Major structural problems at the nation's largest mortgage servicers will continue to hinder operations, with potential financial exposure from putbacks perhaps trumping robo-signing, according to a Federal Reserve official's testimony Wednesday during a Senate banking committee hearing. Fed Gov. Daniel Tarullo also said a preliminary multiagency review of servicing companies found shortcomings at major shops. Findings "suggest significant weaknesses in risk-management, quality control, audit and compliance practices" related to mortgage servicing and foreclosure documentation, Tarullo said. "We have also found shortcomings in staff training, coordination among loan modification and foreclosure staff, and management and oversight of third-party service providers, including legal services." As a result, the review has been expanded to include a look at past-due loans that are not yet in the foreclosure process. "As examiners identify weaknesses, they will require firms to take remedial action and, when necessary, require servicers to address resource shortfalls, training and coordination problems, and control failures. The problems are sufficiently widespread that they suggest structural problems in the mortgage servicing industry," Tarullo said. "The servicing industry overall has not been up to the challenge of handling the large volumes of distressed mortgages." While the extent of the problem is still unclear, it's evident "the industry will need to make substantial investments to improve its functioning in these areas." The Federal Reserve serves as the primary regulator for two of the 10 largest servicers affiliated with banking organizations, one a holding company affiliate and the other a state member bank. Tarullo said mortgage servicers have responsibilities to investors holding residential mortgage-backed securities, as well as to borrowers, to maintain accurate and complete records. "As losses in MBS have been escalating, investors in MBS and purchasers of unsecuritized whole loans are more frequently exploring, and in some cases asserting, contractual and securities law claims against the parties that originated the loans, sold the loans, underwrote securities offerings, or had other roles in the process," Trullo said. "The essence of these claims is that mortgages in the securitization pools, or sold as unsecuritized whole loans, did not conform to representations and warranties made about their quality." Because underperforming mortgages are typically valued substantially less than par, the putback transfers any potential loss from the buyer back to the original seller or mortgage securitizer. During the third quarter of 2010, Fannie Mae collected $1.6 billion in unpaid principal balance from originators, and currently has $7.7 billion UPB in outstanding repurchase requests, $2.8 billion of which has been outstanding for more than 120 days. Freddie Mac has $5.6 billion UPB in outstanding repurchase requests, $1.8 billion of which has been outstanding for more than 120 days. As of the third quarter of 2010, the four largest banks held $9.7 billion in repurchase reserves, most of which is intended for GSE put backs. There are also lawsuits by investors alleging that underwriters and sponsors of securitizations failed to comply with the federal securities laws, concerning risks to investors, the quality of the assets in the securitization, the order in which investors would be paid, or other factors. Since most of such suits are in the early stages, it’s difficult to know their ultimate effect on the parties that sold the loans or underwrote the offerings. Still, the putback risk has been known for some time and the Fed is conducting a detailed evaluation of putback risk to financial institutions, Trullo said. “We are asking institutions that originated large numbers of mortgages or sponsored significant MBS to assess and provide for these risks as part of their overall capital planning process. The problems that are evident to date raise significant reputation and legal risk for the major mortgage servicers. “ Mortgage servicing weaknesses will also affect the rating assigned by Federal Reserve supervisors to management of bank holding companies, even where the servicing activity was in a banking subsidiary of a holding company, he said. Write to Kerry Curry.