Dilemmas of Contracting with Non-Bank Mortgage Servicers

Mortgage lending has been a hot topic for commercial banks in the United States for the last
several years since the financial crisis. The agencies relentless pursuit to stabilize the mortgage
finance system has resulted in a number of rules and regulations that is overwhelming all
financial institutions. Banks struggle to keep their heads above water as regulators persistently
dump new laws on a wide range of mortgage activities. The immense compliance pressure from
intricate rules and increased regulatory scrutiny on financial institutions has caused the non-bank
mortgage servicers to take on more crucial tasks in servicing the residential mortgage loans.

Mortgage Payment
Refinancing
Default Prevention
Options

Borrowers

Non-Bank
Mortgage
Servicers
Collection
Routine Servicing
Default and
Foreclosure

Remittance of
mortgage payments
Contractual
servicing fees

Traditional
Banks

The risks are escalating as traditional banks transfer a portion of or all of their servicing
responsibilities to non-bank mortgage servicers. The Office of the Comptroller of the Currency,
the Board of Governors of the Federal Reserve System and the Federal Deposit Insurance
Corporation released risk management guidance over third party relationships. Third party
relationships are any business arrangements between a bank and another entity. This collection
of guidelines could be applied to non-bank mortgage servicers. However, the distinct business
model of non-bank servicers hinders a comprehensive framework to mitigate the inherent risks
within the service arrangements. To effectively manage non-bank mortgage servicers, traditional

banks would need to align third party risk management guidance with the extent of the service
that will be provided while avoiding pitfalls of ineffective contract structuring agreements and
denying the need to have ongoing oversight.
Prior to entering into and while in a third party relationship, expectations and obligations
between traditional banks and non-bank mortgage servicers are laid out in a written contract
agreement to ensure the adequacy of provision within the legal documents, including compliance
with laws and regulations, ancillary fees and income, handling customer complaints and original
documents, business continuity plans, performance indicators, and ongoing oversight practices.
A weak contract structure can pave the way not only to operational difficulties but also
compliance, regulatory, legal and reputational risks as well.
1. Undefined Compliance Accountabilities
Common legal language within service agreements would include general statements that
servicers will comply with applicable requirements but only to the extent of the regulators with
whom the servicer is licensed and regulated. This means that they have no legal obligation to
comply with the state and federal rules and regulations that applies only to traditional banks.
Failing to address concrete legal requirements affecting mortgage servicing activities can put the
traditional banks at an increased risk of noncompliance. Additional clarity on the lines of
responsibility between parties over applicable requirements related to mortgage loans is essential
to strengthen compliance risk management functions.
2. Unsatisfactory Customer Complaint Management
As the non-bank mortgage servicers turn into the main point of contact for mortgage customers,
their responsibility of managing customer complaints becomes critical in making sure high risk

complaints are escalated timely and appropriately. Additionally, neglecting to establish a regular
consumer complaint reporting including attorney misconducts and other mortgage servicing
compliance concerns may present potential weaknesses within the servicing operations.
3. Unplanned Business Discontinuity
Contract agreements should require maintaining an updated and tested business continuity plan
in accordance with general business practices in an event of a major operational breakdown.
Essential considerations should be given to how servicers will handle data security, data storage
and data migration. Timeline of executions of business continuity plans is also a fundamental
requirement to be able to minimize downtime of operations.
4. Unidentified Performance Indicators
To regularly track servicing performance, contracts should explicitly assert specific expectations
from the non-bank mortgage servicers in the form of Key Performance Indicators (KPIs) that
will be the basis of review to recognize impending concerns with regard to carrying out
mortgage servicing functions. KPI can be both quantitative and qualitative that is assessed on a
periodic basis as determined by the established criteria of risk measurement.
Non-banks are equally regulated by state and federal regulators and are subject to consumer
protection and other laws related to their operations by the Consumer Financial Protection
Bureau (the bureau). Traditionally, non-bank financial companies have escaped regulations
over safety and soundness with respect to capital and liquidity but not any longer. The regulatory
creep is inevitably moving into non-bank mortgage servicers. Title I of the Dodd-Frank Act
established the Financial Stability Oversight Council (the Council) to identify potential
emerging threats and vulnerabilities, address gaps in the regulatory framework and authorize the

Council to designate non-bank financial companies. Dodd-Frank Act defines a non-bank

financial company as any company that is predominantly engaged in financial activities. Nonbank mortgage services evidently falls into this category.
Since the Councils establishment in 2010, it has provided five annual reports that provide an
evaluation of the potential emerging risks to U.S. financial stability including a set of
recommendations to address potential threats. The last two previous FSOC annual reports
identified a growing concern on the migration of traditional banking activities over mortgage
servicing towards non-bank mortgage servicers. Aside from the lack of capital and liquidity
standards, the large-scale service transfers are exposed to data integrity issues and adequacy of
risk management processes within their operations which becomes alarming in an event of a
severe economic downturn.
Non-bank mortgage servicing is not a new financial innovation; they have already been part of
the industry for over a century yet the attention and regulatory treatment they receive is not even
close to what banks are facing. The feeble enforcement of regulations over non-bank mortgage
servicers takes away their incentives to have safe and sound practices, which denotes added
oversight responsibilities for traditional banks.
During the first quarter of 2015, the Conference of State Bank Supervisors (CSBS) and the
American Association of Residential Mortgage Regulators (AARMR) released a proposal over
Regulatory Prudential Standards for Non-bank Mortgage Servicers to better protect the
consumers

by

enhancing

regulatory

oversight,

increasing

transparency,

outlining

accountabilities, and improving risk management and corporate governance standards. The
proposal includes a group of Baseline Standards that will cover capital, liquidity, risk

management, data standards, data protection, corporate governance, servicing transfer

requirements and change-of-control requirements. Because of the wide range of business models
being used in the non-bank mortgage servicing industry, state regulators will most likely dive
deeper into large and complex firms compared to small firms having a clear-cut process.
There were a total of 26 public comments to the CSBSs proposal with distinct concerns and
recommendations on how state regulators can approach the diverse set of business models in the
non-bank mortgage servicing industry. Most of the concerns were related to the duplicative
nature of the proposed rule when combined with existing CFPB Mortgage Servicing Rules on
whether the additional standards are an absolute necessity.
The increased compliance burden of the proposal will definitely be felt by all non-bank mortgage
servicers particularly the smaller servicing firms. Although the Baseline Standards are
fundamentally general business practices, giving state regulators oversight responsibilities
heightens the incentive to have safety and soundness in their operations. On the other hand, the
level of scrutiny needs to be realistic and reasonable where a certain amount of risk should be
accepted.