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This essay is part of a longer paper on the US banking system that is part of my research for a future book. What makes a bank good or bad? In financial terms, a “bad bank” describes an institution that houses problem assets and is being run-off. The bad bank is legally separate from the “good bank,” which is solvent and presumably able to function normally as a going concern. Beyond mere financial factors, however, in the wake of 2008, the idea of bad banks conjures up bleak images of financial contagion and economic dislocation that are universally shared. Even before 2008, banks as institutions did not enjoy particular popularity in American culture. People seem to love their local banker, but hate banks in general – especially enormous banks located in big cities. Small banks and credit unions have fiercely loyal followings, but large banks have proportionately larger groups of detractors. This skeptical view of banks, especially larger institutions, is hardly new. Going back to the founding of the American republic, banks were seen as speculators and parasites, members of the business elite of large cities who preyed upon small farmers and working people. President John Adams, who believed that the US should have a single public bank to serve the nation, in 1813 damned private banking as a giant swindle, a "sacrifice of public and private interest to a few aristocratical friends and favorites." President Andrew Jackson’s veto of the Second Bank of the United States in 1832 was a blow against a privately owned “central bank.” More than defending financial probity, Jackson objected to the elitism and the power of the larger banks of that time. “Nothing galvanized American political conflict more than banking, currency, and finance,” wrote Daniel Feller of the early days of the US. “In the republic's first half-century, no subject, save foreign relations and war, gave greater vexation to American statesmen or aroused more heated public debate.” From 1832 through the creation of the Federal Reserve System in 1913, the US did not have a “central” bank, but it did have thousands of private banking institutions that made loans and issued their own currency. The creation of national banks in 1863 was primarily a means to finance the Civil War, but it also represented another layer of financial leverage for the American economy. National banks were a new source of liquidity in addition to the existing system of state-chartered banks, which largely issued paper money backed by gold or silver. National banks and the new paper money known as “greenbacks,” which were not backed by metal, greatly enlarged the US financial system and financed the Civil War, then helped fuel a remarkable period of economic growth in America. The modern notion of “bad banks” stems partly from the Gilded Age, when large banks and industrial interests amassed monopoly control over whole industries. Businessmen such as J.P. Morgan, John Rockefeller, and Cornelius Vanderbilt consolidated smaller businesses into vast “money trusts” that exercised horizontal and vertical control over much of the US economy and also exerted enormous influence over the American political system. In the muck-raking press of that time, JP Morgan was portrayed as a giant octopus controlling the numerous industries via the tentacles of the money trusts. President Woodrow Wilson said in 1916: “Our system of credit is privately concentrated. The growth of the nation, therefore, and all our activities are in the hands of a few men. We have come to be one of the worst ruled, one of the most completely controlled and dominated governments in the civilized world. No longer a government by free opinion, no longer a government by conviction and the vote of the majority, but a government by the opinion and duress of a small group of dominant men." Modern day regulation of financial markets (and everything else) has its roots in the progressive reaction to the political and economic power of the Robber Barons of the Gilded Age. In the late 1800s, elected state court judges and other officials were bought and sold like chattel, causing progressives to complain that seeking social justice through the courts was impossible. The Progressive movement of the late 1800s featured appeals for easy money and free coinage of silver, but there was also strong Calvinist strain that also wanted to use the power of government to stamp out sin. The modern-day reliance upon regulators and economists to guide American economic life stems from the Protestant ideal of seeking earthly perfection by placing limits upon individual freedom. By the time that President Theodore Roosevelt took the oath of office in 1901, the power of the largest banks and corporations had grown to such a degree that it became a national concern for all of the major political parties. Hixon (2005) notes that “by 1914 bankers had virtually complete control of the money-creation process” and JPMorgan was the de facto central bank, an island of liquidity that stood separate from the private clearinghouses of the era. Other banks seeking to transact business with the House of Morgan had to stand in line in the lobby along with the retail customers. Over the next hundred