The business of making and servicing residential mortgage loans has been evolving very rapidly.

Most of the attention so far has been focused on consumer issues and the robo-signing settlement by the state attorney generals. But the changes to the loan servicing model are far broader and more significant than the narrow issue of consumer protection and stem from a number of different sources.

The first thing which needs to be said about the robo-signing settlement is that the primary beneficiaries are not consumers, but politicians.

State AGs such as Kamala Harris in California are using the rubric of “consumer protection” to advance their political fortunes.

The state AGs are stealing money from private investors using the unfettered power of the state. 

The recently passed California Homeowner Bill of Rights, for example, is a disaster for the California real estate market. It converts the largest single housing market in the U.S. into a de facto judicial state in terms of foreclosures. As California attorney Bob Jackson notes, the Bill of Rights criminalizes some errors by loan servicers while making it more difficult for investors to foreclose on homes in the event of default by borrowers. 

If you look at the problems in the Northeastern states and the difficulty banks and investors have in foreclosing on defaulted mortgages, we should ask how the California Bill of Rights is really helping homeowners in that state.

The goal of AG Harris seems to be to further her political career by making the California housing market less efficient, a development that can only make it more difficult for the residents of California to obtain credit.

Some of the standards imposed by the robo-signing settlement make sense and should have been in place long ago. The requirements for a single point of contact, adequate staffing levels and training, better communication with borrowers, and appropriate standards for executing documents in foreclosure cases, ending improper fees, and ending dual-track foreclosures for many loans are all commonsense initiatives. 

Indeed, both banks and nonbanks are incorporating these normative standards into their business models.

Another development that is very significant in the robo-signing settlement is the effective rollback of state-law preemption by federal bank regulators.

For several decades, the Federal Reserve and the Office of the Comptroller have been creating a safe harbor for banks that effectively made them exempt from regulation by state authorities. The robo-signing settlement provides for state AG oversight of national banks for the first time. 

National banks will be required to regularly report compliance with the settlement to an independent, outside monitor that reports to state AGs. 

Servicers will have to pay heavy penalties for noncompliance with the settlement, including missed deadlines and other errors. And perhaps more important, the increased state-level regulation of banks and nonbanks operating in the loan servicing market will increase costs and the potential for civil litigation. 

Under the AG settlement, for example, servicers must create and retain loan documentation in a comprehensive way and be able to produce loan documents for state and federal regulators. 

As I noted earlier, the changes in the loan servicing market are not just a function of consumers and the robo-signing settlement.  Perhaps the most important factor and the least understood is litigation, both by investors and the state AGs. The lawsuit filed against JPMorgan Chase by New York Attorney General Eric Schneiderman regarding loans and RMBS sponsored by Bear Stearns is the most recent in a series of lawsuits brought by investors and other parties. 

In addition to legal claims, another very important factor driving change in the loan servicing sector is investor preference, both on the part of private investors and the government agencies that purchase and guarantee loans.

Few state AGs or members of the media ever mention the role of investors in setting standards in the mortgage markets, but the standards imposed by the Federal Housing Administration, Fannie Mae and Freddie Mac, and private investors such as banks, funds and others are crucially important. As Kevin Kanouff of Statebridge noted, just the state licensing and net worth requirements from the GSEs now represent a significant barrier to entry for new servicers. 

Another factor that is not well understood is regulatory initiatives such as the Dodd-Frank law and the new Basel III capital standards.  The normative standards for lenders and servicers imposed by Dodd-Frank create a new federal layer of consumer regulation that will exist alongside the state level regulation we have already mentioned. Basel III threatens to impose new capital requirements on mortgage lending and servicing activities that will gradually force banks to change their business models significantly. 

The Basel III capital framework will create new opportunities for nonbank lenders and servicers. Hundreds of billions of dollars in new capital will need to be raised over the next several years to literally rebuild the nonbank mortgage sector.

So what are some of the changes in the servicing market that are being driven by factors other than the robo-signing settlement?

First, loan originators are going to increasingly retain their production and act as servicer with respect to nonconforming loans. Whether you are talking about banks or nonbanks, the role of third parties is likely to decline in the sense that the originating lender is going to have a very strong incentive to retain the MSRs, even if a vendor is used to perform certain functions. 

The increased legal requirements and liability associated with lending and servicing are going to make it far more expensive for a third party to acquire MSRs. Just imagine the representations and warranties that a seller of MSRs will need to make to an investor in order to cover the potential liability created by the AG settlement and Dodd-Frank, to name just two factors. More to the point, who wants to buy MSRs in California given the machinations of Kamala Harris and the CHBR?

Second, a servicer must have the legal authority to manage a loan portfolio, including short sales, modification and foreclosures. This is not just essential to protect consumers with respect to the AG settlement. It is also required given state laws like the California Homeowner Bill of Rights, but is also a key part of protecting the investor who acquires an interest in a mortgage note.

A servicer must be able to manage a portfolio in such a way as to maximize the present value of a mortgage note. This marks a major change in how legacy RMBS have been structured and managed prior to the start of the subprime financial crisis.

Third and perhaps most important, a servicer must have the capacity to stay in contact with the borrower and make sure than they understand the intention of the borrower. The days of sending delinquent borrowers notices in the mail are frankly not going to work.

The standards in the AG settlement, plus the requirements of investors, are going to compel servicers to keep their hands on all borrowers and thereby maintain a current understanding of the intent of the borrower.  At the end of the day, if the servicer is going to perform its legal responsibilities to both borrowers and investors, then understanding the intent of the borrower is absolutely essential. 

As the legal requirements for lenders and servicers evolve in coming years, how banks and nonbanks address operational challenges are also going to change. For example, if the requirements of the law and investors place a premium on effectively communicating with the borrower, then servicers must develop new techniques to contact and engage borrowers.  Initiatives such as the SPOC and other ways to engage a borrower will need to be strengthened both to satisfy compliance issues as well as the practical wants and needs of investors. 

Christopher Whalen is senior managing director of Tangent Capital Partners and a contributing columnist for HousingWire. He was a featured luncheon speaker at HousingWire's REpeform Summit, a mortgage servicing conference that concludes Friday in Dallas.