For the law firms that manage and process foreclosures on behalf of investors and banking institutions, what’s a fair legal fee? What’s a fair filing fee? Should fees to outsourcers be prohibited? And just how much money should it really cost to process a foreclosure?

As I write this, the answer to these and other questions are being fought out in the trenches, in an out-of-sight but increasingly heated battle involving Fannie Mae and Freddie Mac, the law firms that specialize in creditor’s rights, default industry service providers, and various private equity interests.

It’s a complex fight that many say will ultimately shape the way U.S. mortgages are serviced over the course of the next decade — and perhaps beyond. It’s also a debate that promises to spill over into how loans are originated and priced.

“No aspect of the U.S. mortgage business will go untouched by this,” said one attorney I spoke with, on condition of anonymity.

How foreclosures are managed

Typically, a foreclosure involves legal and court filing fees — it is, after all, a legal process involving the forced transfer of a property from a non-paying borrower to secured lender. But the foreclosure process also typically involves a host of other associated fees, including necessary title searches, potential property insurance, homeowner’s association dues, property maintenance and repair, and much more.

Many of these fees are ultimately tacked onto the “past due” amounts tied to a delinquent borrower — and done so legally. Much like when a credit card becomes past due and the interest rate kicks into high oblivion, consumers looking to catch up on their delinquent mortgage payments must also make up the difference in additional fees in order to successfully do so.

Legal fees in the foreclosure business, however, aren’t what you might think. Instead of billing hourly for most work, as most attorneys in other fields would do, attorneys that specialize in processing foreclosures are paid on a flat-fee basis, using pre-determined fee schedules.

Thanks to the market-making power of the GSEs, Fannie Mae and Freddie Mac — both of whom publish allowable fee schedules for every imaginable legal filing and process in the foreclosure repertoire — much of the entire foreclosure process has been reduced to a set of flat fees.

And not even negotiated fees, at that. For firms that operate in the field of foreclosure management, the GSE allowable fees amount to a take-it-or-leave-it menu of prices.

“For us, it doesn’t matter who the client is, even if it isn’t Fannie or Freddie,” said one attorney I spoke with, under condition of anonymity. “We know we’re only going to be able to claim whatever that flat fee schedule they set says we can claim, since other investors tend to employ whatever the GSE fee caps are.”

Fannie and Freddie as housing HMOs? In the foreclosure business, that’s pretty much what it amounts to.

But beyond determining the legal fee schedule for much of the multi-billion dollar default services market, the GSEs also largely determine who gets their own foreclosure work. Both Fannie and Freddie maintain networks of law firms called “designated counsel” or "approved counsel" in key states marked with significant foreclosure volume — and they either strongly suggest or require that any servicers managing a Fannie or Freddie loan in foreclosure refer any needed legal work to their approved legal counsel.

Each state will have numerous designated counsel — sometimes as many as five law firms — but in practice, attorneys say, two to three firms end up with the lion’s share of each state’s foreclosure work. In states hit hard by the housing downturn and foreclosure surge, like Florida, the amount of work can be substantial.

“The GSEs can force a servicer to use their designated counsel, especially if timeline performance in foreclosure management is out of some set boundary,” said one servicing executive at a large bank, who asked to remain anonymous. “It’s usually easiest to simply use their counsel on their loans, even if we don’t see that firm as best-in-class.”

With the vast majority of the mortgage market now running through the GSEs, and much of what’s left of the private market following the guidelines Fannie and Freddie establish, it should come as no surprise to find that a few law firms in each state end up with the majority of the foreclosure work, sources say.

The rise of the ‘foreclosure mills’

Being designated as approved counsel by Fannie Mae and/or Freddie Mac does carry risk. Just ask Florida’s David Stern, who has seen his burgeoning operation pejoratively branded a ‘foreclosure mill’ by consumer groups, dragged through the press for both alleged and real consumer misdeeds, and facing numerous investor lawsuits surrounding the operation of DJSP Enterprises, Inc. (DJSP: 0.00 N/A) — the publicly-traded processing company tied to the law firm.

While Stern’s operation may win the award for ‘most susceptible to negative publicity,’ how the law firm operates is far from unique in the foreclosure industry.

In the past five years, many of the default industry’s largest law firms have leveraged their mushrooming volume — courtesy of their status with the GSEs — into private equity investments, not to mention a large cash payday for their firm’s partners. Unlike many other areas of law, foreclosure processing typically involves a significant amount of paper pushing, and many law firms have set up operating subsidiaries to their legal operations to manage this aspect of their businesses. It’s these paper-pushing subsidiaries that have been purchased by private equity and hedge fund investors in recent years, looking to find a profitable investment during the economic downturn.

A few of these transactions have already gone public, including the aforementioned DJSP as well as Dolan Media Company (DM: 9.50 +3.60%). Other IPOs from related companies are rumored to be in the pipeline for later this year, according to industry sources.

