SEARCH

SEARCH BY CITATION

Abstract

  1. Top of page
  2. Abstract
  3. Mortgage servicers: Honest mistakes and predatory servicing practices
  4. Overview of the secondary mortgage market and the mortgage servicing industry
  5. Toward a model of consumer empowerment and welfare
  6. General discussion
  7. References

Policy makers and consumer advocates suggest that mortgage servicers are prone to mistakes and predatory practices that negatively impact consumer financial well-being. Using this industry as a case study, a general model of consumer empowerment and welfare is developed integrating theoretical concepts related to market structure, firm orientation, and consumer information processing. The model illuminates the most distinctive characteristics of mortgage servicing: high switching costs faced by consumers and mortgage servicers’ inability to negotiate with some borrowers. Additionally, the model posits that the most common remedy in the financial services industry, information disclosure, is unlikely to directly improve consumer welfare.

You do not live in a flood-prone area, but an erroneous note on your mortgage documents states otherwise. When your loan is sold to another firm, an expensive flood insurance policy is purchased for you and you are responsible for the payments. It takes more than two years to resolve the problem, during which you must pay for the insurance (see Der Hovanesian 2007).

You find out that your mortgage payment checks are held for several days and posted only after the due date. Late fees are assessed and are credited to the firm prior to the principal and interest payments; this accounting procedure renders your loan delinquent (see Fairbanks Capital Settlement; Federal Trade Commission 2003b).

What conditions enhance or impair consumers’ ability to protect themselves from financial institutions’ mistakes and predatory practices? In this article, an initial model of consumer empowerment and welfare in financial services is proposed and applied to the mortgage servicing industry. Mortgage servicers are relatively unique financial institutions of growing importance in today’s marketplace. Additionally, the industry has been accused by consumer advocates and governmental agencies as prone to making mistakes and even preying on homeowners. Since the consumer affairs literature has seldom focused on mortgage servicers, I begin by identifying the role these institutions play in the secondary mortgage market and providing examples of both mortgage servicing mistakes and predatory servicing practices. I then present a general model of consumer empowerment and welfare in financial markets, applying this model to the mortgage servicing industry and offering a number of testable propositions. Finally, several significant implications from the theory, including a call for changing the structure of the secondary market and a critique of the policy makers’ current favored remedy, information disclosure, are discussed.

Mortgage servicers: Honest mistakes and predatory servicing practices

  1. Top of page
  2. Abstract
  3. Mortgage servicers: Honest mistakes and predatory servicing practices
  4. Overview of the secondary mortgage market and the mortgage servicing industry
  5. Toward a model of consumer empowerment and welfare
  6. General discussion
  7. References

Mortgage servicers are responsible for collecting and recording the borrower’s principal and interest payments, as well as collecting, recording, and distributing escrow payments (e.g., homeowner insurance, property taxes). Homeowners are assigned a mortgage servicer each time their loan is sold. This servicer is “obligated to maximizing the payments from the borrower” to the holder of the mortgage-backed security (Bair 2007, p. 3). Should a consumer default on his/her loan, the consumer works with the mortgage servicer. Unfortunately, as illustrated in the opening vignettes, mortgage servicers make mistakes and some use predatory servicing practices, which negatively impact consumer well-being.

Honest mistakes, such as erroneous accounting of interest and principal, can have significant negative consequences for homeowners, ranging from disagreement regarding the loan balance to triggering automated foreclosure processes. Mortgage servicers sometimes inappropriately draw automatic drafts. A biweekly loan should be drawn every fourteen days; however, if the mortgage servicer erroneously draws payments every fourteen working days, the payments become unpredictable to the homeowner, significantly affecting household cash flows.

Another relatively common mistake is failure on the mortgage servicer’s part to adequately maintain homeowner insurance records. This can result in forced place insurance even though the borrower has maintained appropriate insurance (Ryan et al. 2005). Forced place insurance is homeowner insurance purchased by the mortgage servicer in the consumer’s name. This insurance is often more expensive than that offered by alternative vendors. The consumer pays for the forced place homeowner insurance, even if it is not needed (as in the case of the flood insurance example presented above) or if s/he already has other active homeowner insurance, until the mistake is resolved.

As a last example of servicing mistakes, consider the fact that inappropriate distribution of property taxes from escrow accounts puts homeownership itself at risk. Local governments can legally sell the property for the back taxes owed. If the back taxes are not paid by the consumer and/or the mortgage servicer in a timely manner, and the property is indeed sold, the sale is final.

While honest servicing mistakes occur, there is also evidence that predatory mortgage servicing practices exist (Der Hovanesian 2007; Federal Trade Commission 1998, 2003b; Guttentag 2004, 2007; Ryan et al. 2005). Predatory servicing includes charging fees for services that are not performed. For instance, during the course of a nondelinquent loan, it is unlikely that a mortgage servicer would require an attorney; yet, the mortgage servicer may charge a borrower unnecessary “legal fees” (Federal Trade Commission 1998). As illustrated by the Fairbanks Capital case used in the opening vignette, predatory mortgage servicers may hold payments until after the due date to assess late fees. Servicers who require escrow of taxes and insurance when the loan originator waved escrow or who make unwarranted increases in mortgage payments (such as increasing the principal and interest payments on a fixed-rate mortgage) are using predatory tactics (Federal Trade Commission 1998, 2003b). Finally, failing to inform borrowers that late fees or forced place insurance payments were paid first from the borrowers’ regular payments of principal and interest is considered predatory as this renders the loan delinquent and may initiate automatic foreclosure proceedings. In such cases, the first time a consumer may become aware of a problem is when s/he receives notice of foreclosure (Der Hovanesian 2007).

