Mortgage Servicing Fraud
occurs post loan origination when mortgage servicers use false statements and book-keeping entries, fabricated assignments, forged signatures and utter counterfeit intangible Notes to take a homeowner's property and equity.
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Nye Lavalle
Sharing secrets. (mortgage banking)
Michael R. Pfeifer
6308 words
1 December 1995
Mortgage Banking
Vol. 56, No. 3, ISSN: 0730-0212
COPYRIGHT 1995 Mortgage Bankers Association of America
Servicers face emerging legal risks from growing demand for traditionally nonpublic, loan performance information. Case law is woefully lacking to help guide servicers through this potential liability trap.

Secrets. In the servicing of real estate loans, mortgage bankers collect them every day. The information comes in the form of confidential records on the creditworthiness and payment practices of every borrower; detailed "nonpublic" information on the terms and performance of every loan and the particular characteristics of every property in a portfolio or securitized pool; environmental problems; prepayment requests; occupancy rates, debt service ratios and operating information on income properties; arrays of aggregate statistics; and a host of other related and derivative facts, reports and calculations that tell experienced investors, regulators and their computers whether a particular investment will succeed or "tank." These are just some of the secrets that mortgage servicers know and almost everyone who stands to gain or lose from real estate investment now wants to obtain.

The demand for "inside" information is particularly intense from the capital markets, where the full disclosure requirements of the securities laws, the information appetites of rating agencies and the ready availability of competing investment alternatives only a "mouse-click" away place a premium on up-to-the-minute data in infinite detail. But even where portfolios are not securitized, investment managers are no longer content with generalized aggregate pool information. Instead they are probing into loan-level, collateral-level and even borrower-level servicing data in an effort to maximize returns and anticipate problems.

So why not just share all of the information equally with everyone who wants it? One obvious problem is that while most borrowers will grudgingly tolerate disclosure of the intimate details of their financial situation to their own lender, they bridle at the thought of such information becoming part of the public domain.

The same considerations apply to the disclosure of individual property information. Every owner is a prospective seller, and no seller wants every detail about his or her property known to prospective buyers. Just where should the line be drawn?

Another less-obvious problem is precisely how to go about disclosing "all" mortgage servicing information to "everyone" - and at what cost? There is no national data base for the collection of mortgage servicing information. Even putting the information for millions of loans on the Internet would not necessarily make it available to everyone who wants it. And what happens if any of the information is incomplete, incorrect or "stale" and someone relies on it to his or her detriment? If only some people are allowed access to key information, would there be "insider trading" problems when those with nonpublic information profit from the purchase or sale of the subject loan pool or the securities collateralized by the loans?

With all of these conflicting interests, it is important to ask more questions and seek some answers regarding the issues confronting mortgage servicers in their handling of the information entrusted to them. Why, for example, does the demand suddenly seem to be increasing for disclosure of what traditionally has been nonpublic information? What legal duties do servicers owe to borrowers, investors, rating agencies and the public at large with respect to the management and disclosure of the information they handle? What practical solutions are actually being tried or considered by servicers and what are some of the unexpected legal pitfalls confronting them? And with new legal risks emerging for mortgage servicers in their handling of nonpublic information, what changes can be expected in the way business is done, both now and in the future?

There is probably no single reason for the intensity of the demands being placed on servicers for disclosure of what has traditionally been internal or nonpublic information. Indeed, the very fact that more detailed "inside" information is being compiled tends to invite efforts to obtain it. There are, however, several clearly identifiable industry developments whose contribution to the call for such information is undeniable. Recognizing these developments and their impact is essential to determine the type of response necessary now, as well as where future problems are likely to occur.

Improved information-handling capacity

The most fundamental and perhaps the most subtle of these developments is simply the dramatically improved information analysis, processing and communication capacity of the entire industry. In an article in the October 1995 issue of Mortgage Banking titled "Reinventing Mortgage Banking," one author states that "the overwhelming evidence of what can be done with even today's technology...strongly suggests [that] the technology revolution will dramatically affect every aspect of the mortgage banking business...."

Increasingly sophisticated financial analysis and data-base management techniques are being used to create elaborate investment models. Many of these are capable of tracking and factoring into their calculations the type of minute and seemingly mundane details of servicing information that no one ever thought much about. However, these once mundane details are now seen as subtle indicators of whether an individual borrower, loan or even an entire pool of loans may be on a trajectory to disaster.

