Recently a young entrepreneur asked to discuss a compelling mortgage industry issue he felt was overlooked and marginalized. Over lunch he described his concerns and asked me to investigate.

My initial reaction was incredulity but later changed to belief after some due diligence. I do not have much experience in the REO part of the mortgage process, particularly securing properties followed by repair and preservation post foreclosure.

My mortgage finance career has been focused on avoiding nonperforming assets or REO although unforeseen circumstances invariably result in some. Aaron Davitian, the founder and CEO of a San Diego-based company with the really cool name, The Remedy, has a persuasive and passionate viewpoint on the process of property security, cleanup and maintenance.

Davitian explained this back end part of the process is highly fragmented, largely unregulated, inefficient and what he dubbed, "The Wild West."

Another senior executive I interviewed called the situation the industry's dirty little secret because often his company has the inevitable task of carting many cubic yards of trash for legal, environmentally safe disposal for inadequate compensation.

Davitian related he is particularly incensed that companies like his trying to do the right thing while taking care of their employees with decent wages and benefits are not rewarded. I was initially skeptical of his claims, after all the mortgage industry is so highly regulated. How bad could it be? Actually far worse as my investigation revealed.

With all the focus on consumer protection especially on loan servicing it is surprising, even inexplicable that the transition of a vacant foreclosed property from a borrower who defaults back to the investor/lender/servicer has so little regulation or oversight. And after the lender or investor has possession of the property as an REO there are no national or industry standards for securing, preserving or repairing that property. Some local governments have enacted laws to ensure REO properties have a semblance of maintenance but enforcement is lax. Often the property condition languishes even after being listed for sale by a real estate broker. Why? In addition to the lack of regulation and standards, the process of securing, repairing, and preserving an REO property seems convoluted and flawed. Let me explain.

Most loans today are being serviced for other investors primarily the big two, Freddie Mac and Fannie Mae. Both of these agencies deal with millions of REO properties so attention to detail is not possible and the primary motivation is to control or drive down costs and expend the absolute minimum on REO properties. In the case of Fannie Mae they have elected to contract with middleman that perform asset management functions including securing the property, disposing of any remaining personal property, hauling away trash, identifying any health and safety hazards, recommending repairs, and getting the property listed with a real estate broker. Since these asset management firms don't have the capability to perform most of the actual work they in turn connect with various size companies that do the heavy lifting. This chain of investor to middleman to local hands on firms, who in turn usually use subcontactors to do the work, is inherently inefficient. And throw in real estate listing agents anxious to make a sale into this mix and the result is toxic and chaotic often resulting in a wide disparity in the maintenance of properties.

Another significant factor contributing to the poor or uneven quality of work is the compensation system. Rather than encouraging those firms doing the actual work on the ground to inspect the property and submit a reasonable fee to complete the assignment, investors like Fannie, Freddie and the major banks, have a predetermined flat fee structure. One size fits all. So out of the flat fee, the asset management company takes their cut, the contracted local firm takes their cut, and finally the rest trickles down to the subcontractors. As you can imagine the fee is usually not sufficient for the chain to cover their expenses and make a reasonable profit. Some properties require lots of cleanup, repairs, and expensive trash hauling and maybe in challenging locations. To complete the profit squeeze for the local firms to turn a profit, if the investor did not perfect the foreclosure/REO process and a homeowner claims personal property was illegally seized guess who maybe left holding the bag? Davitian told me he has paid out thousands in dubious claims just to settle and avoid litigation expense. Often the work orders have the statement "Please contact state rep if value of personal property exceeds $300 GSV." For the uninformed GSV stands for "garage sale value." What does that mean—which garage sale? I talked to several other firms that confirmed this scenario. The concensus from top to bottom in the property preservation chain is the work cannot possibly be done professionally for the fee structure currently in place.

Some banks and to some extent Freddie Mac have tried to vertically integrate to squeeze out the middlemen and reduce costs or in some cases create a profit center. And some bigger soup to nuts asset management firms have evolved but it still boils down to the local contractors with boots on the ground.

Fannie Mae and a couple of other big banks recently threw another wrench into the already dysfunctional works but announcing even lower flat fees and declining to renew the contracts of some of their asset management vendors who did not accept the lower fees. It reminds me of the story where all the subjects refuse out of fear to tell the emperor he has no clothes.

The bottom line is this patchwork system is squeezing the folks trying to manage the assets and those doing the actual hard work. In the end corners are cut or work is never performed to adequately secure and preserve REO properties. The system actually incents the use of illegal labor and the paying of sub par wages and no benefits. Neighborhoods and paying homeowners suffer because properties are not properly maintained and property values suffer. The current preservation system also inhibits accurate feedback on property condition and any needed repairs. We have to ask why isn't this important segment of the process not held to the same high standards and regulation as the rest of the mortgage process?