years, the nature of banks and their relationship to the government agencies that charter and enable their activities, changed dramatically. One of the major transformations in public policy during that era was the adoption of the Progressive agenda, specifically a willingness to use government regulation as a means of controlling the power of the great monopolies and the men who controlled them. Glasser and Schleifer (2001) note that “During the Progressive Era at the beginning of the 20th century, the United States replaced litigation with regulation as the principle mechanism of social control of business.” In 1902 President Theodore Roosevelt said of regulating the money trusts: “Good, not harm, normally comes from the upbuilding of such wealth. Probably the greatest harm done by vast wealth is the harm that we of moderate means do ourselves when we let the vices of envy and hatred enter deep into our own natures. But there is other harm; and it is evident that we should try to do away with that. The great corporations which we have grown to speak of rather loosely as trusts are the creatures of the State, and the State not only has the right to control them, but it is in duty bound to control them wherever the need of such control is shown.” Woodrow Wilson defeated Roosevelt in 1912 and delivered on his promise to rein in the money trusts even as he expanded the scope of the federal government. The creation of the Federal Reserve System in 1913, conveniently enough on the eve of the First World War, began the process of turning over control of the US banking markets to government agencies. Wilson enacted tariff reform, passed anti-trust laws and saw the final passage of the 16th Amendment creating a permanent income tax. The evolution of the US from a Constitutional Republic to a corporate state dominated by the federal government and large corporations would accelerate through WWI and the subsequent financial crises and wars of the 20th Century. Through the post-WWI inflation of the early 1920s, the US banking system supported the growing wave of financial speculation in stocks and real estate that would eventually lead to financial busts early in the decade and finally to the Great Crash of 1929. Whereas the US economy healed itself in the Depression of 1920-21, by the 1929 market bust President Herbert Hoover set in motion “an unprecedented program of federal activism to head off the business downturn,” notes author James Grant. The economist John Maynard Keynes led the chorus of approval for government intervention, declaring that we shall finally be “free, at last, to discard” the pursuit of self-interest. Part of the reason that President Herbert Hoover was able to embark upon the vast social engineering experiment known as the “New Deal” was that the behavior of the largest banks was so absurd. Even as real estate prices collapsed in states such as Florida and the markets were roiled by panic selling, the heads of the major banks cautioned calm. Thomas Lamont of JP Morgan, Charles E. Mitchell of The National City Bank and the heads of the other major banks boldly lent millions to support stocks. On the eve of the crash, Mitchell declared that the trouble in the US securities markets was “purely technical” and that “fundamentals remain unipaired.” But Senator Carter Glass of Virginia, who served as Treasury Secretary during WWI, blamed the market problems squarely on Mitchell, head of the one of the largest banks in the country. By October of that year the US financial system collapsed under the weight of bad investments and fraud. Four years later, as President Franklin Delano Roosevelt took office in March of 1933, every bank from Detroit to New York was closed and had been for weeks. This national catastrophe inspired his memorable phrase about “having nothing to fear but fear itself.” Out of the rubble of the Great Depression and then WWII came a banking system that was heavily regulated and organized around a system of government agencies designed to ensure the stability of banks and even markets. The Glass-Steagall banking laws crafted by Senator Glass in the dark days of 1933 to separate banking from commerce were accompanied by broad regulation of the securities and housing markets. In the 1930s, the Federal Deposit Insurance Corp under Leo Crowley and the Reconstruction Finance Corp under Jesse Jones literally restructured the US banking system as well as other sectors of the economy. The dominance of the large banks was replaced by the supremacy of the federal government, which assumed a central role in the money markets that was reinforced by the mobilization for WWII. From VE Day in 1947 through to the end of the 1970s, the US economy was dominated by the partnership between the US government, including various government-sponsored enterprises (GSEs), and the large corporations and large banks which had helped Washington win WWII and later the Cold War. Only in the 1980s did private, non-bank finance separate and apart from the banking system enjoy a brief renaissance in the US, driving the growth of the 1990s and then ending abruptly with the financial crises of that decade. In the late 1990s, regulators reacted to crises in the securities and money market sectors and inadvertently