As covered earlier this week in a legal alert, the U.S. Department of the Treasury issued a report recommending sweeping regulatory changes for consumer financial services. Within the report, the Treasury also recommended a wide range of changes for the mortgage industry.

In connection with a discussion of the post-crisis increase in market share for nonbank mortgage lenders, the report notes that many nonbank lenders have been early adopters of financial technology innovations. According to the report, early studies indicate that such innovations have accelerated and simplified the loan application and approval process for front-end mortgage originations. The report also notes that the departure of depository institutions from the mortgage market has been driven in part by various factors that have unnecessarily raised the cost of doing business, including False Claims Act (FCA) enforcement and the increased costs of default mortgage servicing.

To further the aim of promoting broad market participation and the adoption of beneficial technological developments, the Treasury makes the following general findings:

• Financial technology and digital mortgage capabilities have the potential to improve the customer experience, shorten origination timelines, and deliver a more reliable, lower cost mortgage product.
• Current limitations on the acceptance of electronic promissory notes by market participants limit the wider use and adoption of this technology, along with the associated benefits to consumers and the marketplace.
• The mortgage production process is unnecessarily time-intensive, with certain components prone to delays. These delays could be relieved through policy changes that enable the adoption of time- and cost-saving technology.
• State-level policy and regulatory differences across key components of the mortgage lifecycle create compliance uncertainty for lenders and servicers, increase costs, and inhibit the wider adoption of enhancing innovations.
• The use of the FCA to impose civil liability for violations of mortgage origination and servicing requirements has likely contributed to the exit of traditional commercial lenders from federal mortgage programs. This has resulted in increased costs and has limited borrower access to mortgage credit for federally insured or guaranteed loans.
• Differences in loss mitigation programs for federally supported mortgages, including the GSEs, Federal Housing Administration (FHA), U.S. Department of Veterans Affairs (VA), and U.S. Department of Agriculture (USDA), have the potential to negatively impact borrowers during periods of financial hardship and slow loss mitigation responses during a period of sustained financial stress.
• Federally supported mortgage programs exposed to nonbank counterparty credit risk could benefit from increased transparency into these counterparties’ financial condition through greater standardization and reporting.

Issues and Recommendations

In light of the above findings, the report makes a series recommendations for the mortgage industry.

Electronic Mortgage Notes

The report recommends a transition from paper-based promissory notes, with "wet signatures" and physical storage, to fully electronic notes (eNotes). Among the advantages of eNotes, the report describes greater uniformity with related digital capabilities, more efficient quality control, faster origination timelines, and ease of transferability in secondary market transactions. Treasury describes certain impediments to a wider adoption of eNotes, including delays in developing capabilities in the primary market, and lack of acceptance by certain key secondary market participants.

Treasury recommends:

• Ginnie Mae should pursue acceptance of eNotes and the measures outlined in its Ginnie Mae 2020 roadmap to more broadly develop its digital capabilities.
• Congress should appropriate for FHA the funding requested for technological upgrades in the President's Fiscal Year 2019 Budget. Part of this funding would be used by FHA to improve digitization of loan files.
• FHA, VA, and USDA should explore the development of shared technology platforms, including for certain origination and servicing activities.
• The Federal Home Loan Banks should explore ways to address their concerns regarding eNotes, with the goal of accepting eNotes on collateral pledged to secure advances.

Appraisals

The report notes that appraisal requirements, enacted in the wake of the housing bubble and subsequent collapse in home prices, have greatly affected the appraisal industry. Appraisals have consequently become the source of delays and extended closing timelines for mortgage originations. At the same time, technological advances have been made that can lower costs and expedite closing timelines, including improvements to automated valuation models and hybrid/desktop appraisals.