One loan evaluation tool currently receiving a lot of attention, for example, is credit scoring. This is a statistical method of assessing credit risk by summarizing the relative likelihood that a given borrower will repay a loan based on computerized evaluation of a number of variables. The variables typically include the number of open accounts a borrower has, account activity, types of accounts, past delinquencies, severity of delinquencies, length of credit history, current level of indebtedness and level of recent inquiries. While the agencies offering this type of analysis often decline to divulge the exact variables they use (because the information is proprietary), it takes little imagination to see how such information products are likely to put pressure on servicers to share more of their "secrets."

More inside information available

For both residential and commercial loan portfolios, servicers are being asked to collect and maintain an ever-expanding list of information items on individual borrowers, loans and properties. Some of this comes from federal regulations such as the Real Estate Settlement Procedures Act (RESPA), the Home Mortgage Disclosure Act (HMDA), the Truth-in-Lending Act (TILA), the Community Reinvestment Act (CRA), the Equal Credit Opportunity Act (ECOA) and the Fair Housing Act (FHA). Individual state regulatory requirements and even local land-use and other municipal restrictions on land encumbrance, such as rent control ordinances, add to the information-gathering requirements. Ironically, while retention of such information is often mandated by public authorities, dissemination of it to anyone other than such authorities may also be restricted.

Stricter underwriting requirements also result in the collection of more personal information from individual borrowers and more detailed information about their properties. And much of this is mandated by the major secondary market agencies such as Fannie Mae and Freddie Mac. The Fannie Mae Selling Guide, for example, contains detailed underwriting guidelines, updated within the last year, that require more intensive investigation into every detail of a prospective borrower's payment history on previous mortgages, "undisclosed debts," revolving accounts, judgments, garnishments, liens, bankruptcies, previous foreclosures, current net worth, debt-to-income ratios and housing expense-to-income ratios. It also identifies which compensating factors are acceptable.


It has been estimated that by 1993 the securitization process was funding two out of three home loans and that even though that rate has dropped during the last two years, the mortgage-backed securities (MBS) market may be a $2 trillion market (see Mortgage Banking, October 1995, p. 15-17). According to the October 9, 1995, issue of National Mortgage News, the commercial side of the MBS market has been expanding vigorously, with CMBS issuance during the first three quarters of this year already exceeding the total for all of 1994.

This activity, and perhaps even more importantly, the possibility of future securitization of any given portfolio, is transforming the information demands on mortgage servicers and minimizing the distinction between public and nonpublic servicing data.

Rating agencies, such as Standard & Poor's, Duff & Phelps, Fitch and Moody's, whose judgments about the investment potential of a securitized pool of mortgages are the critical determinants of whether a particular offering succeeds or fails, are exercising a profound influence over what information is collected and reported. The competition between them fosters an ever-increasing need to produce more refined analysis that incorporates more and more individual and heretofore nonpublic data. And that influence is not confined to the original security issuance stage.

Most major rating agencies maintain surveillance over the securities they rate and the underlying collateral pools. Standard & Poor's states in its promotional literature: "Given today's economic environment, all issues must be monitored continuously to provide accurate ratings." In the commercial arena, many agencies are even rating the servicers themselves as a key element in rating a new CMBS issue (see Servicing Management, vol. 6, no. 11, July 19, 1995).

In analyzing mortgage-backed securities, most rating agencies say that they focus on the legal infrastructure; the credit quality of the collateral; the amount and quality of loss protection provided; and the payment structure. According to Standard & Poor's, when the collateral pool consists of conventional single-family mortgages, "the analysis becomes much more complex. Assumptions must be made concerning the credit quality of the mortgage pool to determine expected losses from all reasonable sources."

Recent literature from Duff & Phelps indicates it does everything possible to reduce these assumptions to hard facts. D&P says it has developed "a computer model to analyze the expected losses on a mortgage pool...which examines the characteristics of each individual mortgage to determine its contribution to the expected pool defaults and losses." D&P requests individual mortgage data on the pool, sent by diskette, including "a variety of information on the specific characteristics of each mortgage." These appear as an exhibit and include such data as the borrower's name, street address, original loan amount, original LTV ratio, loan purpose, debt-to-in-come ratio and something called "borrower quality code."