It is difficult to tell how common mistakes and predatory practices are since consumer complaint data in the mortgage industry is not detailed. However, consumer satisfaction data suggest that consumer experiences with the mortgage servicing industry have not been positive. The Better Business Bureau reported 12,799 complaints regarding Mortgage and Escrow Companies in 2003, a number that placed mortgage and escrow firms in the “Top 10” list of consumer complaints (Better Business Bureau 2004); and J.D. Powers reports that only 10% of borrowers are loyal to their mortgage servicer (J.D. Powers 2002). Industry experts, such as Jack Guttentag (2007), suggest that these practices are common and, compared to predatory lending, are “more vicious, and the adverse consequences … are more far-ranging” (p. 1).

Overview of the secondary mortgage market and the mortgage servicing industry

  1. Top of page
  2. Abstract
  3. Mortgage servicers: Honest mistakes and predatory servicing practices
  4. Overview of the secondary mortgage market and the mortgage servicing industry
  5. Toward a model of consumer empowerment and welfare
  6. General discussion
  7. References

As of 2002, approximately 90% of the mortgage loans originated in the United States were sold on the secondary mortgage market to investors (Gabriel and Rosenthal 2006). The purpose of this secondary market was to increase the flow of money to lending institutions so that money moves from low-demand areas to high-demand areas, thereby increasing the efficiency of the financial markets and the likelihood that consumers can achieve “The American Dream”—homeownership. Two government-sponsored secondary mortgage market enterprises, Fannie Mae and Freddie Mac, along with one government-owned corporation, Ginnie Mae, are major institutions that help make this market work. However, private label mortgage-backed securities are growing rapidly, doubling from 9% to 18% of the mortgage securities market between 2003 and 2006 (Bair 2007). The secondary market is critical to liquidity for mortgage loan originators and is likely to increase in importance due to the U.S. current “soaring” foreclosure and default rate (Veiga 2007). Indeed, Countrywide Financial, as part of its long-term strategy to recover from subprime lending problems, will now only make “loans that can be sold on the secondary market to government-backed enterprises such as Fannie Mae or Freddie Mac or that qualify under investment requirements for its banking unit” (Veiga 2007, p. 2).

The secondary mortgage market is extremely complex. In a nutshell, hundreds of mortgage loans are bundled together, recombined, and sliced up to form various types and grades of asset-backed securities. The bundle of loans could be divided such that the resulting investments carry different levels of risk ranging from the very lowest-risk rating (AAA) to high-risk, “bottom-rung” investments (see McLean 2007). Alternatively, the bundle of loans could be carved into rights: rights to the principal, rights to the interest, and rights to servicing. Investors purchasing rights to principal (interest) receive the principal (interest) payments generated by the loans bundled into the security. Principal rights are less risky than interest rights since most loans are paid off prior to the term of the loan thus ending the stream of interest payments. Servicing loans are lucrative because the mortgage servicer generally receives about three-eighths of a percent of the funds. While this percentage is low, the sheer volume of loans (billions of dollars) creates significant income (Light 2002).

The secondary market has been a major contributor to the increase in homeownership between 1990 and 2000. Gabriel and Rosenthal (2006) found that selling 42 loans within a particular census tract increased the number of loans originated by 3.5%. The U.S. Office of Management and Budget estimates that mortgage rates are one-quarter to one-half percent lower because of Fannie Mae and Freddie Mac, resulting in saving borrowers about $23.5 billion annually (Freddie Mac 2007).

Clearly, consumers are well served by the secondary mortgage market in terms of the cost and accessibility of money and increased homeownership. Yet, their relationships with mortgage servicers have room for improvement as evidenced by low satisfaction ratings, high complaint rates, and the significant impact of predatory practices and mistakes on consumers. How can consumer welfare in this, and other financial markets, be improved? What are the conditions that allow consumers to act on their own behalf and protect themselves? These questions motivate an initial model of consumer empowerment and welfare in financial markets.

Toward a model of consumer empowerment and welfare

  1. Top of page
  2. Abstract
  3. Mortgage servicers: Honest mistakes and predatory servicing practices
  4. Overview of the secondary mortgage market and the mortgage servicing industry
  5. Toward a model of consumer empowerment and welfare
  6. General discussion
  7. References

This model’s premise is that consumer welfare depends on three primary factors: (1) aspects of the market that influence the firm’s likelihood of a mistake or predatory practice and the interaction between the consumer’s likelihood of (2) detecting and (3) resolving a mistake or predatory practice. The likelihood of a mistake or predatory practice is posited to be negatively related to consumer welfare, while the likelihood of detecting a mistake/predatory practice interacts with the likelihood of resolving the mistake/predatory practice such that the highest consumer welfare results when both of these likelihoods are high (see Figure 1).

image

Figure 1. Model of Consumer Financial Well-being

Download figure to PowerPoint

This model is not intended to be all inclusive; rather, it identifies some of the most important factors and critical interactions facilitating consumer financial welfare. The ultimate goal is to provide testable propositions for future research and theoretical guidance for policy makers considering solutions to today’s financial market problems.

