Editor's note: This story was originally featured in the December issue of DS News, out now [1].
Our industry learned a great many lessons in 2007 and the years that followed. When the financial crash sent one out of every 10 homeowners into default, the foreclosure industry was forced to deal with a workload it had never anticipated.
Overnight, the industry was flooded with loans in default. To the shock of many, the collateral paperwork that was supposed to protect investors from borrower default was often discovered to be in complete disarray. Servicers expected to find complete sets of loan documentation in the pallet loads of paper files they received from the nation’s document custodians. Of course, that’s all too often not what they found.
The work that companies were called upon to do was nothing short of a massive cleanup campaign that took years to sort out.
Fortunately, it’s been a decade since the financial crash and this is one thing we no longer have to worry about, right? Actually, no.
In the post-crash rush to pass laws and create rules designed to improve the industry, the operations surrounding management of collateral files went largely untouched. After all, the mortgage, title policy, modifications, and assignment documents rarely impact the consumer in any meaningful way, so they fly somewhat under the radar. Even the ratings agencies care more about the documentation related to the borrower credit underwriting than the collateral file.
The result is that our industry is still subject to substantial risk. It’s a serious problem that cries out for a better solution. The management and control over an exception-free collateral file has an impact on all aspects of the life of the loan, whether it is for default, MSR transfers, whole-loan sales, securitizations, or even when the loan is paid off.
Origin Story
The process of manufacturing a mortgage loan is complex, with many moving parts and documents produced as the deal moves down a partially automated track from application to close. After the close, a great deal of work still remains, with trailing documentation arriving sometimes long after the deal has been boarded onto the servicing platform.
Typically, a document custodian will hold these files and keep them safe until such time as they are required, either for a transfer of servicing rights, whole-loan sale, a payoff, or all too often, by the default servicer. Custodians have historically done a reasonable job of keeping the information and documents secure but have never fully been charged with the role of maintaining the files, other than the documents they are aware of. All too often, the custodian is simply not up-to-date with third-party activities that have a negative impact on the security of the files, data, and documents that never made it to the custodian to begin with.
We have seen literally hundreds of thousands of collateral files with important documents missing, sometimes even the promissory note. Even today, this problem could be considered epidemic.
For most of the past 50 years of mortgage lending, the investor requirements have focused on a solid origination and loan underwriting process, the assumption being that if the loan was underwritten correctly, the chances of a problem would be very small and servicers could always dig up the documents they needed in the event of a problem. For too long, concerns about the integrity of the collateral files or subsequent documents filed against the loan at the county level were not given the level of attention warranted.
Digging Up Lost Documents
For the most part, investors were right in assuming that most lenders underwrote the loans according to their guidelines, actually had the correct paperwork signed, and delivered the loan as agreed. While investors may never have seen the documentation, they had good reason to believe that it was sitting in some vault somewhere, safe and sound.
In truth, we have found loan documents for the same deal housed in a number of vaults, sometimes owned by different companies. More files than you can imagine have gaping holes in the document stack, leaving servicers and investors at risk. Since the crash, loan portfolios have been bought and sold a number of times, sometimes leaving a trail of documents in their wake, or even worse, the correct documents resulting from these sales never made it to the county recorders or the collateral file to begin with.
It didn’t take long for us to realize that document custody had to be more than just putting a box of loan files under lock and key. There had to be some ownership assumed for the completeness of the files.
One of the most serious problems our industry faced during the foreclosure crisis was the inability to provide the courts with proper documentation indicating who had standing to foreclose. In judicial foreclosure states, this problem proved to be very costly. In some states, the inability to produce the signed note meant the servicer’s case was lost. A single lost mortgage assignment clouds a title and gave defense counsel the opportunity to stop the process.
We were on the front lines, working to help servicers perfect their collateral files in order to move forward. The work was hard, and in the end, many regretted the decision they had made to not worry about the problem before it became a costly issue.
New Opportunity for Old Problems
Today, foreclosures have returned to a more historically normal level, but there are still portfolios of loans being traded without complete documentation to back them up. This really became an issue a few years back when the former GSEs decided to begin selling off some of their distressed assets.
We saw huge pools of nonperforming or reperforming loans hit the market. Fortunately, there was an appetite for the product and sales were brisk, but soon problems emerged. Side letters and rebuttals from buyers along with repurchase requests began to come back to the sellers, requesting additional information on loans in the pool or failing that, for the buyer to take back the loans.
This began to happen to other investors who were also beginning to sell these seasoned pools back into the market. Many were realizing that they were still spending an unexpected amount of time and money responding to requests for information about loans that they had sold months or even years before!
In the process of cleaning up these portfolios for sale, we found that the custodial exception reports were not accurate, the non-note collateral was not properly married to the note collateral and there were backlogged queues filled with improperly indexed trailing documents.
Seeing the extent of the problem, we visited with a number of the ratings agencies only to find that there was no mention of collateral reviews in their requirements. In a “summary of requirements” document we finally received from one of these agencies, collateral review was listed among the requirements but marked “not required.” The agencies were primarily concerned with the loan’s servicing history and its origination documents. Today, we’re seeing portfolio sellers invest in perfecting their collateral files before they ever put the pools up for sale. It gets them a better price for their assets but it also eliminates all of the cost and hassle of responding to requests for additional information during and after the sale. Even so, wouldn’t it be better if document custodians could just provide complete documentation for every loan file in their care?
A Better Way Forward
The job of the document custodian must evolve. It must become more than just the task of stacking up documents and storing them away. A custodian must be a partner to the investors and servicers, with solid procedures in place to ensure the integrity of the collateral. We need to leverage technology to create an auditable record of the documentation during the life of the loan.
A better document custody solution should live up to the following requirements.
1. It must still meet the initial basic mandate. To keep the documentation safe, the provider should offer a state-of-the-art vault, with advanced physical security, fire and other disaster protection, and climate control.
2. It must go beyond the basic mandate of storage only and include remediation support. The staff must be able to perfect the files by hunting down missing documentation or creating new documents, if required. Expert staff should be able to source information from the custodian’s exception report, the servicer or subservicer, the public record, and its own researchers to complete the file.
3. It must be able to scale. While we will hopefully never see a foreclosure crisis like the one we so recently lived through, we can expect to continue to see large pools of loans bought and sold across the industry. The document custodian of the future should be able to house and remediate massive pools quickly to keep the industry moving.
The future lies with digital solutions wherever possible. With the possibility of the industry one day adopting blockchain technology, the electronic generation and storage of the note, at a minimum, must become a priority. The electronic storage and protection of collateral documents is inevitable and has to be where our future investment lies. Even if we stay with a paper note for the near future, there is already no reason to store the rest of the collateral in the same fashion. There is less risk of corruption or loss surrounding a solid digital process than storing reams of paper on open shelves. The GSEs certainly appear to be onboard with the idea, so what are we waiting for?