created the present-day large bank/GSE monopoly. The regulatory changes put in place after the collapse of Kidder Peabody (1994) and the failure of Long Term Capital Management four years later curtailed the ability of nonbank companies to finance themselves and thereby handed a monopoly on short-term finance to the largest banks. Non-bank finance was truncated in 1998 when the Securities and Exchange Commission amended Rule 2a-7, which effectively precluded nonbanks from funding themselves outside the banking system via sales of assets to money market funds. Since 1998, the largest banks have enjoyed effective control over short-term funding sources for nonbanks operating in the mortgage and other sectors, while the GSEs dominate the long-term debt markets. This terrible error in public policy led directly to the subprime mortgage market bubble and financial collapse a decade later. Today even supposed “innovations” such as peer-to-peer lending are constrained by the large bank monopoly on short term finance. Smaller banks and nonbank mortgage lenders likewise cannot compete with the large banks and GSEs in the long end of the bond market. The reaction to the 2008 financial crisis only served to confirm the European-style, corporate model of political economy in America, where “big” is considered good when it comes to private enterprises and anything with a government guarantee is even better. No private corporation can compete with a GSE, after all, and today large banks are now fully GSEs. At the apex of the post-WWII credit pyramid and regulatory hierarchy is government debt, followed by securities issued by the various GSEs and then private obligations, in that qualitative ranking. And as in the case of Europe, in America the rights of private investors now are clearly subordinate to the shifting goals of public policy in Washington.

The term mortgage servicing right or "MSR" generally describes a party's contractual rights with respect to servicing or controlling the servicing of a pool of mortgage loans owned by others, including the entitlement to receive servicing compensation. There are a number of risks involved with investing in MSRs, including accurately estimating the prepayment rates of the underlying mortgages and managing the related swings in valuation due to movements in benchmark securities such as the 10-year Treasury. For example, in October 2007 Countrywide recorded a write-down of nearly $1 billion on its MSR which at the time had a book value of $18 billion on a balance sheet of $200 billion in assets, meaning that virtually the bank’s entire capital position was essentially represented by the mortgage servicing asset. The largest risk facing an investor in MSRs and/or a creditor holding exposure to MSRs as collateral, however, is that the ownership of the asset may be “terminated” by a government agency or investor. This risk is binary for the parties at interest and can be particularly significant in the case of non-bank lenders and loan servicers (“seller/servicers”), because as asset managers for loans owned by third parties, the MSR frequently is the only significant asset on the company’s balance sheet. While the academic literature regarding MSRs is limited, those sources that are available most often focus on the risk to the borrower or home owner in the event of interruption. From a credit and business perspective, however, the prospect of an interruption or involuntary termination of servicing rights raises potentially catastrophic risks to counterparties and investors. This idiosyncratic risk of servicing termination is a function of both quantitative factors such as the financial performance of the seller/servicer and qualitative factors such as management, internal systems and controls, compliance and operations. Indeed, in many cases the human resources function of a seller/servicer is one of the most important internal functions in the entire enterprise. All of the federal housing agencies, including government sponsored entities such as Fannie Mae (FNMA), Freddie Mac (FHLMC), and Ginnie Mae (GNMA), have the unilateral right to transfer the servicing of loans and/or securities they guarantee. The GSEs and GNMA also have approval rights over the transfer of MSRs, again associated with securities that these entities guarantee. All three agencies have established review procedures for transfers of MSRs since the 2008 financial crisis. FNMA, for example, has published a Servicing Transfers Overview that sets forth criteria for the approval of MSR transfers. In addition, investors have consent rights to servicing sales and transfers for non-agency mortgages, but the requirements of private transfers of servicing are onerous. “As a condition to providing the consent,” notes a 2015 report by the Federal Reserve Board and other bank regulatory agencies, “investors have historically required that the buyer of the MSAs assume direct recourse liability for origination and servicing defects, regardless of whether that buyer, as the new servicer, originated the loan or caused the servicing defect.” In general, the reasons for an involuntary termination of servicing rights primarily turn on quantitative factors, in particular the financial soundness of the servicer. Virtually