A tripartite conceptualization of consumer welfare is used. First, the consumer should receive the maximum benefit from the dollars spent. For instance, defrauded consumers are not getting the most for their money nor are consumers who are paying fees for services they do not need. Consumers should be paying interest rates no higher than those justified by their risk situation given market conditions. The second dimension considers the time costs to correcting a problem and the lost opportunity of using that time to further other financial, psychological, or social goals. Consider the time costs of a one-hour phone conversation with a mortgage servicer needed to correct a problem. The borrower may have used that hour to earn income, to spend time with his/her family, to exercise for improved health, or any number of other valued activities. Finally, satisfaction is a postuse, affective, and emotional component of welfare. In the following sections, the three major antecedent conditions for consumer welfare are detailed.

Likelihood of mistake and/or predatory behavior

The likelihood that a financial institution makes mistakes or engages in predatory behavior depends on (1) customer switching costs, (2) the amount of information the firm regularly provides about customer interactions, and (3) the firm’s focus on customer lifetime value.

Customer switching costs

Behavior is shaped by the consequences of actions. When mistakes or predatory practices result in hardship for the firm, the firm learns to make fewer mistakes and to abide by ethical practices. Within competitive markets, one of the primary motivators of providing customers with high-quality products and services is that the dissatisfied or defrauded customers have the ability to “vote with their feet” and switch to other firms. Thus, poor performance on the firm’s part results in fewer customers. This suggests that firms in markets with low customer switching costs are less likely to make mistakes or use predatory practices.

Switching costs are particularly high in the mortgage servicing industry. Note that most homeowners do not choose their mortgage servicer—rather, a mortgage servicer is assigned to them when the loan is sold to a new investor. To change mortgage servicers, consumers must refinance the loan, a process that often has high monetary costs, as well as significant time and effort costs, and requires consumers to assume the risk of increasing interest rates. Even after refinancing, borrowers are still unable to choose the mortgage servicer since the new loan is also likely to be sold. The standard procedure for home loan closings includes a signed disclosure that the homeowner is aware that the loan could be sold. While there is the possibility that the borrower could negotiate with the lender to hold, rather than sell, the loan and include such agreement in the loan contract, contract law generally allows for the free assignment of financial contracts (Petty 2007a, 2007b). The Uniform Commercial Code Subsection 2 states that the default position is for free assignment of negotiable instruments, such as mortgage notes, unless there is a clause within the contract which states that the contract cannot be assigned. However, even when the contract contains such a prohibition, the instrument can often still be legally sold (see official comment 3 to UCC 2-210 and article 3 of the Uniform Commercial Code). In order for the consumer to stop the sale of a loan, the consumer would need to show that s/he would be damaged by the sale. This is a high burden of proof because the court’s position is that since the terms of the consumer’s financial obligations do not change, the consumer is not disadvantaged (Fitzgerald & Brooks, PA 2007; rule 65 of the Federal Rules of Civil Procedure).

Evidence suggests that this lack of control due to high switching costs and involuntary changes in mortgage servicers triggered by a sale of a mortgage-backed security negatively affects consumer welfare as measured by satisfaction ratings. J.D. Powers (2006) found that customers whose loans have been sold have customer satisfaction scores 32 points lower than those who have remained with the loan originator.

Amount of information the firm regularly provides

The more information provided about the firm’s actions, the less likely the firm is to make mistakes or engage in predatory behavior (c.f., Guttentag 2007). Transparency via information, as required by government entities or professional associations, or voluntary by the firm, allows scrutiny by the firm’s customers, investors, and other publics. The amount of consumer-based information regularly provided to consumers varies widely. Some financial firms commonly provide monthly statements of account activity (e.g., Edward Jones Investments, Citibank credit cards, Loancare mortgage servicers); others provide less information, perhaps only annually (e.g., some life insurance policies) or no information at all (e.g., Wendover Financial mortgage servicers).

Important in mortgage servicing is the Real Estate Settlement Procedures Act 1974 (RESPA). RESPA requires servicers to provide borrowers using escrow accounts with an annual escrow statement that includes the escrow balance and payments for property taxes and homeowners insurance. Additionally, RESPA requires a new mortgage servicer of a loan to provide information about the anticipated activity in the escrow account for the coming year. The National Affordability Housing Act of 1990 requires that consumers receive notice from the mortgage servicer whenever their loan is being sold. The new mortgage servicer must also provide notice when it takes over the loan servicing. These measures make the sale of a loan more transparent to the borrower and protect consumers from fraudulent claims that their mortgage had been sold.

Interestingly, there are no requirements that the mortgage servicer regularly (either monthly or annually) update the consumer regarding payment history or loan balance. Thus, some mortgage servicers provide a monthly statement which details the payment dates, as well as the amount of each payment devoted to principal and interest. Other firms do not provide this information unless requested.

Firm’s commitment to lifetime value of a customer

Firms seek to maximize profits. Many marketing scholars argue that one of the best ways to maximize profits is to focus on the lifetime value of the customer (c.f., Gupta, Lehmann, and Stuart 2004). Lifetime value is a function of customer repeat business, cross-selling, and referrals. A strategic, analytical approach to lifetime value focuses a firm on identifying profitable customers and increasing the number and amount of services purchased by these customers over an extended period of time. Thus, a bank with such a focus may offer loyal customers checking and savings accounts, auto loans, home mortgages, securities, and personal investment counselor. The bank may wave fines for bounced checks or late payments for its most profitable clients. It would have a service recovery plan to maximize the chances that the consumer remains with the firm even after mistakes occur. It follows that a firm implementing a lifetime value of a customer strategy would be aware of the costs of losing a customer and would then implement service quality procedures to minimize the chance of a mistake or predatory practice which could lead to consumer defection.