Even more detailed credit quality data and property-level information is sought by the agencies in connection with the rating of CMBS because of the greater individuality and complexity of factors affecting the viability of the underlying loan pools.

Another aspect of securitization that is helping to create the exploding demand for nonpublic information is competition from competing investment products. Mortgages are not the only financial asset being securitized, and mortgage-backed securities are far from the only asset-backed investment vehicle available in the market today. In a recent Mortgage Banking article, Leon Kendall, former chairman of MGIC and a professor at The Kellogg Graduate School of Management at Northwestern University, observed that "institutional investors can now choose other securities for their investment dollars - from vehicles not available five years ago. And mounting evidence shows they are doing just that."

Other assets now serving as collateral for securitization include auto loans, equipment leases, student loans, aircraft loans, recreational vehicle loans, SBA loans, commercial paper, credit card receivables, junk bonds and even delinquent tax liens and Third World debt.

One of the ways to make mortgage-backed securities more attractive to investors is to provide them with better insights into and about the underlying mortgage collateral. The following excerpt is instructive. It is from the minutes of a CMBS buyers' meeting in Boston that occurred in April 1995 and was attended by many of the largest institutional investors in the country:

There was a broader range of views as to what should be done to improve the collateral credit information made available to investors. There was strong consensus that certificate holders should have access to whatever information the servicers obtain from borrowers. Buyers felt that it is important that a mechanism be developed to accomplish this. They believe the marketplace could be improved if investors had access to the more detailed information which is believed to be available to the servicer, the trustee, the investment bankers and the rating agencies.

All of this intense scrutiny of what has traditionally been nonpublic information is encouraged and reinforced by the "full disclosure" philosophy of the securities laws. These laws were promulgated primarily to protect investors in companies that sold "widgets," not units of the "American Dream." Such laws were never intended to take into consideration an individual's interest in the privacy and confidentiality of what is often the largest and most important financial transaction in many people's lives - the loan on their home.

And the very things that securitization values most - standardization, impersonal uniformity and total predictability - are in direct conflict with the reality of most borrowers' lives. Given the inexorable dynamics of the securitization process, how long can it be before servicers are required to provide an updated psychological profile on every borrower in a pool?

Privacy vs. disclosure: The legal risks

On May 30, 1995, the United States District Court for the District of Columbia issued an opinion in United States of America et al. v. John C. York et al. in which an issuer and subservicer of Ginnie Mae securities was found to have breached what the court determined were its "fiduciary" duties. It did so, the court found, by purchasing some of the securities it had issued and serviced for GNMA and profited through the use of nonpublic information it had obtained during the servicing relationship. The respondent, York Associates, was not only required to disgorge all profits it had gained, but more important, to forfeit all fees it had received from GNMA under its servicing agreement - a total sum in excess of $6 million. (The case is on appeal.)

While this ruling is only by a district court and does not involve particularly novel legal theories, it is important for several reasons: (1) It is one of the first cases to examine the duties of a servicer with respect to the handling of "inside" information in a mortgage-backed securities context; (2) it illustrates how easily servicers can run afoul of the maze of conflicting obligations they have with respect to the information they handle; and, perhaps most significantly, (3) it shows how unforgiving the courts can be in holding servicers to the very highest standards of legal accountability, regardless of accepted industry practices and pressures. The following excerpt from the court's opinion is illuminating:

It further appeared to the Court that counsel was implying through its repeated reference to Salomon Brothers at oral argument that if Salomon Brothers (the 'biggest in the business') considered its clients' conduct acceptable in the marketplace, any less sophisticated entity should naturally also find the conduct acceptable. The court fails to see, however, how Salomon Brothers' role in any transaction at issue is relevant in any meaningful way to the Court's findings.

Duties to the borrower

With respect to their handling of nonpublic information, servicers have legal duties to a number of parties: borrowers, investors, rating agencies, regulators and even the public. Of these, the source of most "inside" information, and from whom such information is most often collected, is the borrower. At loan origination, borrowers are asked to provide intimate details of their financial condition and the property securing their loan. This information is often supported by copies of their income tax returns and, depending on the nature of the borrower and the loan, other detailed information about their assets and liabilities, payment practices, other investments and sources of income.

