Consumer Compliance Outlook > 2020 > Fourth Issue 2020

Consumer Compliance Outlook: Fourth Issue 2020

Mortgage Servicing: Managing Change

By Katie E. Ringwald, Supervisory Examiner, Federal Reserve Bank of St. Louis

For homeowners, the journey from deciding to purchase a home to closing the transaction involves many steps. But experienced homeowners know that obtaining the keys to a new home is only the beginning. Over time, the homeowner will have to perform routine maintenance and deal with unexpected repairs.

Lenders must comply with numerous compliance regulations beginning when they receive a mortgage loan application and ending when they sign the loan agreement. However, similar to a homeowner’s responsibilities, compliance obligations for the loan servicer (whether or not the lender is also the servicer) begin at closing. Depending on the terms of the loan agreement and regulatory requirements, the servicer is required to perform routine tasks and respond to anticipated and unanticipated changes. For example, forbearance and modification requests can spike in response to a crisis, such as the 2008 financial crisis or the recent pandemic. As a result, servicing resources may be strained, work may need to be performed remotely, and critical third-party providers may experience similar disruptions.

This article reviews some important aspects of routine mortgage loan servicing, including adjustable-rate mortgage (ARM) rate adjustments, private mortgage insurance monitoring, and annual escrow account analysis. This article will also discuss sound practices mortgage loan servicers can implement to help manage and adapt to unexpected changes, such as those seen through the recent COVID-19 crisis.

Adjustable-Rate Mortgage Rate Adjustments

ARMs have different servicing considerations than fixed-rate loans because, during the term of the loan, the rate periodically resets according to the terms of the loan agreement. ARM loan schedules can be set up in a variety of ways, using different indexes, margins, initial fixed-rate periods, and subsequent adjustment frequencies. Moreover, interest rate caps in the loan agreement may limit changes and impose rounding rules. As a result of these factors, Federal Reserve examiners and other regulators continue to identify ARM rate adjustment errors. For example, in 2019, the Consumer Financial Protection Bureau (Bureau) settled with a financial institution for “failing to promptly enter interest rate adjustment loan data for ARM loans into its servicing system. … [and therefore sending monthly statements] that sought to collect inaccurate principal and interest payments.”¹ Given the potential for noncompliance, servicers of ARM loans should implement risk management strategies to ensure compliance.

Examiner Insights: Sunset of London Inter-Bank Offered Rate (LIBOR)

Servicers of adjustable-rate mortgage loans should ensure they are adequately prepared for the sunset of the LIBOR, a commonly used index, by the end of 2021. The Federal Financial Institutions Examination Council’s Joint Statement on Managing the LIBOR Transition² underlines the importance of understanding the legal, operational, and other risks faced as a result of the LIBOR transition, stating “[t]ransition plans should identify affected consumer loan contracts, highlight necessary risk mitigation efforts, and address development of clear and timely consumer disclosures regarding changes in terms.” In addition, the Bureau is amending Regulation Z to address the sunset of LIBOR³ and has issued Frequently Asked Questions to address LIBOR transition topics and regulatory questions under the existing Regulation Z.⁴

Finally, on November 30, 2020, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency issued an interagency statement on the LIBOR transition, which included this statement:

• Given consumer protection, litigation, and reputation risks, the agencies believe entering into new contracts that use USD LIBOR as a reference rate after December 31, 2021, would create safety and soundness risks and will examine bank practices accordingly. Therefore, the agencies encourage banks to cease entering into new contracts that use USD LIBOR as a reference rate as soon as practicable and in any event by December 31, 2021.⁵

In addition, with some exceptions, each rate adjustment requires disclosure to the borrower in advance of the rate change.⁶ The notice must provide certain information, such as an explanation that the interest rate and payment will change, the effective date of the change, and the current and new interest rates and payments. Rate adjustment notices are generally required to be provided 60 to 120 days before the first adjusted payment is due.⁷ However, in addition to the standard adjustment notice, the first rate adjustment during the life of the loan generally requires an additional advance disclosure 210 to 240 days before the first adjusted payment is due.⁸ While this first notice is similar to other adjustment notices, it also includes special information such as a phone number for consumers to call if they anticipate not being able to make their new payments, alternatives to paying at the new rate, and ways to access homeownership counseling organizations.⁹

