Watch Those Servicing Assets
Lenders are reacting to a changing marketplace. Experienced players see a familiar shifting cycle, increasing home-equity or subprime lending to compensate for flagging refinance business. As this trend continues, it poses new risks for servicers. Refi volume fell from $319 billion in the first quarter of 2004 to $262 billion by the fourth quarter, according to the Mortgage Bankers Association. This business, which accounted for over 50% of the overall lending volume in 2003, will account for less than 23% in 2006. Purchase business alone cannot make up this gap.
As the industry turns to home-equity product, data indicate that all A-paper home-equity lenders are competing for the same borrowers. Conventional paper in this sector is originated almost exclusively for borrowers with FICO scores within about 25 points of each other. As this market becomes saturated, lenders will be forced to target borrowers outside this credit range, leading to riskier deals.
Subprime lending has become increasingly popular since the 1990s, but over the past year or so has grown dramatically. There are a number of reasons for this. Technology has made it easier for competitors to get into this business. Subprime automated underwriting tools, virtually unknown in the 90s, are common now. In addition, improved risk mitigation tools have brought more investors to the table.
These loans carry higher risks because of the nature of the borrowers that are attracted to these products. According to the Federal Reserve Board, serious delinquencies in subprime are more than seven times as high as delinquencies in a conventional loan pool. However, as lenders struggle to maintain their previous origination levels, it is clear that more borrowers from these lower credit grades will be securing mortgage loans.
It doesn't take a crystal ball to see that delinquencies and foreclosures are going to rise in the months ahead. Servicers are already gearing up to deal with more REO. But there are other steps they can take now to mitigate these risks.
The first step in mitigating delinquency and foreclosure risk in these portfolios is to keep better tabs on these borrowers. The most successful subprime servicers are prepared to take action the minute a loan payment becomes delinquent. But timely principal and interest payments are not the only liabilities that must be monitored. Property taxes and insurance must also be paid on time.
Because interest rates and closing costs are higher on subprime loans, originators may forgo setting up an escrow account to give the borrower the impression that the overall loan costs are lower. However, lenders must keep in mind that escrow accounts become more valuable when attached to riskier loans because these borrowers are more likely to encounter a problem that prevents them from paying these important bills on time.
In addition, where state laws permit it, servicers can earn interest on the funds held in escrow. This can act as an additional hedge against the costs associated with bringing a delinquent loan back up to date.
With or without an escrow account, it will be increasingly important that servicers do a very good job of tracking tax and insurance payments over the life of the loan. Failure to satisfy these liabilities will result in the loss of the collateral, which is the primary reason these borrowers got the loan in the first place.
Servicers sometimes depend on internal staff to handle this complex responsibility. This works best when the operation is large enough to hire dedicated personnel for this important job. If the company cannot support such a department, it is beneficial to contract with an expert vendor that provides this service.
Tax assessments and insurance premiums are not static, nor do they change according to a fixed pattern, such as with an amortization schedule. Keeping track of these liabilities involves frequent contact with the insurance company and the taxing authority. Because many properties are subject to multiple taxing authorities, it can be challenging for lenders to effectively track these payments.
In addition, spending resources in this area takes away from the company's core competency, servicing mortgage loans and dealing with borrowers. Different skills are required and technology alone will not allow a servicer to keep track of these bills as they change.
A mistake in this area can cost the company even if the taxing authority fails to levy a penalty. Unpaid tax or insurance bills will have a negative effect on the value of a portfolio, costing the company money when it takes it to market.
Knowing the liabilities on a portfolio by using a tax or insurance outsourcing company to track the payments can mean better loss mitigation efforts and more money earned for a portfolio on Wall Street.
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