Private lenders who strive to become best-in-class servicers will set themselves up for healthy profits.

Loan servicing has historically been a rather ho-hum industry, long the domain of the traditional bank. Today, however, servicing is a critical value driver for mortgage originators and investors alike. The playing field between large and small servicers has leveled out—particularly with federal government guarantee programs like Fannie Mae, Freddie Mac and Ginnie Mae.

Although banks dominated mortgage lending immediately after the 2008 financial crisis, they now face stiff competition from Quicken Loans, Freedom Mortgage, LoanDepot, Caliber Home Loans and many others. Nonbanks issued nearly half of mortgages sold to Fannie Mae and Freddie in 2016, compared with 8 percent a decade ago. Now they are taking a bigger slice of the servicing business as well.

The stakes are higher with servicing though. That’s because of regulatory and compliance hurdles, as well as the overall trend in the market where originations are tougher to come by due to inventory shortage. Still, servicing can boost profits due to rising interest rates, which serve to reduce demand for refinancing and thus retain borrowers longer. Not surprisingly, consolidation among servicers and subservicers alike is now in vogue. And technology advancements are likely to disrupt old-line thinking and push early adopters to the front of the pack.

Whether you service mortgages directly, subservice them, or are thinking about entering the field, there are five steps you can take to build a profitable operation to enhance your relationship with borrowers
and reduce your risks.

1 – Become Familiar with Fannie and Freddie

The government mortgage guarantee programs offer lucrative opportunities for private servicers and subservicers. Fannie Mae, of course, refers to the Federal National Mortgage Association (FNMA), which the federal government created in 1938. Freddie Mac is short for the Federal Home Loan Mortgage Corporation (FHLMC), which was launched in 1970. Most readers are familiar with the fact that Fannie and Freddie, as well as Ginnie Mae and the Federal Housing Administration (FHA)  were formed to stabilize the U.S. residential mortgage market and expand opportunities for homeownership and affordable rental housing. Today, these quasi-private federal entities invest in or insure more than 90 percent of mortgages in the U.S.

Fannie’s original purpose was to buy mortgages from struggling banks to free up capital for more lending. The goal was, and still is, to make more affordable mortgages available to low- and middle-
income buyers. Fannie Mae typically buys loans from lenders of all sizes, including banks, credit unions and private lenders.

Servicers of Fannie Mae loans are paid a servicing fee by the federal government, whether they originated or currently carry the loan. The process is automated, so the fee amount appears on the trial balance report produced by Fannie Mae’s investor reporting system. Because servicing fees are computed on the same basis as the interest portion of the borrower’s monthly installment payment, the servicer generally can base its servicing fee calculation on the interest collected. However, when a mortgage loan is in default and undergoing negative amortization, servicing fees are based on the interest amount that is accrued, rather than on the amount that was collected. In either case, the federal government guarantees the payments.

Working with Fannie is less time-consuming than you may think, so private lenders are on an equal footing even with banks that deploy significantly larger staff. The agency deployed a suite of online reporting tools to reduce the friction in compliance and reporting. Servicers can manage loss mitigation workout cases and monthly deficiency reporting exclusively online. Fannie’s platform provides for real-time evaluation and decision-making, again leveling the playing field between the big banks and the smaller privately-held businesses.

This year Freddie Mac quietly started extending credit to nonbanks that issue mortgages, a move it says will help the companies maintain access to a crucial stockpile of cash if their home loans go sour. The new Freddie credit lines, which haven’t been publicly announced, are meant to support nonbanks’ mortgage-servicing operations. In its list of 2018 goals for the companies, Freddie’s oversight board, the Federal Housing Finance Agency (FHFA), said they should find ways to support mortgage-servicing liquidity.

Freddie Mac lending is welcome news for private lenders, because things can turn problematic for a servicer when the borrower defaults. The servicer is still obligated to keep sending monthly payments to the mortgage investors even though it’s no longer collecting any money from the borrower. Eventually, Fannie or Freddie will reimburse the servicer. But in the meantime, there can be a serious cash crunch. Naturally, banks can absorb this shortfall because they are deposit institutions—but nonbanks don’t have this additional cushion of liquidity. Until this year, they would have to borrow against their future income stream. But now, with Freddie stepping in to offer additional credit, the nonbanks can compete even harder against traditional lenders for servicing or subservicing.

2 – Get Going with Ginnie Mae

In the past, it was almost always banks that insured loans with the Government National Mortgage Association, called Ginnie Mae for short. Today, nonbank lenders are originating the majority of Ginnie Mae loans. This serves as a highly effective way to level the playing field between banks and private lending institutions, since taxpayer support backstops the loan. If a borrower defaults on their mortgage, Fannie and Freddie are responsible for the losses on the loans they guarantee to investors, while Ginnie Mae is financially responsible for the bond payments to the holders of Ginnie Mae securities.