Private Mortgage Insurance Monitoring

For conventional loans with less than a 20 percent down payment, private mortgage insurance (PMI) is typically required and most commonly paid for through monthly premiums added to the mortgage payments. According to recent survey data from the National Association of Realtors, 57 percent of noncash homebuyers make a down payment of less than 20 percent of the purchase price, so PMI is frequently required.¹⁰

In 1998, Congress enacted the Homeowners Protection Act (HPA) to provide consumer protections for fixed- and variable-rate residential mortgage loans subject to PMI.¹¹ The HPA governs, among other things, the date on which the borrower with a good payment history (as defined in §4901(4) of the HPA) has the right to cancel PMI (defined in the HPA as the cancellation date) and the date on which the servicer must cancel PMI (defined in the HPA as the termination date). For both fixed- and variable-rate loans, the cancellation date is the date on which the principal balance reaches 80 percent of the original home value (i.e., an 80 percent loan-to-value (LTV) ratio), based on either the original amortization schedule or the actual payments the borrower has made. For example, if the borrower made extra principal payments, the cancellation date would be earlier than the date based on the amortization schedule.¹² The HPA defines the termination date as the date when the principal loan balance is scheduled to reach 78 percent of the home’s original value (i.e., a 78 percent LTV), provided the borrower has a good payment history.¹³ The HPA also provides that if PMI was not cancelled on the cancellation or termination dates, it must be cancelled by the final termination date, which §4902(c) defines as the first day of the month immediately following the date of the midpoint of the loan amortization period, provided the borrower is current on payments. In summary, the borrower may cancel the PMI when the LTV is scheduled to or actually reaches 80 percent, and the servicer must automatically cancel PMI when the LTV reaches 78 percent. If PMI was not cancelled by these dates, the servicer must cancel it no later than the loan’s midpoint based on the amortization schedule.

To ensure that PMI is cancelled consistent with the HPA’s requirements, it is important for servicers to maintain controls and monitoring mechanisms to track the loan balance relative to the home’s original value and appropriately respond to requests for PMI cancellation or cancel it automatically by the termination date.

The communications servicers provide to borrowers and the way servicers respond to customer inquiries are also a vital aspect of servicing loans with PMI. In 2018, the Bureau identified instances in which borrowers who requested PMI cancellation were denied their requests even though they had reached 80 percent LTV by making extra principal payments. While the borrowers in these instances had not satisfied all the requirements to cancel the PMI, the servicer’s responses to these requests misrepresented the requirements to end the PMI and did not accurately communicate the reasons the servicer denied the borrowers’ requests. The Bureau therefore found the communications were deceptive.¹⁴ It is important that bank communications and disclosures concerning PMI are clear and not deceptive.

The HPA also regulates loan modifications. Under §4902(d), if a loan with a PMI is modified, the cancellation date, termination date, and final termination date must be recalculated to reflect the modified terms and conditions of the loan. See also Fried v. JPMorgan Chase & Co., 850 F.3d. 590 (3d Cir. 2017)(analyzing whether original or updated property value is used to recalculate PMI dates for modified loans).

Annual Escrow Account Analysis

As noted in a 2018 Consumer Compliance Outlook article,¹⁵ examiners continue to observe violations of escrow compliance. Before establishing an escrow account, an institution must conduct an initial escrow account analysis to determine the amount the borrower must deposit into the escrow account at inception and the amount of the borrower’s periodic payments into the escrow account.¹⁶ The institution must also prepare and deliver an initial escrow account statement to the borrower.¹⁷ Subsequent to the initial escrow account analysis and statement provided to borrowers, servicers must conduct an annual escrow account analysis to review the account history and projections; determine whether a shortage, surplus, or deficiency exists; adjust the account; and send an annual statement to the borrower.¹⁸

As with ARM interest rate adjustments, errors identified in the escrow account analysis may result from inaccuracies in one of the several key pieces of information needed to calculate the shortage, surplus, or deficiency. Such key information includes projected disbursement dates and amounts, the account computation period, and the amount of cushion maintained in the account.¹⁹

Furthermore, escrow account statements are required to contain specific information for the borrower, such as the amount of the monthly mortgage payment and the amount of the payment added to the escrow; the total amount paid into and out of the account during the past year; and an explanation of how any surplus, shortage, or deficiency will be handled.²⁰ Escrow analysis errors, or simply omissions of required information, can result in inaccurate or incomplete disclosures.