all of the servicing transfers seen in recent years have occurred because of financial difficulties at the seller/servicer, but the reasons for a transfer vary. In the case of GNMA, transfers are usually initiated out of concern that the seller/servicer has liquidity problems and cannot either 1) maintain timely payments to bond holders and/or 2) repurchase defaulted mortgages out of GNMA pools. In the case of FNMA and FHLMC, on the other hand, servicing transfers have been far more rare and are usually motivated by concerns about the ability of the seller/servicer to service the loans and engage in effective loss mitigation of loan defaults. It is important to understand that GNMA guarantees only the pass-through payments to security-holders, not the credit performance of the underlying loans. The loans which underlie a GNMA security are guaranteed by the Federal Housing Administration (FHA), Veterans Administration (VA) or US Department of Agriculture (USDA). But unlike the GSEs, GNMA has no balance sheet with which to fund advances to bond holders in the event that a seller/servicer suffers liquidity problems. More, GNMA cannot purchase troubled loans or MSRs, and thus the agency tends to be very proactive when it determines that a seller/servicer is in financial distress. Another reason for the GSEs or GNMA to initiate a servicing transfer is reputational risk. Negative publicity with respect to a seller/servicer can lead to reputational harm, which can have adverse effects on other lines of business, the availability of funding from counterparties and on a firm's MSR portfolio itself. Potential borrowers may be less likely to originate a loan with a firm that has had servicing issues, and in some instances reputational harm may have led some bank and non-bank institutions to leave or divest of their mortgage servicing activities. For example, in the case of Ocwen Financial (NYSE:OCN), publicity related to its operational problems and related action by the states of New York and California led to “voluntary” servicing transfers of GSE and GNMA MSRs in 2015 to other entities including Nationstar (NYSE:NSM) and JPMorgan Chase (NYSE:JPM). These transfers were actively encouraged by regulators and subject to approval by FNMA and the Federal Housing Finance Agency (FHFA). In a 2015 comment letter from the American Bankers Association to the MSR Task Force of State Bank Supervisors, the trade group noted: “If a non-bank servicer were to fail, significant questions could arise regarding the capacity of the market to financially absorb and operationalize the transfer of an unprecedented number of servicing rights. We are also concerned about the potential gaps in borrower service and borrower confusion that could occur in this situation.” The Risks of Servicing Transfers First and foremost, the involuntary termination of servicing can result in a total loss to the owner of the MSR and also cause losses to any creditors with a security interest in the intangible asset or the underlying loans. In the event of an involuntary termination initiated by one of the federal housing agencies, the MSR asset essentially disappears from the balance sheet of the former servicer, who receives no compensation from the new servicer. This potential for a total, binary loss with respect to the MSR due to a termination and involuntary transfer has negatively colored the view of these assets within the mortgage finance and credit communities. As discussed below, uncertainty as to how such a transfer process would work in the event of default of a servicer has historically made lenders reluctant to lend against MSRs or loan collateral tied to an MSR, especially for GNMA exposures. This situation has improved recently, however, with changes made by GNMA in its acknowledgement agreement. The new agreement provides some comfort to investors and lenders that GNMA “won't interfere with financiers' rights to servicing,” reports National Mortgage News, “so long as Ginnie is given all the information it needs to be sure the bond payments that the agency insures flow through to investors.” The changes to the GNMA acknowledgement agreement made at the end of 2016 have had a tangible and positive impact on how investors and lenders view GNMA MSRs. Whereas a year ago, lenders were reluctant to lend more that 50% against GNMA MSRs or advances for distressed loan servicing, today the loan rates vs GNMA MSRs and loan collateral advance rates have climbed into the 70s vs 90% for FNMA and FHLMC exposures. In the first quarter of 2017, asset-backed securities transactions using GNMA MSRs as collateral have been completed by PennyMac Mortgage Investment Trust (NYSE:PMT) and Freedom Mortgage. Involuntary termination of servicing have been extremely rare and have usually involved smaller banks and nonbank servicers that have experienced financial difficulties or failed. There have been few forced transfers of mortgage servicing by the FNMA, FHLMC or GNMA involving a mortgage servicer that was still in operation. In cases where the loan servicer encounters financial problems, however, the risk of termination rises dramatically. The Federal Reserve Board noted in a report to Congress: “Mortgage servicing is governed by regulations and contracts that can