Treasury recommends:

• Congress should revisit the Title XI FIRREA appraisal requirements to update them for market developments. Such an updated appraisal statute should account for the development of automated and hybrid appraisals and permit their use depending on the characteristics of the transaction and market conditions.
• Support is voiced for the GSE's efforts to implement standardized appraisal reporting, the GSE's and FHA's adoption of proprietary electronic portals to submit appraisal forms, and the GSE's limited adoption of appraisal waivers. However, the report cautions that further use of digital, automated property valuations must be carefully monitored and integrated with rigorous market standards when used in lieu of traditional appraisals.
• FHA and other government loan programs should develop enhanced automated appraisal capabilities to improve origination quality and mitigate the credit risk of overvaluation. Further, the programs should consider allowing targeted appraisal waivers in situations where a high degree of property standardization and information about credit risk exists to support automated valuation, and where the overall risk of a mortgage transaction make such a waiver appropriate.
• Government loan programs should explore opportunities to leverage industry-leading technology capabilities, to reduce costs to taxpayers and accelerate the adoption of new technology in the government-insured market.
• Support is voiced for the Appraisal Qualifications Board's recently updated appraisal certification guidelines, which ease the education requirements to obtain an appraiser credential. The report notes that providing off-ramps for the education requirement—in favor of on-the-job training or other education credits—can attract qualified appraisers and relieve appraiser supply shortages.

Electronic Closing and Recording

The report notes that notarization methods have expanded and now can be performed either in person using a digital document and notary seal, or remotely using webcam interaction along with a knowledge-based identification to confirm the borrower's identity. Treasury states that additional legal clarity is needed, beyond existing state eNotarization laws and the revised model notarial act framework promulgated by the Uniform Law Commission, to ensure acceptance of both in-person and remote electronic notarizations. Despite progress in certain states, and model legislation published by the American Land Title Association and Mortgage Bankers Association (MBA), the report cites issues stemming from a lack of broad nationwide acceptance.

The report also discusses the acceptance of digital security instruments on the county level. While 33 states and U.S. territories have enacted the Uniform Real Property Electronic Recording Act (URPERA), implementation of these measures may still be held up in particular counties for those states.

Treasury recommends:

• States that have not yet authorized electronic and remote online notarization should pursue legislation to expressly permit the use of this technology, and the interstate recognition of remotely notarized documents. Such legislation should align for further standardization.
• Congress should consider legislation providing a minimum national standard for electronic and remote online notarizations. Such legislation would facilitate, but not require, this aspect of a fully digital mortgage process.
• Recording jurisdictions that do not yet recognize and accept electronic records should implement the necessary technology upgrades to process and record such documents, and to digitize existing property records.

False Claims Act

The report details the recent trend of civil actions brought under the FCA by the U.S. Department of Justice (DOJ), for claims that lenders submitted loans for government insurance that did not meet federal eligibility standards. Liability under the FCA, having resulted in approximately $7 billion in FCA settlements and judgments to date, is cited as a factor in the departure of depositories from the government-insured market. The report claims that this market shift has negatively impacted borrower access to credit.

Regarding FCA enforcement practices, the report details concerns with the manner in which the DOJ and HUD-FHA calculate damages, and determine that a false claim is knowing and material. Treasury affirms that material errors in origination and servicing of government loans should continue to be subject to enforcement, and that bad actors who knowingly defraud the government should face significant penalties. However, when FCA enforcement practices cause reluctance in the broader industry to originate or service government loans, such practices counterproductively increase the cost of credit and limit borrower access to federal loan programs.

Treasury recommends:

• An appropriate balance should be struck between program requirements that an agency deems material, and thus subject to potential FCA enforcement, and program requirements that are not material, which are appropriately addressed outside of the FCA.
• HUD should establish more transparent standards in determining which program requirements and violations it considers to be material in order to assist the DOJ in determining which knowing defects to pursue. This clarification should include information on the remedies and liability lenders and servicers face, such as indemnification or premium adjustments.
• Lenders that make errors deemed immaterial to loan approval should receive safe harbor from a denial of claim and forfeiture of premiums. A similar safe harbor should be granted for material violations that are cured based on remedies prescribed by FHA, absent patterns indicating a systemic issue.
• In determining the appropriate remedies for program requirement violations, HUD should consider the systemic nature of the problem, involvement or knowledge of the lender's senior management, the overall quality of the originations of a specific lender, and whether or to what extent the loan defect may have impacted the incidence or severity of the default.
• DOJ should ensure that materiality, for purposes of the FCA, is linked to the standards in place at the agency administering the program to which the claim has been filed, and that DOJ and HUD work to clarify the process by which mutual agreement is reached on the resolution of claims. DOJ, in consultation with HUD and FHA, should consider seeking dismissal in the event a qui tam action is pursued against a lender for a nonmaterial error or omission.
• If the above recommended administrative actions are unsuccessful at increasing lender and servicer participation in federal mortgage programs, Congress should consider appropriate remedial legislation.

