Monday, February 9, 2009

Mortgage Servicing Problems for Prepayments

By Adam Levitin on Credit Slips:

With all the problems in the mortgage industry caused by defaults, it's easy to forget that the traditional bugbear of mortgage lenders isn't credit risk, but prepayment risk. If a lender contracted for a 6% return and the loan is prepaid, there's a chance that the best return the lender can get now is say 4.5%.

As it turns out, prepayments can cause just as many problems for servicers as defaults. Recently, one of my relatives laid into me with this story about her problems getting her servicer to correctly credit her prepayments. The servicer has been crediting them all to interest, not to principal, so the loan balance isn't getting paid down (and the servicer is making more money that way, at the expense of the investors). What's worse, is that the servicer says it can't correct the problem because some of the prepayments were made before it acquired the servicing rights. And, the servicer says that if it corrected the problem, it would result in the account being listed as 30-days late and credit reported because the servicer did not make an automatic withdrawal one month because it treated the prepayment as a regular (but partial) payment (even though the total prepayments should put the loan way ahead on its original amortization schedule).

Put another way, the servicer is saying that they cannot produce an accurate payoff balanceand that if the homeowner demands one it will result in her being credit-reported incorrectly.

This aggrevating situation illuminates what a mess the mortgage servicing world is in. For all of the attention justly paid to mortgage servicing problems with defaulted homeowners and servicing fraud in the context of default, my relative's case makes me wonder whether the rot in the servicing industry extends all the way up the tree, to an inability to properly handle transferred servicing rights and an inability to properly handle prepayments.

And here's the real problem: consumers trust financial institution creditors to be competent and fair. They trust that balances are right, that APRs are properly applied, that amortization schedules are correct, etc. Without that trust, the entire system of financial intermediation cannot work. Financial institutions trade in trust. Absent that trust, every consumer would have to subject every credit card bill, auto loan bill, mortgage bill, and student loan bill, etc. to a forensic accounting. That would be astonishingly inefficient. We shouldn't want consumers to have to be so careful. It's one thing to expect consumers to look at their bills to make sure that there are no unauthorized line items. It's another to expect them to run interest and amortization calculations.

For the most part the system works, as it's all highly automated. But when it doesn't, the power imbalance between the financial institution and the consumer puts the consumer at a serious disadvantage. We really need a better system for resolving consumer disputes with financial institutions. I'm not sure what it is, but maybe the trick is to avoid the disputes by making sure the FIs get things right. The least cost avoider of the errors is the financial institution, and we should really have stronger incentives for FIs to get it right.

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