository is updated until such time as there is a final disposition," she says.

In the past, there were two technical roadblocks to achieving this: Everyone involved worked off of different systems lacking common standards, and there was no common network. Also, at the time, such a system was simply too expensive to create given the available resources. The foreclosure attorneys (who are essentially small entrepreneurs) did not have the resources at their disposal to participate, and the larger servicing companies--if they were to undertake the project--would most likely create a system that relied on their attorneys and service providers exclusively, not a platform created as a common endeavor.

Secondary market investors were the logical source of the investment capital, but in the conventional mortgage servicing world that meant Fannie Mae and Freddie Mac. In the subprime world, creating such a system would require a handful of the many investors to make the effort worth-while.

"An ideal collaborative commerce system would function as an industry utility, like MERS [Mortgage Electronic Registration Systems], that is an electronic repository for servicing rights and other items," explains Allen, who served as the initial consultant to the development effort behind MERS.

"MERS was not designed to be a profit-making entity. Rather, it was created as a neutral technology provider to manage the database, handle the administration and provide support to MERS members. A default management system should probably be set up along similar lines for the servicing industry. What is needed is a small, independent entity to manage the database, provide technical support [help line, security] and handle the administration [membership, fees, etc.]."

The real challenge to creating a system like MERS for defaults is not technology-related; it lies in securing the startup capital and designated resources in multiple organizations to facilitate its realization.

"The startup capital should not just fall on the attorneys," Allen adds. "Servicers and investors should also contribute, because everyone will benefit from the system. It makes sense to me to reopen the discussion based on current technology capabilities and see who wants to participate."

A loan wellness program

Another solution may be for servicing companies to be more proactive in heading off defaults and foreclosures before they happen.

As an industry, we must ask: Where is the benefit from time spent endlessly dissecting the regional and loan-type scenarios in order to predict rising foreclosure rates? It may provide some sense of control, but does the research produce any substantial improvements to the bottom line for servicers and investors?

If best practices were in place to find solutions that keep homeowners in their homes, loan products and borrowers would not need to be classified or segmented in order to treat Cleveland borrowers differently than, say, borrowers living in Santa Barbara, California.

In fact, doing so may open a potentially destructive debate on the fairness and equity of lending practices that treat a fixed-rate borrower any differently than an adjustable-rate one--not to mention treating an Indianapolis homeowner differently than one in San Francisco.

Post-workout problems (foreclosure and REO) must be dealt with head-on. The first step must also be the highest priority: Get the now-vacant, unused and deteriorating asset back on the market as quickly, efficiently and productively as possible. Where vacancy is concerned, there is simply no time to waste.

The costs of maintaining a vacant property are almost immeasurable, and immeasurably severe. Each week of every month, property depreciation is on track to turn a simple asset loss into outright blight.

REO is not a disease easily cured. As MBA's NDS reveals, the trend line has shown a relatively steady increase in FHA's foreclosure inventory since early 2001. This growing foreclosure sector may be manageable at the moment, but who knows what the post-boom future holds as the refi boom's production starts to season and more foreclosures arrive in more neighborhoods.

Quick, aggressive sales strategies, already tested and proven, are likely to be the best antidote for servicers committed to adopting better processes and willing to seek solutions where others have been hesitant to look. Unless servicers constantly strive for improved efficiencies, seek out or even develop new solutions such as those mentioned here, the health of a servicer's bottom line may well be at risk. Servicers would be wise to give some thought to this important aspect of their business should the threat of a foreclosure boom become a reality.

Dean Williams is president and chief executive officer of Tulsa. Oklahoma-based Williams & Williams, a provider of real estate-owned (REO) disposition services for both investment and mortgage bankers. He can be reached at [e-mail].