pose significant legal and compliance risks. Various federal and state agencies' rules and regulations address mortgage servicing standards, including consumer protections. In addition, the GSEs and Ginnie Mae require servicers to comply with guidelines to service loans guaranteed by those entities, while separate contractual provisions govern the servicing of loans in private-label MBS. Mistakes or omissions by servicers can lead to lawsuits, fines, and loss of income. Use of subservicers or other contractors can compound this risk. In addition, when a servicer does not comply with the standards established by the GSEs or Ginnie Mae, these entities can confiscate the servicing, forcing the servicer to charge off the value of the MSA.” “Moreover, negative publicity can lead to reputational harm, which can have adverse effects on other lines of business and on a firm's MSA portfolio itself. Potential borrowers may be less likely to originate a loan with a firm that has had servicing issues, and in some instances reputational harm may have led some banking institutions to leave or divest from their mortgage servicing activities.” With all of these caveats enumerated, however, it is important to remember that most mortgage servicing portfolios have enormous stability and considerable intrinsic value, primarily because when managed properly they throw off large amounts of cash and can thus be readily transferred in the event such action is required. Case Study: Taylor Bean Whittaker In 2002, FNMA terminated Taylor Bean Whittaker’s (TBW) status as an approved seller/servicer after discovering significant fraud in the company’s loan origination and sales practices. FNMA, however, did not formally advise Freddie Mac, its regulator, the FHA or other interested entities about TBW's termination or the reasons for the action. Indeed, FNMA instead entered into an non-disclosure agreement with TBW and then took active steps to conceal the reasons for the termination. Following its termination by FNMA, TBW dramatically increased the volume of its business with FHLMC and GNMA. By 2009 when it filed for bankruptcy protection, TBW serviced a mortgage portfolio of approximately 512,000 loans with an aggregated unpaid principal balance (UPB) exceeding $80 billion. The 2009 bankruptcy of TBW resulted in the confiscation by GNMA of an MSR representing $26 billion in unpaid principal balance (UPB) of loans. The reason for the action was that the financial failure of the entity placed GNMA at risk of default on its insured securities. In a September 2014 report, the Inspector General of GNMA noted: “The ultimate failure, of course, is the inability of an issuer to pass through payments to security-holders or to otherwise demonstrate a lack of compliance so significant as to render it unfit to maintain its nominal ownership of the MSRs. Historically, such failures have resulted in Ginnie Mae’s declaration of a default, with the accompanying extinguishment of an issuer’s rights to the MSRs and termination of approval status. In such cases, the MSRs become government property and are serviced on behalf of Ginnie Mae by a third party subservicer.” On August 14, 2009, Colonial Bank, Montgomery, AL, TBW’s insured depository, was closed by the Alabama State Banking Department. The Federal Deposit Insurance Corporation (FDIC) was named Receiver and sold the bank’s branches to BB&T (NYSE:BBT), but the FDIC insurance fund ultimately took a roughly $3 billion loss. Also, Deutsche Bank (NYSE:DB) and BNP Paribas (NYSE:BNP) together lost over $1.5 billion, due to the fraud related to TBW’s bogus commercial paper operations, which were conducted out of a non-bank subsidiary of the group. In 2010, GNMA bought over $4 billion of non-performing TBW loans out of its guaranteed MBS pools and increased its applicable reserve for losses by $720 million to prepare for anticipated losses. The Federal Housing Administration (FHA) and GNMA Mae eventually lost hundreds of millions on defective loans placed in MBS pools that were guaranteed by FHA. FHLMC lost over a billion dollars on defective loans that TBW sold it, after TBW's frauds were uncovered and the firm ceased operations. Voluntary Servicing Transfers The failure of TBW was an extreme event that involved deliberate acts of fraud, acts which ultimately saw the head of the company prosecuted criminally. The losses due to TBW, however, were actually exacerbated because FNMA did not take active steps to see that the bank’s fraudulent operations were promptly shut down by prudential regulators. In the case of the bankruptcies of both TBW and ResCap, however, the loan servicing operations that remained continued to operate in due course post-filing and, indeed, under the protection of the Bankruptcy Court, which rightly saw the MSRs and whole loans as valuable assets of the bankruptcy estate that warranted protection. Even though the housing agencies suffered losses due to the fraud at TBW, the GNMA servicing assets were eventually sold voluntarily. All of the FHA, VA and Rural Housing Services loans that were current were transferred to Bank of America (NYSE:BAC). Delinquent loans were transferred to either Saxon or Ocwen. In other cases where a seller/servicer merely encounters financial difficulties, it