On commercial and multifamily loans, borrowers also may be asked to provide periodic updates of this information, along with operating statements, rent rolls, inspection and environmental reports, property reserve data and a variety of other pertinent information. Yet, surprisingly - and contrary to what is probably the expectation of most borrowers - existing law seems to offer very little privacy protection for this information once it's in the hands of a mortgage servicer.

The Right to Financial Privacy Act (FPA) appears to restrict disclosures only of "financial records" by "financial institutions" to "governmental authorities," which are defined as "any agency or department of the United States, or any officer, employee or agent thereof." To the extent a servicer is not a "financial institution" such as a bank, savings bank, credit union or consumer finance company, and the information is not disclosed to an agency of the federal government, the act may not apply.

The Fair Credit Reporting Act (FCRA) by its express terms, only applies to entities that prepare and distribute "consumer reports," which are defined as the "communication of any information...bearing on a consumer's credit worthiness, credit standing, credit capacity, character, general reputation, personal characteristics, or mode of living, which is used or expected to be used or collected...for the purpose of serving as a factor in establishing the consumer's eligibility for credit...primarily for personal, family or household purposes."

FCRA does not apply to those who merely supply information to "consumer reporting agencies." If a mortgage servicer is deemed to be a consumer reporting agency, it may not furnish a "consumer credit report" to anyone except a person it has reason to believe "has a legitimate business need for the information in connection with a business transaction involving the consumer." The penalty for noncompliance is payment of the consumer's actual damages and attorneys' fees. Punitive damages are recoverable if the violation is "willful."

A mortgage servicer is likely to be brought within the scope of FCRA only if it "regularly engages in whole or in part in the practice of assembling or evaluating consumer credit information...for the purpose of furnishing consumer credit reports to third parties"; and then only if the subject loan was originated by an individual consumer for personal, and not business, reasons.

While this is more likely to happen to servicers of residential mortgage loans, the act only prohibits disclosure of consumer information to persons not reasonably deemed to have "a legitimate business need" for it. This limitation makes it unlikely that a mortgage servicer would ever face significant liability under the FCRA.

It is possible that under certain circumstances a servicer could be held liable for invasion of privacy, libel, slander or intentional interference with economic relationships. Each of these torts, however, requires a plaintiff to prove outrageous, willful or reckless conduct by the defendant. The mere negligent disclosure of inaccurate or damaging information will not suffice, although it could give rise to a claim for negligent interference with economic relationship. With respect to causes of action for libel and slander, truth is an absolute defense and most state statutes are likely to permit liability only if it can be established that the provider of the information transmitted false information with malice or willful intent to injure.

Servicers also can limit their potential liability to borrowers for disclosure of credit and other nonpublic information by obtaining a borrower's explicit authorization to disclose information to interested third parties. This is most easily obtained before credit is extended and can be included in the initial loan documents.

Servicers also can require all recipients of the disclosed information to sign confidentiality agreements that limit the recipients' use and subsequent disclosure of the information, although when dealing with certificate holders in a mortgage-backed securities context, the number of potential information recipients may make this impractical or cost prohibitive. Another option is to code the information so that it cannot be identified with any particular borrower or property address.

Duties to investors and/or trustees

In almost every instance, the relationship between the investor and servicer is one of "agency," in which the servicer, as agent, owes to its principal, the investor, the highest duty of loyalty and fidelity. This basic agency relationship is the source of the "fiduciary" duty - to place the investor's interests above those of the servicer - upon which the court in the York case predicated its award of damages.

The terms of this relationship are almost always defined by a written contract. In the commercial context, this is the "Correspondent Agreement" or "Pooling and Servicing Agreement." In the residential context, the relationship is most often with one of the secondary market agencies, Fannie Mae, Freddie Mac or GNMA. Lengthy and detailed seller/servicer guides define the servicer's duties regarding the handling of information it obtains. Whether commercial or residential, however, the written requirement usually calls for total and complete disclosure of every bit of information in the servicer's possession at any reasonable time and in whatever format requested by the investor (see e.g., Freddie Mac Guide, vol. 2, ch. 51.9; Fannie Mae Servicing Guide, vol. I, p. 403).