Aligned Federal Mortgage Loss Mitigation Standards

The report notes that while the CFPB has implemented regulations that mandate certain procedures for evaluating delinquent borrowers for loss mitigation, there are no federal regulations dictating a national loss mitigation standard. Accordingly, market participants have raised concerns with the variance in loss mitigation options across different federal mortgage programs. The report commends recent efforts to establish loss mitigation standards that include components of crisis-era programs, including the GSE's Flex Modification, the MBA's One Modification proposal, and FHA-HAMP. However, loss-mitigation offerings continue to vary across the GSE’s, FHA, VA, USDA, bank portfolio servicers, and private-label securities servicers. This varied landscape leads to particular challenges and inefficiencies for mortgage servicers, and substantially differing treatment among borrowers experiencing a financial hardship.

Treasury states that a greater degree of standardization and transparency across the federal housing footprint would benefit the market, and accelerate the ability of the industry to respond during a future economic downturn. Further, the report states the position of mortgage servicers that FHA servicing rules are complex, and in some cases, conflicting and outdated when compared to GSE requirements, private-label guidelines, and other regulatory requirements.

Treasury recommends:

• Federally supported mortgage programs should explore standardizing the most effective features of a loss mitigation program across the federal footprint. The standardization should align a loss mitigation approach that facilitates effective and efficient loan modifications when in the financial interest of the borrower and investor, promotes transparency, reduces costs, and mitigates the impact of defaults on housing valuations during downturns. The standards should also establish parameters such as a standardized application package, affordability standards (e.g., suggested housing-expense-to-income ratios and minimum payment reductions), modification waterfall standards that specify suggested acceptable loss mitigation steps, and referral of delinquent borrowers to financial counseling. However, these standards should not prescribe a specific modification product.
• FHA should continue to review FHA servicing requirements, in order to increase certainty, reduce needlessly costly and burdensome regulatory requirements, but fulfill FHA's obligation to the Mutual Mortgage Insurance Fund.
• FHA should consider changes to the manner in which penalties are assessed across FHA’s multi-part foreclosure timeline. Such changes should allow servicers to miss intermediate deadlines, while adhering to the broader resolution timeline, and to better align with the CFPB’s loss mitigation requirements.
• FHA should explore changes to its property conveyance framework to reduce costs and increase efficiencies.
• FHA should continue use of—and consider expanding—programs that reduce the need for foreclosed properties to be conveyed to HUD, such as Note Sales and FHA's Claim Without Conveyance of Title.

State Foreclosure Practices

The report notes that foreclosure practices are one of the most divergent state-level requirements for the mortgage industry, and that the variation has been highly problematic for housing markets since the collapse. According to the report, the national average timeline to complete a foreclosure increased from approximately six months in 2007 to about 33 months by the end of 2017, with generally longer periods for judicial states. Further, while the nationwide number of loans in the foreclosure process have returned to pre-crisis levels, the foreclosure rate in judicial states remain elevated as compared to both nonjudicial states and the pre-crisis level. Timelines in some judicial states, such as Florida and New Jersey, exceed three years on average—and in certain judicial review cases, a borrower has been able to remain in a property for more than five years without making a payment before a foreclosure is completed.