Mortgage servicers who have other lines of business may also focus on customer lifetime value. Consider, for instance, United Services Automobile Association (USAA), which offers many financial services (insurance, credit cards, savings, and investments) in addition to mortgage servicing. However, when a firm perceives few options for growing a particular customer’s business, or does not strategically recognize that opportunity, then its focus moves from increasing repeat customer business to other methods of increasing profitability.

What are some of these alternatives available to enhancing profitability? Firms must either generate new business or reduce costs. For mortgage servicers, generating new business often means that the firm looks for new investors (i.e., entities purchasing mortgage-backed securities). The mortgage servicers have also significantly increased their reliance on technology-based methods of collecting, reporting, and distributing loan payments as a major cost-cutting initiative. Reducing costs may mean reducing the number of service employees. Finally, when a mortgage servicer does not offer any other services to a borrower, the only way in which it can increase income from a particular borrower is to increase the fees charged; thus, these firms seek ways to increase fee collections and face the temptation to charge unwarranted fees (c.f., Guttentag 2007).

In sum, it is proposed that:

  • P1: The likelihood of a financial services firm making a mistake or engaging in predatory practices is:

  • P1a: positively related to customer switching costs.

  • P1b: negatively related to the amount of information the firm regularly provides about customer interactions.

  • P1c: negatively related to the firm’s commitment to the lifetime value of a customer.

  • P2: The greater the likelihood of mistake or predatory practice, the lower consumer welfare (e.g., less benefit from dollars spent, greater opportunity costs, and/or lower satisfaction).

Likelihood of a consumer detecting mistake and/or predatory behavior

The likelihood that a consumer detects a financial institution’s mistake or predatory practice depends on the interaction between the totality of information available to a consumer, the consumer’s comprehension of that information, and the consumer’s conscientiousness in analyzing the information.

Total information available to the consumer

As stated earlier, the transparency to consumers is an important antecedent to consumer welfare and varies from industry to industry and firm to firm. Financial firms may be required to provide regular information about accounts to their customers and often firms provide more frequent and detailed information than required by law. In addition, there are certain protections which allow consumers to access more information when requested; thus, the information is not automatically provided but can be accessed by the consumer. A clear example of this is the consumer’s right, as laid out in the Fair and Accurate Credit Transactions Act of 2003, to request a free credit report annually from each of the three major credit-reporting organizations (Federal Trade Commission 2006).

Turning to the mortgage servicing industry, RESPA 1974 allows consumers to request more than 35 pieces of information from mortgage servicers using a “qualified written request.” This information includes a history of fees and service charges collected by the mortgage servicer, history of the escrow account, contact information for any trustee, and the prospectus for investors. RESPA also requires that the mortgage servicer acknowledge the qualified written request or any complaint letter within twenty days and attempt to resolve the issue within sixty days (Federal Trade Commission 2003a). Thus, the consumer has access to regularly provided information as well as requested information from a mortgage servicer.

Information comprehension

Simply providing information to consumers is inadequate; consumers must also be able to comprehend the information given. Comprehension depends on interaction between the consumer’s financial literacy and the format friendliness. Most educational groups involved in financial literacy focus on providing consumers with the knowledge and abilities needed to make appropriate financial decisions for themselves (Jump$tart 2007; Reynolds and Tie 2004; U.S. Treasury 2007). Thus, as a consumer progresses through life, financial literacy needs vary because the consumer is facing new circumstances (e.g., first credit card, purchasing a home, and planning for retirement). Financial literacy, then, is not a generalizable consumer characteristic which can predict success across a number of situations; rather, it is context dependent with different dimensions which are a function of the type of decision the consumer is making. Therefore, within this model, financial literacy is defined conceptually as consumers having the knowledge and abilities needed to make appropriate financial decisions for themselves. Operationally, however, financial literacy will differ substantially from industry to industry and decision to decision because the set of skills needed in one situation, such as negotiating a car loan, is likely to differ from skills needed in another situation, such as working with a health insurance firm after an accident. In the case of mortgage servicing, consumer literacy could be operationalized by the consumer understanding monthly or annual statements (if they are available) well enough to detect a mistake or predatory practice. Included in that set of literacy skills would also be the knowledge to operate in this market, such as the consumer knowing his/her rights to request information via RESPA and understanding the RESPA information, as well as understanding mortgage-related fees, interest rates, and mortgage amortization.

Unfortunately, tests of financial literacy leave no doubt that youth and experienced adults have difficulty with financial information. As examples, consider the results of a representative sample of 1,269 respondents over the age of 50 in which only 34% could correctly answer three simple questions on interest, inflation, and the relative risk of single stock versus mutual funds (Lusardi and Mitchell 2007). The average score on the 2006 Jump$tart Coalition’s 30-question financial literacy test administered to a national sample of high school seniors was 52%, with 62% of the students receiving a “failing” (below 60%) grade (Jump$tart 2006).