The fiduciary duties created by an agency relationship give rise to the potential liability of servicers for what is known as "constructive fraud." This liability could arise in the event any information transmitted to the investor is inaccurate or misleading and the investor relies on it to its detriment. The existence of a fiduciary relationship eliminates the normal requirement associated with a fraud claim that the party responsible for misinformation also intended to deceive or mislead. In such a context, intent is presumed. This opens up the possibility of punitive damages against a servicer for fraud in connection with the disclosure of erroneous information, even if there is no "self-dealing," as in the York case, and even if there is no actual intent to deceive.

The situation is difficult enough in a straightforward servicer-investor relationship. The real difficulties occur when a loan portfolio is securitized and a trustee is interposed between the investor/certificate holder and the servicer. The purpose of a trustee in structured finance is to provide only one master for the servicer. But trustees are often reluctant or ill equipped to answer certificate holder "after-issue" questions about the status of the whole portfolio or individual loans. So certificate holders increasingly find themselves in the position of being able to get answers from no one.

At the CMBS buyers' meeting mentioned earlier, the following comment appears in the minutes: "Many in the group would like to see servicers work directly for the certificate holders. In most cases, servicers report to trustees. A number of CMBS buyers are not satisfied with the answers (or lack of answers) they receive from trustees and want direct access to servicers."

But there are grave problems for servicers in dealing directly with certificate holders. While the ultimate fiduciary duties of agency are likely to remain the same, the servicer/agent becomes accountable to a potentially far larger group of principals, whose various interests may be quite diverse. Does the servicer's fiduciary duty extend only to the trustee or to the individual certificate holders? When there is a conflict, who does the servicer answer to? And what about when there are multiple tranched classes of certificate holders? Are some more equal than others? These issues are only now beginning to be addressed by the courts, and there are certainly no clear or reliable guidelines anywhere in the law.

Another problem with having servicers provide information directly to certificate holders in the mortgage-backed securities context is the issue of insider trading. Potential problems can arise when there are multiple certificate holders, or multiple classes of certificate holders, and otherwise nonpublic information is given only to some - or only to those who ask for it - and the information is then used or relied on for the purpose of making decisions about holding or selling securities. Servicers, in such instances, find themselves in the strange position of owing a fiduciary duty of disclosure to existing investors, while at the same time potentially violating the securities laws' prohibitions against "tipping" to someone in a position to trade on the information.

The conflict of interest is made even more vexing by the new industry trend - at least in the commercial sector - of requiring servicers to purchase for their own account the subordinate or "first loss" position in a new security issue, as a precondition of being appointed servicer. How can a careful servicer avoid the liability imposed by the York case when Wall Street actually requires the servicer to purchase for its own account an interest in the security it will service?

There is little or no case law on this issue as well, so servicers have good reason to be concerned about their potential liability. Because this issue also involves servicers' disclosure of inside information to potential MBS investors, this article now turns to the matter of servicers' duties to rating agencies and the public in general with respect to "inside" information.

Duties to the public

Servicers do not have contractual duties to the public. Traditional common law theories of negligence and intentional fraud with respect to disclosure of nonpublic servicing information may always be available under specific circumstances, but the real concern is whether, and to what extent, the investor fraud and insider trading liability provisions of the securities laws may apply. Section 2(1) of the Securities Act of 1933 (the "1933 act") defines a "security" as follows:

...unless the context otherwise requires - the term "security" means any note..., bond..., evidence of indebtedness..., collateral trust certificate..., investment contract..., or, in general, any interest or instrument commonly known as a "security," or any certificate of interest or participation in...any of the foregoing.

Due to the nature of the instrument and the circumstances in which it is purchased, a certificate evidencing an ownership interest in a pool of mortgages almost always constitutes an "investment transaction," requiring the mortgage-backed certificate issued in the transaction to be treated as a security under federal securities laws.

The most pertinent section of the securities laws for this discussion is Section 10(b) of the Securities Exchange Act of 1934 (the "1934 act"). That section makes it unlawful for any person, directly or indirectly, to use or employ any manipulative or deceptive device in connection with the purchase or sale of any security. Although Section 10(b) does not specifically provide for a private right of action, the courts have implied one.

Rule 10b-5 was adopted by the Securities and Exchange Commission (SEC) pursuant to Section 10(b) of the 1934 act. It prohibits, in connection with the purchase or sale of any security, the employment of any scheme or device to defraud; the engagement in any act, practice or course of business that operates or would operate as a fraud or deceit, and more specifically, the making of any material misrepresentation or omission of a material fact "necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading."