Treasury asserts that borrowers in states with protracted foreclosure timelines likely bear a portion of the cost of these delays, due to a risk premium embedded in interest rates for loans in that state. The report further states that prolonged foreclosure timelines create a negative externality on home prices, which may impact nearby property values and dampen appreciation. The report notes that, since their pre-crisis peak, housing prices in nonjudicial states have appreciated twice as much as those in judicial states. According to Treasury, evidence suggests that the judicial review process leads to higher rates of persistent delinquency than nonjudicial foreclosures, without measurably improving foreclosure outcomes.

The report notes in particular that for federal housing programs, which impose a degree of national pricing, a portion of the added cost from long foreclosure timelines is borne by borrowers in states with shorter timelines. In 2013, in response to differences in loss severities due to varying foreclosure procedures, the FHFA directed the GSEs to impose a quarter-point guaranty surcharge in Connecticut, Florida, New Jersey, and New York (all judicial review states), as the foreclosure costs in those states were more than two standard deviations above the national average. The decision, however, was subsequently reversed in 2014 under a new FHFA director.

Treasury recommends:

• States should pursue the establishment of a model foreclosure law, or make any modifications they deem appropriate to an existing model law, and amend their foreclosure statutes accordingly.
• Federally supported housing programs, including FHA, USDA, VA, and the GSEs, should explore imposing guaranty fee and insurance fee surcharges to account for added costs in states where foreclosure timelines significantly exceed the national average.

Nondepository Counterparty Transparency

The report notes that, with the departure of credit investors following the housing collapse, Ginnie Mae experienced a surge in volume. In addition, Ginnie Mae's issuer base changed significantly, with nondepository issuers filling the market vacated by depositories exiting government loan programs. The GSEs have also seen their seller-servicer counterparty population shift toward nondepositories. Many in the industry have consequently observed that the increase in nondepository activity, with a less standardized approach to safety and soundness regulation, creates heightened counterparty risk.

The report notes that nondepositories are subject to federal financial oversight, and must comply with the net worth, capital, and liquidity requirements imposed by Ginnie Mae and the GSEs. However, unlike their bank counterparts, nonbanks are not subject to uniform safety and soundness standards, and do not have access to the same sources of liquidity in the event of sustained financial stress. Of particular concern is the durability of funding structures for nonbank servicers. Required advances to investors in the event of nonpayment by borrowers may expose servicers to extended periods of liquidity strain. Because counterparty risk represents Ginnie Mae's primary financial exposure, the report finds that its leadership is reasonably concerned about these issues.

While Ginnie Mae and the GSEs have various counterparty risk-management tools, the data quality and present reporting fields may not be sufficient to gain the insight needed to assess counterparty financial health. Further, despite the dramatic increase in Ginnie Mae's portfolio, it lacks the flexibility to adjust its MBS fees and hire additional staff for risk management.

Treasury recommends:

• Ginnie Mae should collaborate with FHFA, the GSEs, and the Conference of State Bank Supervisors to expand and align standardized, detailed reporting requirements on nonbank financial health. Such reporting should include terms and covenants associated with funding structures, to give confidence that taxpayers are protected during severe market stress.
• Support is given to Ginnie Mae's consideration of enhancing its counterparty risk mitigation approach, including the imposition of stress-testing requirements.
• Ginnie Mae should have sufficient flexibility to charge guaranty fees appropriate to cover additional risk arising from market or program level changes.
• Ginnie Mae should undergo a comprehensive assessment of its staffing and contracting policies, including the costs and benefits of alternative pay and/or contracting structures. Ginnie Mae should be enabled to more readily attract personnel, with the necessary expertise, by paying salaries comparable to other financial agencies with premium pay authority. In addition, being able to adopt contracting procedures, similar to other agencies that are outside of federal acquisition laws, would enable Ginnie Mae to effectively respond to changing market conditions and needs.
• Nondepositories should provide greater transparency about their financial health, to address concerns about their sustainability. Greater standardization of requirements and reporting could benefit nondepositories by reducing disparate state-level and principal counterparty requirements.

The full report, titled "A Financial System That Creates Economic Opportunities - Nonbank Financials, Fintech, and Innovation," can be found here.