Federal Reserve Governor Sarah Bloom Raskin called out housing finance players in a speech on Friday, reminding them of the "low road" they traveled before the housing collapse and the debt they owe the American people for rescuing them from their excesses.  She also told her audience that reforming the servicing industry is "the key to economic recovery."

Speaking to the Midwinter Housing Finance Conference in Park City Utah, Raskin said that in an economic sense the recession is over, but "Americans still looking for work, living in cars or motels, or trying to keep their businesses out of bankruptcy would beg to disagree."  The lethargic pace of recovery has many causes but, in her view, the big drag is the state of the housing sector.  Usually it is the first to recover because of low interest rates and pent-up demand and is followed by consumer expenditures which magnifies and multiples the effect of the housing recovery.

Today recovery is hampered both by losses in income and net worth and by persistent unemployment.  With the pipeline full of distressed properties we might even see further downward pressure on prices.  Uncertainty about prices destabilizes expectations outside of the sector as banks must increase loss provisions, reducing their ability to lend.  Raskin quoting a Census Bureau study finding that falling homeownership rates have more than wiped out the increase in homeownership that had taken place between 2000 and 2007.  This is not only a drag on the recovery but means millions of American families have lost their homes and their hopes and the impact is felt by the broader community as business investment is undermined, homelessness increases, and health problems multiply.

To see the kind of economic recovery we want we should start at the ground level to prevent additional foreclosures; make sure they "take place only when there is no option available that would be preferable to both the borrower and the investor."  Servicers must review all options before deciding that foreclosure is the best course of action and investors need to be supportive of these efforts. 

For those in the servicing industry this means difficult changes and significant investments to rectify broken systems. "For those servicers who are subsidiaries or affiliates of a broader parent financial institution, the responsibility for change and further investment absolutely extends up to that parent company, many of which have enjoyed substantial profits while their servicing arms have been run on the cheap."

Raskin recalled a speech she gave in November about the servicing problems that were undermining the performance of the industry and said they remain unaddressed. Late last year, the federal banking agencies began a targeted review of loan servicing practices at those large financial institutions that are heavily into servicing and found widespread weaknesses that risk mortgage servicing and foreclosure processes, impair the functioning of mortgage markets, and diminish overall accountability to homeowners. "I have seen little to no evidence of improvement in the operational performance of servicers since the onset of the crisis in 2007: Until these operational problems are addressed once and for all, the foreclosure crisis will continue and the housing sector will languish."

She called for strong corporate governance servicer procedures that are monitored and enforced system wide and sound policies and procedures against which internal operations are assessed. Senior leadership must communicate performance expectations that hold all business lines accountable to strong procedural controls. When errors occur, servicers must act swiftly to contain the damage and they must foster an operational environment that reflects safe and sound banking principals.  Regulators must be prepared to monitor servicing functions on an ongoing basis.  "When servicers misapply payments, lose paperwork, file incorrect foreclosure affidavits, or simply do not answer the phone or make available knowledgeable staff persons, there are consequences to the consumer. With few adequate remedies to provide meaningful recourse in the event errors occur--after all, it's not as if consumers have a choice regarding who does their servicing--many consumers find themselves captive to practices that have emphasized speed and aggressive timeframes over responsiveness, accuracy, and completeness." "In my mind, massive foreclosures were always a sign of an equally massive market failure. Well, now it seems to me we have reached a point where this sign of failure is hindering our economy's ability to rebound."

Participants in the servicing industry must change the pricing model.   In addition to float income and ancillary fees, servicers earn money through an annual fee on each loan which must cover some wildly varying costs.  The current model is structured with the hope that, over a given period of time, there are enough of the low-touch performing loans to cross-subsidize the high-touch non-performing ones, so that the overall pool of servicing fee revenue is sufficient to cover expenses and return a reasonable profit. When that doesn't happen, servicers are either being paid too much for their efforts or not enough.

The current model also rests on the expectation that, in good times, servicers are using some of the residual income to build out systems and procedures to handle the pressures that come with worse times. Unfortunately this also has not happened.

Raskin called for a business model that would:

• Closely tie expenses to compensation. Servicers could be compensated modestly for routine processing of payments and required to have either sufficient capacity for loss mitigation or contracts with third parties that do.
• Require contracts that obligate the investor to pay higher and more direct compensation for the labor-intensive work involved in delinquent loans without incentivizing them to encourage delinquency.
• Provide more clarity and specificity about loss mitigation standards and systems for auditing internal procedures.
• Limit the extent to which servicers have to advance principal and interest on non-performing loans.
• Set up more detailed pooling and servicing agreements that provide clarity about what a servicer can and cannot do and that the servicer is expected to work in the aggregate best interest of the investor regardless of tranche.
• Find ways to deal with conflicting interests of senior and junior lien holders.

Raskin said, "Too many of the practices in the mortgage servicing industry have been developed and defended solely on the basis of "standard industry practice," but many practices were not only standard but shoddy," and we now see courts rejecting some of those practices.

To rebuild the system we must all play a role.  The Federal Reserve needs to consider reforms that are needed in the realm of strong mortgage lending, but government can only do so much.  Private sector actors must think beyond their bottom line and focus on how their firms' actions are or are not contributing to recovery. "It will be essential for each of us to commit to furthering the good of our nation, our neighborhoods, and our fellow citizens."

In concluding her speech, Raskin took on the past performance of the housing industry saying there were too many players in all "functional component parts" from origination to servicing, "who were interested only in making their own profits and were indifferent to the consequences of their actions for homeowners and communities, much less the nation as a whole. This selfish free-for-all ultimately led to an economic slide the effects of which are still visible in the boarded-up houses and sheriffs' foreclosure notices posted all over America."

Only the massive infusion of public dollars into the banking system prevented collapse. "In other words, the public was forced into a position where it had to put a lot on the line to save the financial system from its own follies and from total ruin. And many were bitter about having to do so."

She called on the industry to pay back the American citizenry in full by supporting those who have been buffeted and injured by the housing crisis. "When we traveled the low road," she said, "the only question was: Will this practice make me rich? Taking the high road means we continually ask: Do our financial and legal arrangements contribute to the public welfare and the common good?