Examiner Insights: CARES Act Guidance on Servicing

In response to the COVID-19 crisis, the Federal Reserve Board, the Bureau, the Federal Deposit Insurance Corporation, the National Credit Union Administration, the Office of the Comptroller of the Currency, and the State Banking Regulators (agencies) issued the Joint Statement on Supervisory and Enforcement Practices Regarding the Mortgage Servicing Rules in Response to the COVID-19 Emergency and the CARES Act (Statement).²¹ The statement specifically addresses servicers’ obligations with respect to the annual escrow statements in light of the pandemic:

• The agencies … understand that annual escrow statements typically generate a high volume of calls. The agencies recognize that this may cause challenges for servicers’ call center operations. Thus, as of April 3, 2020 and until further notice, the agencies do not intend to take supervisory or enforcement action against servicers for delays in sending the annual escrow statements required by Regulation X, 12 CFR 1024.17(i), provided that servicers are making good faith efforts to provide these statements within a reasonable time.²²

This flexible supervisory and enforcement approach applies regardless of whether a borrower is experiencing a financial hardship due ― directly or indirectly ― to the COVID-19 emergency.

The Bureau also issued servicing guidance on the same date addressing other servicing issues titled “The Bureau’s Mortgage Servicing Rules FAQs related to the COVID-19 Emergency.”²³ These FAQs acknowledged that for borrowers facing financial difficulties during the crisis, the presence of a shortage in their escrow account may be troubling. The FAQs noted that while servicers are required under Regulation X to explain how a customer will pay for any shortage or deficiency, they are not required to collect it.²⁴

Loss Mitigation

When borrowers experience difficulties making loan payments, servicers may choose to implement various loss mitigation strategies to help borrowers avoid foreclosure within the strictures of Regulation X’s loss mitigation requirements.²⁵ Some loss mitigation options include forbearance programs that temporarily pause mortgage payments and loan modifications. Certain regulatory compliance requirements may be triggered depending on the specific option selected.

For example, a servicer may agree to a forbearance program that allows a borrower to defer payments for a specified number of months and then initiate a repayment plan to bring the account current. Or a creditor may opt for a more formal loan modification, either initially or following a period of deferred payments.

In the context of flood insurance, modifications to a designated loan (i.e., a loan secured by a building or mobile home located in a special flood hazard area in which flood insurance is available)²⁶ may be a triggering event for flood insurance requirements if the modification makes, increases, renews, or extends a loan (commonly known as MIRE). On May 6, 2020, the Board of Governors of the Federal Reserve System issued guidance to address this issue, noting that a loan modification to extend the loan term is a triggering event, requiring lenders and servicers to comply with certain flood insurance requirements.²⁷

Examiner Insights: Strain on Servicers from COVID-19 Servicing Requests

Many servicers received an unanticipated volume of forbearance and modification requests at the start of the COVID-19 crisis. This high volume of requests put a strain on many compliance programs that may not have had the resources available initially to manage these requests. Banking regulators acknowledged this through an April 3, 2020, Joint Statement, stating: “[m]ortgage servicers play a vital role in assisting consumers when they face challenges in paying their mortgages, and the agencies understand that the current crisis could pose temporary business disruptions and challenges for mortgage servicers, including staffing challenges, that could impede their ability to assist consumers at this critical time.”²⁸

Additionally, because of the increased volume of forbearance and modification requests, some servicers less familiar with working with borrowers to accommodate these requests may not have anticipated the domino effect that deferments may have on other aspects of loan compliance. Sound practices, discussed next, can help servicers manage unexpected changes such as the increase in deferments.

Other considerations when comparing loss mitigation options include the treatment of escrow accounts and PMI discussed previously. While a servicer may choose to allow a borrower to defer escrow payments, it will need to conduct an escrow account analysis after the deferment period and consider how subsequent shortages will be repaid.