Ginnie Mae was established as part of the Great Society program of the 1960s to promote home ownership. As a wholly-owned federal corporation within the Department of Housing and Urban Development (HUD), Ginnie Mae’s mission is to expand affordable housing finance by providing market liquidity to federally-sponsored mortgage lending programs.

A Ginnie Mae guarantee allows mortgage originators—banks, credit unions or private—to underwrite loans to lower income people who otherwise may not be able to qualify or afford a higher cost of financing. It guarantees the loans, so they can obtain a higher price when bundled and resold in the capital markets. Lenders then can use the proceeds to make new mortgage loans, advancing Ginnie Mae’s mission of creating more affordable home ownership opportunities for families.

Ginnie Mae also enables existing “seasoned” loans to be securitized with its guarantee. Many private lenders may be unaware that loans originated and insured under FHA, VA or RHS/USDA guidelines can also be securitized with Ginnie Mae. There are a few conditions that must be met for modified loans or those purchased out of a pool to be securitized. But the approach is quite like the process for new loans.

3 – Create Technology to Cut the Cost of Servicing

It’s no surprise that banks are usually not “early adopters” when it comes to using technology to service loans. This is an area where nimbler private lenders may not just level the playing field but beat the banks. It all comes down to finding ways to use tech tools to reduce the cost of servicing and risk.

In general, the cost of servicing loans has increased dramatically since the 2008 financial crisis. Banks as well as nonbank institutions were required to add staff and new procedures to comply with the tough new rules for consumer protection put in place by the Dodd-Frank legislation, as well as new rules issued by the Consumer Finance Protection Bureau that Dodd-Frank created.

An Urban Institute study indicates that from 2005 to 2015, the cost of servicing a performing loan increased more than three times, from $59 to $181. Naturally, it’s much greater for nonperforming loans. In 2005, servicers spent an average of $482 to deal with a nonperforming loan, compared to an average of $2,586 10 years later—a staggering increase. This means the stakes are much higher to get servicing right, especially with borrowers who are underwater or fall behind on payments.

Servicers can use technology for more reliable platforms and processes. For compliant loans, this means adopting new applications to replace labor costs and improve reliability for the mundane work of managing escrow accounts, collections, investor remittances, reports and reconciliation. When it comes to nonperforming loans, it is even more valuable to use technology to build relationships and a closer connection to borrowers.

Imagine the value of keeping borrowers engaged and communicating 24/7 year-round with an interactive, artificial intelligence platform. Think how convenient borrowers would find it, for example, if they could make weekly trial modification payments using a peer-to-peer mobile app like Zelle or Venmo.

Furthermore, technology can help servicers and subservicers reduce risk by segmenting borrowers based on their likelihood of becoming compliant again. For example, sentiment analysis of their social media presence can predict how likely certain borrowers are to improve their financial condition, especially considering how little slack there is in the labor markets today. Technology can both reduce manpower costs and strip out risks when adapted to servicing.

4 – Partner with a Bank or Credit Union to be their Subservicer

There’s the adage—if you can’t beat ’em, join ’em. Private lenders should consider approaching banks and credit unions with new opportunities to handle a wide range of responsibilities as a subservicer. It often makes sense for lenders to originate loans and then pass over servicing to more expert firms. High-quality subservicers can keep delinquency rates low, ensuring originators and investors a secure and reliable source of capital for new loans.

5 – Become Best in Class at Customer Service

When it comes to lending, strong customer service capabilities make companies more profitable and reduce risk.

This is especially true when it comes to troubled borrowers. A good servicer or subservicer can reduce both defaults and the risk of damage to the originator’s brand name by employing highly effective customer management methods and processes. Rather than each lender duplicating this effort in-house, the industry has split out servicer and subservicer roles to allow for functional expertise to bloom for servicing.

Servicing and subservicing will become more important to the mortgage value chain as originations become scarcer due to both the shortage of housing supply and the rising interest rate environment. Interest rates are expected to continue to steadily climb, which is great news for client retention. In a rising rate environment, borrowers are likely to stick with their existing loans rather than refinance. For servicers, retaining existing clients is much more profitable than signing up new service contracts and onboarding new borrowers. When servicers and subservicers retain their borrowers, it’s easier for them to reap some efficiencies of scale that benefit the bottom line.

This is a good time to be a servicer or a subservicer because there’s a terrific tail wind. Housing values are growing steadily, as the burgeoning millennial generation become first-time homebuyers. But due
to the constricted supply, originations will not be quite as valuable a line of business as before. Servicing is where the action is. As housing values climb, there’s more equity both for the homeowner’s balance sheet and for the mortgage investor. And the recent robust returns in the stock market add liquidity that can continue to pour into the housing markets even in the rising interest rate environment.

By getting engaged with the governmental guarantee programs from Fannie, Freddie and Ginnie Mae—as well as adopting new technology, partnering with banks and credit unions as a subservicer, and adapting best-in-class customer service—private lenders can readily compete with banks. The market has shifted, and private lenders who set a strategy to become best in class as a servicer or subservicer will reap healthy profits for years to come.