The difficult concepts in financial services, however, are better comprehended when presented in a friendly format. Indeed, recently, researchers have been seeking format-based solutions to improve financial disclosures (Cude 2005; Durkin 2002, 2006; Lacko and Pappalardo 2007; U.S. Government Accountability Office 2006a, 2006b). These researchers suggest that consumers’ comprehension is maximized when the most important information is provided at the beginning of a disclosure; larger fonts and standardized formats are used; when white space, titles, and headings are provided; and when information is presented as briefly as possible at an eighth-grade reading level.

Consumer financial conscientiousness

Regular effort is needed to maintain the appropriate mix of financial services in light of the consumer’s changing needs over time since financial needs, such as investments and insurance, do not remain the same as individuals age. Additionally, consumers should regularly devote resources to determine if accounts are being accurately recorded by the financial institutions and be on alert for errors made by the financial service provider. Consumer financial conscientiousness captures these behaviors. Conscientiousness is a basic personality trait which includes the consumer’s tendency to be orderly, organized, and precise (Brown et al. 2002). This construct is directly related to financial-planning knowledge and indirectly affects financial preparedness (Hershey and Mowen 2000). Consumer financial conscientiousness is the situation-specific manifestation of conscientiousness; specifically, the consumer regularly attending to financial matters in an organized, orderly, and precise manner.

It seems logical that financial conscientiousness requires, at a minimum, reading the documents provided to the consumer. The few studies examining such behavior provide several interesting insights into this construct. According to a Harris Interactive Survey, only about 12% of consumers consistently read privacy disclosures provided by financial institutions (Privacy Leadership Initiative 2001) and approximately 60% are unlikely to do anything more than “glance over” the disclosure. In Durkin’s 2002 survey of credit card disclosures, approximately half the respondents stated that they carefully read Truth in Lending disclosures. Cude (2005) found that the vast majority of the informants in her focus group study of insurance services stated that they would not read mandated disclosures. Together, these studies suggest that only a minority of consumers actually read information provided by financial institutions. Yet, in a more recent study of credit cards, Durkin (2006) reports that consumers are more likely to attend to information which is relevant to their specific needs. For instance, consumers who carry balances on their credit cards were more likely to read the Annual Percentage Rate (APR) reported on the monthly statement than those who paid the balance in full. Thus, if the consumer perceives information to directly affect his/her financial welfare, then s/he is more likely to be vigilant.

In sum, it is proposed that:

  • P3: The likelihood of a consumer detecting a mistake or predatory behavior is a function of the interaction between the totality of information available to the consumer, the consumer’s comprehension of that information, and the consumer financial conscientiousness. Detecting a mistake/predatory practice is most likely when all three constructs are at a high level. The impact of each of the three constructs is conditional on the level of the other two constructs, implying that none of these constructs have a main effect on the consumer’s ability to detect a mistake/predatory practice.

  • P4: Consumer comprehension is an interactive function of consumer financial literacy and format friendliness. Maximum comprehension results from both these factors presenting at a high level; neither construct is expected to have a main effect.

Likelihood of resolving a mistake and/or predatory behavior

The final major antecedent construct in this model is the likelihood of resolving a mistake or predatory practice. Each of the three constructs proposed to influence the likelihood of resolution (public policy and legal codification and support, industry and firm’s customer orientation, and the parties’ ability to negotiate) are discussed below.

Public policy and legal codification and support

Hogarth and English (2002) make a case that third-party involvement (such as assistance from governmental entities) facilitates complaint resolution. Additionally, codified consumer rights and regulations regarding appropriate firm behavior (such as clearly stating interest rates) increase the chance that complaints against a financial firm are resolved to the customer’s satisfaction. Hogarth and English (2002) found that the Federal Reserves System’s facilitation of consumer complaints against banks, together with the Truth in Lending Act’s statutory right to complain, and the various regulations governing the credit industry (checking, savings, credit cards, and other bank offerings) increased the probability that the complaint was resolved in the consumer’s favor.

For each industry, and within each state, the policy and legal environments differ. In mortgage servicing, the right to complain to a mortgage servicer is codified at the national level by RESPA 1974, which states that borrowers have the right to complain in writing. The mortgage servicer must acknowledge the request within twenty days and must attempt to resolve the issue within sixty days (Federal Trade Commission 2003a).

More recently, the U.S. Bankruptcy Code was significantly amended by The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (Resnick and Sommer 2005), providing more rights to borrowers in bankruptcy. Section 541i of The Bankruptcy Abuse Prevention and Consumer Protection Act explicitly discusses mortgage servicers crediting consumer payments that are made according to the bankruptcy payment plan (Gardner 2007; NCLC Reports 2006; Resnick and Sommer 2005). The code states that a mortgage servicer’s willful failure to credit payments that are provided by the borrower according to the chapter 13 plan is considered a violation of the discharge injunction. Miscrediting payments are a pervasive problem generally driven by inability of the cost-reducing automated loan recording technologies to identify bankruptcy plan scheduled payments. Depending on the extent of the violation and the judge’s interpretation of the situation, a borrower can receive both compensatory and punitive damages for mortgage servicer’s miscrediting (Fitzgerald & Brooks, PA 2007). Section 541i of The Bankruptcy Abuse Prevention and Consumer Protection Act changed the mortgage servicing landscape for postbankruptcy borrowers by providing for redress and clarifying the courts’ ability to remedy problems due to mortgage servicer errors. Indeed, until The Bankruptcy Abuse Prevention and Consumer Protection Act was passed, courts were uncertain that they had the authority to remedy problems arising from crediting errors (see NCLC Reports 2006 for a detailed discussion).