Attorneys in the industry say that such an outcome is simply the effect of how the GSEs have impacted legal fee structures throughout the industry, where an assembly-line mentality now rules the day.

“Like it or not, the GSEs have created a flat fee structure for legal work,” said one attorney, who asked not to be named. “That structure rewards those attorneys that understand how to generate economies of scale, who know how to push volume, and who can identify areas for process automation.”

Not that all attorneys appreciate working under such an environment. A number of attorneys I spoke with say they would prefer the work to be priced differently.

“We represent our clients the best we can given the fees we can earn,” said another attorney, under condition of anonymity. “This isn’t a high margin business for any lawyer, so we’re forced to do the best with what we have. We’d be able to do more for both the borrower and the investor, and there would be fewer ‘foreclosure mills,’ were lawyers in this field being paid what they’re actually worth."

Odd bedfellows

Not everyone agrees that attorneys specializing in foreclosure ought to be earning more. Consumer groups, for one — newly empowered by the financial crisis, most consumer groups contend that ‘foreclosure mills’ are unjustly enriching their owners. But they aren’t alone: odd as it may seem, a growing chorus of default outsourcing specialists are joining the cry, as well.

As foreclosure volume mushroomed during the financial crisis of 2007 and 2008, overwhelmed servicers often found themselves turning to outsourcers to manage everything from loss mitigation and short sales, to bankruptcy and REO property resales.

And attorneys, too. It became much easier for many banks and servicers to work with a single point of contact for all their legal needs — to allow the outsourcer to manage local attorney relationships, or at least handle day-to-day attorney communications — versus having to manage hundreds, if not thousands, of attorney-client relationships directly.

Many outsourcers that specialize in default management have long contended that through the use of central supplier networks, including attorneys, they can further drive down the costs of default management — effectively making foreclosures less costly, both to investors and to consumers.

But only recently have they aggressively begun pushing such a claim. One such outsourcing and technology provider, Jacksonville-based Lender Processing Services (LPS: 16.78 +1.39%), recently announced that it would form its own Strategic Partnership Group to accomplish just such a goal.

“The Strategic Partnership Group will establish a network of default-related service providers, including attorneys, title companies, foreclosure trustees, publication and posting providers and service of process companies dedicated to lowering costs and creating efficiencies for consumers, mortgage servicers and investors,” the company announced on Aug. 19.

“We realized that by reducing the number of attorney partnerships to those who can provide the lowest cost and highest service level and can meet the demands of the regions they are supporting, we will create a more efficient process, which will help borrowers and investors save money,” said Clay Cornett, president of LPS Default Servicing Solutions.

“Last year, legal vendors billed nearly $2 billion in default fees. Even a 10 percent reduction would be significant. Such reductions would make it less costly for defaulted borrowers to reinstate or pay off loans in default.”

A new battleground

Fannie Mae and Freddie Mac aren’t taking lying down the implicit suggestion that their allowable fees for foreclosure and bankruptcy might be too high. On August 2, Fannie Mae fired off a policy update that effectively dropped a neutron bomb on an industry largely reliant on outsourcing arrangements, by limiting the fees that outsourcers can earn.

“Effective September 1, 2010, Fannie Mae is imposing a limit of $25.00 per loan for the life of a default … that any attorney or trustee handling a Fannie Mae loan may pay for technology charges,” the servicing directive read. “This amount is not to be charged as a cost to the borrower, and will not be reimbursed by Fannie Mae.”

Fannie also said it would prohibit servicers from “directly or indirectly requiring or encouraging attorneys or trustees to use specified vendors in connection with Fannie Mae referrals” — vendors listed in the announcement included title companies, posting and publication vendors, and service of process vendors.

“Many of these outsourcers relied on their relationships with the servicers, and not the attorneys, in order to get their business,” said an attorney I spoke with. “The Fannie directive literally turned an entire industry on its head.”

Freddie Mac went even further, and sent out a memorandum last week to its designated counsel stating that its law firms could not agree to a blanket cut in foreclosure and bankruptcy fees involving Freddie Mac loans without the GSE’s approval first. The GSE argued in the memo that it believes its existing fee structure “adequately compensates [law firms] for their investment in the human and technological capital necessary to run an efficient, effective and ethical law practice.”

All of which means that the debate over fees is likely only beginning, sources say. And it’s not likely to be pretty, either; after all, how does one ultimately peg a value on something so socially unpopular, but yet so critically necessary, as foreclosure?

“It won’t be long until we have a federally-regulated foreclosure industry, where Congress sets allowable fees,” opined one of the attorneys I spoke with. “We might even operate under a single set of federal statutes when all of this is said and done.”

Paul Jackson is the publisher of HousingWire.com and HousingWire Magazine. Follow him on Twitter: @pjackson