Sound Practices

This article discussed some of the servicing requirements warranting review to ensure compliance. Examiners have observed sound practices at many financial institutions that can help mitigate compliance risk in these areas. Some effective controls include:

• conducting regular, targeted compliance reviews;
• maintaining policies and procedures that align with the complexity of the institution;
• implementing robust and responsive training programs; and
• carefully using monitoring systems, software, and third-party vendors.

Compliance Reviews

Loan terms may require periodically calculating new payment amounts, interest rates, and escrow account balances, and then communicating these changes to borrowers at various required time frames. When subject to such servicing requirements, banks may find that targeted reviews can promote compliance by verifying computational and disclosure accuracy.

Effective compliance reviews of ARM interest rate adjustments compare the terms of the loan agreement and initial disclosures with the calculated interest rate adjustments. While many servicers use automated software to calculate interest rate adjustments, most software still requires some manual input. If any ARM loan terms have been improperly input into the servicing software, the new interest rate may be miscalculated. Additionally, verifying the correct data (the correct index value, for example) that were used to calculate a rate adjustment is especially important for servicers with multiple ARM products. In addition to verifying the interest rate calculations, effective ARM loan reviews ensure compliance with requirements for interest rate adjustment notices, including the content, format, and timing of notices.

Similarly, effective escrow compliance reviews verify that:

• Data used for the analysis are accurate, including to ensure that the cushion used complies with regulatory limits and loan documents;
• The projected disbursements are based on previous tax statements/insurance amounts;
• The identified shortage, surplus, or deficiency is treated appropriately; and
• Customer disclosures are timely and comply with all requirements for content and formatting.

When a compliance review identifies an error, a sound compliance program will determine its root cause, assess the pervasiveness of the error, take appropriate corrective action, and prevent future errors by addressing the underlying cause. Follow-up reviews will validate the efficacy of corrective actions.

Policies, Procedures, and Training

Detailed, comprehensive, and accurate written servicing procedures and robust training programs can be particularly effective for mitigating compliance risk, particularly for institutions with higher servicing volumes. Mortgage servicing employees knowledgeable about specific product characteristics, regulatory compliance requirements, and a bank’s internal systems and processes are more likely to perform their functions consistent with compliance expectations. For customer-facing staff, in particular, the ability to articulate clear and compliant responses to customer inquiries can help prevent misinformation and even potential mistreatment of customers, especially in the event of an unexpected outside change that may cause an increase in customer requests (such as the increase in requests for loan modifications seen during the COVID-19 crisis).

The most effective training programs will include both initial and ongoing training, and training targeted to review findings, business/product changes, or unique outside situations, such as regulatory changes or the onset of a crisis. Proactive training programs can help prevent compliance issues.

Systems, Software, and Vendors

With the potential complexities involved in mortgage loan servicing, software systems can be an effective tool to manage risk. For example, an automated tickler system may be used to effectively monitor the timing of interest rate adjustments, and software may be used to accurately calculate the amount of shortage, surplus, or deficiency in an escrow account. While it can be an effective tool, software typically does not eliminate the potential for human error when inputting data, and software may need to be periodically updated and tested. Performing additional testing after any software updates is a sound practice to ensure the correct parameters are still in use.

In addition, servicers should be prepared to update software in response to unexpected changes. For example, even with automated systems, servicers who worked with borrowers to accommodate forbearance requests during the COVID-19 crisis may have needed to take additional steps to ensure that they complied with the CARES Act.²⁹

Moreover, some servicers may choose to outsource specific servicing responsibilities, such as PMI monitoring, to third-party vendors. In this instance, a servicer should consider that it retains responsibility for ensuring compliance when making decisions regarding the appropriate level of vendor management oversight. Depending on the level of risk, vendor management oversight may include frequent monitoring and evaluation of the vendor’s performance.³⁰ If a servicer identifies a compliance issue caused by the vendor, the servicer is responsible for communicating and working with the vendor to correct the issue.