The manner in which the problem is framed by policy makers is also important to consumer protection. As discussed by Hogarth and English (2002), several federal agencies are required to investigate consumer complaints so that they devote many resources to protect consumers’ rights. In the secondary mortgage market, policy makers have primarily focused on loan origination as opposed to mortgage servicing. Policy makers frame the secondary market as one of investor relationships and ignore the homeowner/mortgage servicer relationship. Consider Freddie Mac’s discussion of how the secondary market affects consumers. “For the most part, the process is invisible to borrowers” (Freddie Mac 2007, p. 1). Freddie Mac’s and Fannie Mae’s customers are mortgage lenders and investors—not home loan borrowers. Ginnie Mae’s (2007) goals include “Excellence in Customer Service: To provide excellent service to its customers, including issuers, investors, and other stakeholders” (p. 1). The borrower is not mentioned among the stakeholders. Interestingly, each of these institutions’ primary goal is similar, that is, to increase homeownership. Borrowers are to reap the benefits of the secondary mortgage market, and yet, the borrowers themselves are not part of these organizations’ external interface nor are they given much attention by the government-sponsored secondary mortgage market enterprises. It should be noted that in 2000, Fannie Mae developed a Consumer Bill of Rights which includes homeowners’ rights to access mortgage credit, to have the lowest-cost mortgage for which they qualify, to have full knowledge of the costs involved with a mortgage, and to have full information about how a lender made a decision (Fannie Mae 2000). No mention is made of consumer rights after the mortgage documents are signed.

Industry and firm customer orientation

Herein, customer orientation is defined as having two components: the industry’s or firm’s definition of who is the customer, along with a philosophy of customer care. As examples of the former, a health insurer may identify its customer as organizations offering the insurer’s services to their employees and/or the employees who are actually using the health insurers’ services. Resources, then, can be primarily devoted to satisfying employer needs (e.g., low cost, easy access to the firm’s decision makers), or devoted to satisfying the needs of the insured employees (e.g., simplified paperwork, quick approvals, short phone hold times).

Mortgage servicers act on behalf of the investors holding the mortgage-backed security. Keeping customers satisfied generally means keeping investors, rather than homeowners, satisfied. For example, General Motors Acceptive Corporation (GMAC) Mortgage identifies its customers as “financial institutions, government-sponsored enterprises, specialty finance companies, insurance companies, utility companies, and investment banking firms” (Business Wire, Inc. 2006, p. 2). Standard & Poor’s, as well as Fitch, provide quality ratings for mortgage servicers. Standard & Poor’s quality ratings include such factors as the number of years experience of senior management in mortgage servicing, effective investor reporting, and integrated technology platforms (Standard & Poor’s 2004), while Fitch’s ratings include mortgage servicer’s experience, training programs, and control systems (Fitch, Inc. 2007). Both rating services examine the investor/mortgage servicer relationship as opposed to the borrower/mortgage servicer relationship. This supports the idea that, as an industry, mortgage servicers view the investor as the customer. Consumer advocates feel that this lack of alignment with borrowers’ definition and the mortgage servicers’ definition of customer satisfaction is a problem in this market.

The second component of customer orientation deals with customer care. Estelami (2003), in a study of postpurchase complaint behavior, suggests that problems which arise after the consumer has made a purchase need to be “healed to ensure the continuation of that relationship” (p. 411). Healing is a function of whether the firm compensates the consumer for a loss, whether the company representative was empathetic and polite, and whether the response was prompt (Estelami 2003). When the profitability of a current customer is greater than the cost of replacing a customer, and the consumer has many options from which to choose, a firm is likely to have a greater incentive to retain the customer, thus more likely to devote resources to complaint resolution (Estelami 2003). Estelami’s (2000) empirical work confirms that a greater number of competitors (and presumably, a greater ability for the consumer to choose an alternative provider) was significantly related to consumers being “delighted” with the firm’s response to a complaint. As previously noted, borrowers have few options for mortgage servicers given the high switching costs. Based on this, mortgage servicers as an industry may exhibit low customer orientation with respect to borrowers.

Parties’ ability to negotiate

To successfully resolve a disagreement, both parties need to have the ability to negotiate. Generally, when a consumer is working with a financial institution, the institution has the ability to negotiate. The local bank may waive a check-bouncing fee, or a credit card company may offer a lower interest rate. Mortgage servicers, however, are contractually bound by the terms of the particular securitization documents (such as the Pooling and Servicing Agreement) tied to the consumer’s loan. These terms may be straightforward or quite vague, may require legal opinions from outside sources, or require active consent from a majority of the investors in the mortgage-backed security. Some of these securities, such as Real Estate Mortgage Investment Conduits, generally do not allow for any changes in the underlying mortgage terms (Bair 2007). In fact, borrowers facing trouble-making payments in today’s mortgage market are told to contact their lender and work something out. Yet, mortgage servicers have only been able to modify 1% of the Adjustable Rate Mortgages (ARMs) which reset in July 2007—partially because of the “Mother, may I?” factor (i.e., mortgage servicers having to seek permission of the investors of the mortgage-backed loans) and because of the “Are you my mother?” factor (i.e., mortgage servicers not knowing who to ask for permission to modify the loan because the ownership is unclear due to the bundling and slicing of loans supporting the mortgage-backed security; Sahadi 2007). Thus, even the willing mortgage servicer may not be able to negotiate with the borrower due to the limitations set in the mortgage-backed security contracts.