seems reasonable to expect based upon past experience that FNMA, FHLMC and GNMA Mae would likely acquiesce in the voluntary transfer of servicing, as in the case of Ocwen in 2015. Again, the key question in the case of GNMA is whether or not the seller/servicer was able to continue 1) making payments to bond holders and/or 2) fund the repurchase of defaulted loans. With the GSEs, the issue is a more general concern about liquidity in the context of loss mitigation activities on defaulted loans. Both the 2009 bankruptcy of TBW and the 2012 ResCap bankruptcy resulted in the orderly transfer of mortgage servicing and loan portfolios with the consideration flowing to the respective estates. Ocwen Financial Corp and Walter Investment Management Corp (NYSE:WAC) ultimately prevailed in a bankruptcy auction for the ResCap mortgage business with a $3 billion bid that topped rival Nationstar Mortgage Holdings (NYSE:NSM). Ironically, the acquisition of the ResCap MSR caused significant operational problems for Ocwen three years later. Neither the bankruptcy of TBW nor ResCap created a financial panic or broader problems in the financial markets. In both cases, the successful use of bankruptcy suggests that mortgage servicing is inherently stable and that FNMA, FHLMC and Ginnie Mae will acquiesce in a voluntary restructuring of a seller/servicer so long as 1) creditors are kept at bay via an orderly bankruptcy or receivership process and 2) the servicers have sufficient liquidity to maintain in process payments to bond holders and other creditors, in the case of GNMA, and to fund loss mitigation activities, in the case of both GNMA and the GSEs. Conclusion While the potential risk of termination of a mortgage servicing portfolio is very real, in reality the chances of such an occurrence seem to be relatively small. A big part of the reason for the remoteness of involuntary mortgage transfers seems to be the fact that all of the housing agencies carefully monitor the financial stability of the seller/servicers operating in the markets in which they operate. Also, financial problems at a seller/servicer that result in the involuntary termination of servicing rights can cause significant problems for consumers and thus has become a major area of concern for federal regulators. Preserving the value of the MSR is a key consideration in any situation where the liquidity or financial strength of the seller/servicer is in question. As a result, all of the housing agencies tend to take a very proactive approach to surveillance of seller/servicers and require voluntary transfers when necessary, especially for smaller seller/servicers. In the rare cases where a servicer has filed bankruptcy, both the courts, the federal housing agencies and federal bank regulators have worked together to achieve a smooth and voluntary transfer of servicing with consideration paid to the original MSR holder. Despite the ugly details around both bankruptcies, the cases of TBW and ResCap illustrate the fact that a loan servicing business is stable and can operate in bankruptcy. The fact that the MSR is often the most valuable asset of a seller/servicer seems to have made the federal courts and corporate creditors willing to work to achieve an orderly resolution in the event of a bankruptcy by a seller/servicer. In general, when assessing the potential risk of the involuntary transfer of mortgage servicing, it seems obvious that investors, analysts and regulators should pay close attention to quantitative factors such as the financial soundness and sources of liquidity of the seller/servicer. Another area of interest should be the management team and its ability to assess and control risks to the enterprise. Any evidence of operational problems at a seller/servicer are obviously a red flag for investors and counterparties. But perhaps the biggest issue in assessing a mortgage servicer is operational, namely whether the seller/servicer can effectively manage the compliance, training and human resources challenges in servicing residential loans. As we have seen with Ocwen and other large legacy seller/servicers including banks and nonbanks, failure to effectively manage the loan servicing process can result in fines and sanctions, public censure and reputational risk, and a cascade of events that can even threaten the ability of the enterprise to remain a going concern. The bottom line is that the most egregious example of termination of mortgage servicing rights, TBW, involved deliberate acts of fraud and criminality. Most of the other events shown in the table of GNMA terminations of mortgage servicing involved smaller banks and nonbank servicers that encountered financial difficulty and subsequently failed or were sold. In those cases where a large seller/servicer has filed bankruptcy, the transfer process for MSRs has been smooth and the rights of creditors have been protected, suggesting that outside of cases where fraud is present the overall risk to investors and creditors is relatively manageable given a surveillance program that follows the criteria outlined above. A version of this commentary with footnotes and appendices can be found on SSRN https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2936422 #Finance #Mortgage #Banking