Conclusion

An Internet search for a “home maintenance checklist” yields millions of results detailing routine tasks homeowners should perform seasonally or annually. In the meantime, appliances may break, a roof may be damaged, or high winds could unexpectedly bring down a tree. Mortgage loan servicing is similar: Servicers must manage the routine aspects of servicing but be prepared for unexpected challenges. In addition to the specific servicing aspects detailed above, other routine aspects such as flood monitoring,³¹ credit reporting, periodic statements, late fees, and servicing transfers all may impact servicing on an ongoing basis throughout the loan term. Furthermore, unexpected changes can affect servicing requirements.

The sound practices to manage routine compliance risk noted in this article can also serve institutions during unexpected crises. Effective, proactive loan servicing programs are more easily able to adapt to changes,³² especially in times of crisis. Maintaining an effective loan servicing program requires strong procedures and controls because events can occur during the servicing of the loan, such as a loan modification, that trigger regulatory requirements. Specific issues and questions should be raised with your primary regulator.

ENDNOTES

¹ See Consumer Financial Protection Bureau Settles with BSI Financial Services (CFPB, March 29, 2019).

² See Joint Statement on Managing the LIBOR Transition (FFIEC, July 1, 2020).

³ See Amendments to Facilitate the LIBOR Transition (Regulation Z)(CFPB, June 4, 2020).

⁴ See “LIBOR Transition FAQs” (CFPB, June 4, 2020). The Federal Reserve’s safety and soundness publication for community banks also published a recent article on the LIBOR transition. Loren Lozano, “Steps to Prepare for the Cessation of LIBOR” Community Banking Connections (Third Issue 2020).

⁵ See Statement on LIBOR Transition (November 30, 2020).

⁶ See 12 C.F.R. §1026.20(c).

⁷ See 12 C.F.R. §1026.20(c)(2).

⁸ See 12 C.F.R. §1026.20(d(2)).

⁹ See 12 C.F.R. §1026.20(d).

¹⁰ See Realtors Confidence Index Survey (National Association of Realtors Research Group, May 2020).

¹¹ See 12 U.S.C. §4901 et seq.

¹² See 12 U.S.C. §4901(2), 4902(a).

¹³ See 12 U.S.C. §4901(2), 4902(b).

¹⁴ See Supervisory Highlights (CFPB Issue 18, Winter 2019), pp. 7‒8.

¹⁵ See Richele S. Brady, “Escrow Accounting Rules: Are You in Compliance?” Consumer Compliance Outlook (Second Issue 2018).

¹⁶ See 12 C.F.R. §1024.17(c)(2).

¹⁷ See 12 C.F.R. §1024.17(i).

¹⁸ See 12 C.F.R. §1024.17(c)(3).

¹⁹ These terms are defined in the definition section of Regulation X, 12 C.F.R. §1024.17(a).

²⁰ See 12 C.F.R. §1024.17(g).

²¹ See Joint Statement on Supervisory and Enforcement Practices Regarding the Mortgage Servicing Rules in Response to the COVID-19 Emergency and the CARES Act (April 3, 2020).

²² The statement clarifies, however, that servicers must continue to comply with the requirements concerning timely disbursements from escrow accounts in Regulation X, 12 C.F.R. §1024.17(k).

²³ See the Bureau’s Mortgage Servicing Rules FAQs Related to the COVID-19 Emergency (updated April 3, 2020).

²⁴ See Endnote 22, pp. 9‒10.

²⁵ See Regulation X, 12 C.F.R. Part 1024, Subpart C.

²⁶ See 12 C.F.R. §208.25(b)(5).

²⁷ See CA letter 20-7, Flood Insurance Compliance in Response to the Coronavirus. The FDIC issued similar guidance. See Frequently Asked Questions for Financial Institutions Affected by the Coronavirus Disease 2019 (FDIC, May 27, 2020).

²⁸ See Joint Statement on Supervisory and Enforcement Practices Regarding the Mortgage Servicing Rules in Response to the COVID-19 Emergency and the CARES Act, p. 1.

²⁹ See Coronavirus Aid, Relief, and Economic Security (CARES) Act, Public Law 116-136 (March 27, 2020).

³⁰ See CA letter 13-21, Guidance on Managing and Outsourcing Risk.

³¹ See CA letter 20-7, Flood Insurance Compliance in Response to the Coronavirus.

³² See Allison Burns, “Promoting Effective Change Management,” Consumer Compliance Outlook (Second Issue 2019).