The consumer’s ability to negotiate is likely to be a function of his/her worth to the firm in that highly profitable customers are rewarded with special treatment. Emerson’s (1962) classic power-dependence model defines power as the ability of one party to overcome the resistance of another party. Thus, the power of the consumer in negotiation is a function of his/her ability to compel the firm to change its behavior. Power is inversely related to dependence on one party to help meet the goals of the second. The greater the consumer’s reliance on the firm to meet financial goals, the less power the consumer has, and vice versa. For many financial institutions, the individual customer is quite valuable to the firm’s profitability because profits are driven by repeat customers and bundling services. However, some of the conditions in the secondary mortgage market, such as high switching costs and defining the customer as the investor, make it unlikely that some mortgage servicers will change their conduct in light of demands from a particular borrower. Additionally, the borrower is dependent on the mortgage servicer to remain in his/her home. These factors may significantly limit the consumer’s ability to negotiate.

In sum, it is proposed that:

  • P5: The likelihood of resolving a mistake or predatory practice is:

  • P5a: positively related to public policy and legal codification and support.

  • P5b: positively related to the industry’s and firm’s customer orientation.

  • P5c: positively related to the parties’ ability to negotiate.

And, finally:

  • P6: Consumer financial welfare is an interactive function of the likelihood of detecting a mistake or predatory practice and the likelihood of resolving the mistake or predatory practice. An interaction effect is expected such that when both factors are high, consumer welfare is maximized. If the likelihood of detection is high, but the likelihood of resolution is low, consumer welfare may actually be lower than if the problem was not detected.

General discussion

  1. Top of page
  2. Abstract
  3. Mortgage servicers: Honest mistakes and predatory servicing practices
  4. Overview of the secondary mortgage market and the mortgage servicing industry
  5. Toward a model of consumer empowerment and welfare
  6. General discussion
  7. References

It is hoped that this model will prove fruitful in both research and public policy focusing on improving consumer financial welfare. Yet, several caveats for the model as it is currently presented must be made clear. This is a tentative model which can serve as catalyst for future discussion regarding consumer financial welfare but is certainly not a final product. It is probable that there are correlations among the constructs and crossover effects between the constructs in the model. Some of the constructs may lack discriminate validity. Important constructs may be missing. Interactions and simultaneous paths have not been empirically verified. However, the model is steeped in both theory and existing data and therefore should provide a sound beginning to a very important discussion.

Indeed, many of the main effects have either empirical and/or theoretical support. Yet, the interactions are virtually unexplored and thus become a top priority for future research. Consider for instance P3, which states that the likelihood of detecting a mistake or predatory practice is a function of the interaction between the total amount of information available, information comprehension, and financial conscientiousness. No main effects are expected because, logically, each element must be present at a high level for the consumer to detect a problem—a consumer cannot detect problems if s/he does not have information, does not understand the information, or does not regularly attend the information.

What is undoubtedly an eye-raising implication of the interactions is that increasing financial literacy (a necessary condition for comprehension) will not directly improve consumer financial welfare unless the information is available and the consumer is conscientiously attending it. In fact, P4 states that literacy is not enough to improve comprehension; the format must also be friendly to the user. Both P3 and P4 are at odds with the underlying assumption that greater financial literacy directly improves consumer welfare and thus need empirical investigation.

Another interaction, between the likelihood of detection and the likelihood of resolution, offers a rich stream of research as well. P6 states that both these constructs must be present at a high level to maximize consumer welfare. Implicit in P6 is that if a consumer detects a problem but is unable to resolve it, consumer financial welfare may be worse than if the problem was never detected because the consumer will encounter significant opportunity costs and lower satisfaction levels. A 2 × 2 case-based experiment may be the best way to first study this proposition.

The model may also prove helpful in identifying how particular firms or industries can improve consumer financial welfare. For instance, a J.D. Powers (2006) study of mortgage servicers ranked USAA Federal Savings Bank as having the highest satisfaction rating (897 of 1,000), while Ocwen Financial received the lowest satisfaction rating at 600. As part of testing the proposed model, researchers could use the J.D. Powers satisfaction ratings as one indicator of consumer welfare. Independent firm-level variables, such as the amount and format of regular information the individual firms provide to borrowers and firms’ reliance on lifetime customer value, could be regressed against satisfaction scores and other indicators of welfare to determine if the proposed relationships hold.

Much of this article has provided information regarding an understudied financial institution, the mortgage servicer, and suggests that this industry may be particularly prone to mistakes and predatory behaviors. Researchers could compare industry-level data on consumer financial welfare (e.g., satisfaction ratings, complaint rates, class action lawsuits indicating that consumers have not received maximum benefit for their expenditures) to determine whether relative to other financial services (e.g., banking, credit cards, loan origination, life insurance), consumer financial welfare is indeed lower in mortgage servicing industry. The hypothesized predictors of consumer financial welfare (e.g., switching costs, information provided, customer orientation, negotiation) could be measured to determine areas, which significantly increase the likelihoods of making, detecting, and resolving mistakes/predatory practices.

