This Article argues that a principal-agent problem plays a critical role in the current foreclosure crisis.
A traditional mortgage lender decides whether to foreclose or restructure a defaulted loan based on its evaluation of the comparative net present value of those options. Most residential mortgage loans, however, are securitized. Securitized mortgage loans are managed by third-party mortgage servicers as agents for mortgage-backed securities (“MBS”) investors.
Servicers‘ compensation structures create a principal-agent conflict between them and MBS investors. Servicers have no stake in the performance of mortgage loans, so they do not share investors‘ interest in maximizing the net present value of the loan. Instead, servicers‘ decision of whether to foreclose or modify a loan is based on their own cost and income structure, which is skewed toward foreclosure. The costs of this principal-agent conflict are thus externalized directly on homeowners and indirectly on communities and the housing market as a whole.
This Article reviews the economics and regulation of servicing and lays out the principal-agent problem. It explains why the Home Affordable Modification Program (“HAMP”) has been unable to adequately address servicer incentive problems and suggests possible solutions, drawing on devices used in other securitization servicing markets. Correcting the principal-agent problem in mortgage servicing is critical for mitigating the negative social externalities from uneconomic foreclosures and ensuring greater protection for investors and homeowners.
This Article presents the first comprehensive overview of the residential mortgage servicing business and shows that mortgage servicing suffers from an endemic principal-agent conflict between investors and servicers. Securitization separates the ownership interest in a mortgage loan and the management of the loan. Securitization structures incentivizeservicers to act in ways that do not track investors‘ interests, and these structures limit investors‘ ability to monitor servicer behavior. Monitoring proxies, such as ratings agencies and trustees, are themselves subject to perverse incentives and are limited in their ability to monitor servicer behavior.
As a result, servicers are frequently incentivized to foreclose on defaulted loans rather than restructure the loan, even when the restructuring would be in the investors‘ interest. The costs of this principal-agent conflict are not borne solely by MBS investors. The principal-agent conflict in residential mortgage servicing also has an enormous negative externality for homeowners, communities, and the housing market.
The principal-agent problem in residential mortgage servicing could be addressed by restructuring servicing compensation. Other types of securitizations use measures that mitigate the principal-agent conflict between servicers and investors. There are costs to applying these measures to residential mortgage securitization, which are likely to be borne partly by borrowers in the form of higher mortgage costs. Yet, correcting the principal-agent problem in mortgage servicing is critical for mitigating the negative social externalities from uneconomic foreclosures and ensuring greater protection for investors and homeowners.
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