Moreover, the model may be used to empower consumers to resolve problems with financial institutions. If consumer advocates have appropriately identified mortgage servicing as prone to mistakes and predatory practices, then the model suggests possible solutions. The most notable difference in the mortgage servicing market and other financial markets is the consumer’s high switching costs. A fundamental change in market structure would be required to reduce switching costs. Guttentag (2004) suggests that when the consumer’s loan is sold and a new mortgage servicer is assigned, consumers be allowed to switch servicers after a six-month grace period. He also proposed a Servicing System for Borrowers (Guttentag 2003). For a small fee paid by the borrower, Servicing System for Borrowers would work for the borrower and distribute funds to the lender’s servicer. Servicing System for Borrowers could provide other services to the borrower such as monitoring accounts held by the primary servicer, confirming that the ARM adjustments have been calculated properly and offering flexible payment plans.

Alternatively, given that the mortgage servicing component of the loan is separable from the mortgage interest and principal payment, it is feasible that the borrower could maintain the rights to assign servicing from the loan’s inception. Servicing rights could remain with the loan originator or the consumer could use internet technology to choose a servicer at will. Given the wide use of integrated database technology platforms in this industry, switching should be relatively easy. This would reposition the mortgage servicer as an intermediary connecting the consumer and the investor in a relationship where the intermediary must satisfy both partners, thereby increasing its attention to the borrower.

Another avenue to improve consumer welfare would be changes in policy framing and codification of borrower’s rights in mortgage servicing. Governmental regulation could address issues of redress and reduce borrowers’ switching costs. Recall that it was not until the 2005 amendments to the U.S. Bankruptcy Code that consumer rights to redress when a mortgage servicer inappropriately credits loan payments for consumers in bankruptcy were guaranteed. Perhaps other legislation at the national level could address redress for consumers who are not in bankruptcy or develop a consumer bill of rights for mortgage servicer customers, including the rights of mobility (i.e., low switching costs) and the rights of complaint and restitution.

Legislation may also be needed to redefine the legal relationship between mortgage servicers and borrowers. Today, this relationship is equivalent to a creditor/debtor relationship—a contractual relationship in which the mortgage servicer collects and distributes funds from the debtor. Yet, given the borrower’s exposure to considerable risks of a mortgage servicing mistake (i.e., risk of foreclosure and loss of home), this relationship may better be defined as a fiduciary relationship in which the mortgage servicer is legally obligated to operate in the borrower’s best interest. The fiduciary responsibility is currently between the investor and the mortgage servicer, leaving the borrower without a representative protecting his/her interests. A breach of fiduciary responsibility is a much more serious matter than a breach of a creditor/debtor relationship and should increase firms’ focus on borrowers since individuals (such as the accountants and lawyers employed by the mortgage servicer) may lose their license to practice when fiduciary responsibilities are not met (Sypolt 2007). Indeed, consumers are more likely to receive punitive damages in a breach of fiduciary responsibility (Sypolt 2007).

Third, the model may guide policy makers and firms interested in increasing consumer financial welfare. To begin, the framework forces policy makers to consider the policy’s goal. Remarkably, many required financial disclosures have no specific objectives (Cude 2005). This model suggests that the goals could be to reduce the firm’s likelihood of making mistakes/using predatory practices and/or to increase the consumers’ chances of detecting and resolving a mistake. The ultimate goal should be to enhance financial welfare by allowing consumers to choose the lowest-cost options, with minimal opportunity costs and maximal satisfaction. An excellent example of disclosure research, which is clearly focused on increasing consumer welfare, is Lacko and Pappalardo’s (2007) investigation of the mortgage broker compensation disclosures proposed by Housing and Urban Development (HUD) in 2002. One of the dependent measures in their investigation was the consumers’ judgments regarding which loan was less expensive. This is an important measure of consumer financial welfare since, all things being equal, the consumer is better financially with the less-expensive loan.

The model also realigns the favorite tool of policy makers—disclosure. Generally, policy makers approach correcting financial marketplace problems with greater disclosure (Burgess, Shank, and Borgia 2001). In fact, as a partial solution to the subprime lending crisis, President Bush has proposed mortgage broker compensation disclosures, along with explicit information regarding interest rate increases and prepayment penalties (Solomon 2007). Yet, consumer behaviorists question whether financial disclosures are effective (Burgess, Shank, and Borgia 2001) and empirical evidence shows that disclosing information often fails to improve consumer comprehension. For instance, Lacko and Pappalardo (2007) found that mortgage broker compensation disclosures actually reduced the ability for consumers to choose the less-expensive loan, thus these disclosures appear to reduce consumer welfare. The proposed model provides a frame for not only determining if a disclosure is focused on consumer welfare but also on how to develop effective disclosures based on the interrelationship between format friendliness, financial literacy, information availability, comprehension, and financial conscientiousness. It can help focus policy makers on the gestalt of consumer understanding and welfare, as opposed to the “quick fix” assumption underlying disclosure use.

In sum, financial services are complex and difficult markets. It is hoped that this model will allow more systematic empirical research and more thoughtful regulatory decisions, as well as greater attention to the mortgage servicer/consumer relationship.

References

  1. Top of page
  2. Abstract
  3. Mortgage servicers: Honest mistakes and predatory servicing practices
  4. Overview of the secondary mortgage market and the mortgage servicing industry
  5. Toward a model of consumer empowerment and welfare
  6. General discussion
  7. References