Although elements of a Rule 10b-5 violation vary slightly from court to court, the following items must generally be established:

* The defendant must have used an instrumentality of interstate commerce or of the mails or of any facility of interstate commerce;

* A material misrepresentation or omission, or other deceptive or manipulative device;

* In connection with the purchase or sale of any security;

* With deliberator on the part of the defendant;

* On which the plaintiff relied, to the extent that reliance is not presumed under the circumstances;

* Which caused injury to the plaintiff.

For servicers, Rule 10b-5 is significant because any information on the collateral of a securitized pool disclosed to existing certificate holders or prospective certificate holders must be accurate and complete or the servicer risks possible securities fraud liability to any investor injured by the misinformation. The main problem now facing servicers in this regard is how to disclose accurately and completely processed information or opinion - such as an appraisal or inspection report, environmental analysis, or information that has been provided or developed by the borrower using standards or assumptions about which there may not be universal agreement (e.g., net operating income, debt service coverage or property reserve data). Even such standard loan features as prepayment protection, assumability and recourse could become the subject of a misrepresentation claim to the extent underlying provisions are nonstandard. This is particularly a problem on commercial loans and grows in significance when one considers that a violation of 10b-5 may give rise not only to private damage actions, but to SEC injunctive actions and even criminal prosecution.

With respect to the disclosure of nonpublic information, the servicer also has the additional burden of avoiding liability for "insider" trading. Although Rule 10b-5 does not expressly address trading on the basis of material nonpublic information, the courts have found such activity to be, in fact, a violation. In the case of SEC v. Texas Gulf Sulfur Company (TGS), the Court of Appeals for the Second Circuit found that certain officers, directors and employees of TGS had violated Rule 10b-5 by purchasing TGS stock or facilitating the purchase by others through "tipping," without disclosing to the general public material information concerning the company's discovery of a possible ore strike. The court held that an insider, someone who possessed material inside information, "must either disclose it to the investing public, or, if he is disabled from disclosing it in order to protect a corporate confidence, or chooses not to do so, must abstain from trading in or recommending the securities concerned while such information remains undisclosed."

The dilemmas for servicers of securitized mortgage pools are many, but there are no clear guidelines established by case law on precisely what nonpublic servicing information can be disclosed to existing and prospective investors. Neither are there guidelines on precisely how it should be disclosed to minimize liability. Periodic "8K" filings with the SEC might help mitigate some disclosure risk, but such filings normally would not be frequent or detailed enough to cover all the potential problems in a cost-effective way.

The situation has been compounded by enactment of the Insider Trading and Securities Fraud Enforcement Act of 1988. The act expands on the civil penalty exposure of insider trading liability by authorizing the SEC to seek such penalties against "controlling persons" of up to three times the profit gained or loss avoided by the unlawful trading or tipping.

Duties to regulatory and rating agencies

A servicer's duties with respect to information disclosure and reporting to regulatory authorities are governed by statutory and regulatory requirements. Servicers have little or no discretion over what they can choose to provide. And as a practical matter, as far as securitized portfolios are concerned, the same is pretty much true for the rating agencies.

The rating agencies, however, have no statutory or otherwise governmentally mandated right to the information they seek. While they are, without question, indispensable to the entire process of securitization, servicers have no protection from their trustee/investor if information is disclosed without proper authorization. Where possible, servicers should try to obtain formal confidentiality agreements with rating agencies limiting further disclosure.

However, the ultimate efficacy of such agreements as a defense to liability for improper disclosure of nonpublic information remains to be seen. There is no case law that even begins to address the issue of whether disclosure under a confidentiality agreement, which restricts further disclosure of specific servicing information, protects a mortgage servicer from any adverse effects of a rating agency's disclosure of that information in the aggregate, processed form known as a rating.

When a bond issue is downgraded by a rating agency based on information supplied by the servicer, do existing certificate holders have any recourse against the servicer? If you think not, does it make any difference if the information upon which the downgrade was based was incorrect, incomplete or somehow otherwise defective? Satisfactory answers to these questions are not currently available.

Industry initiatives

In the November issue of Servicing Management, Robert Hunter, a senior vice president of information services at ALLTEL Information Services in lacksonville, Florida, discusses the concept of a "mortgage information warehouse" accessed by sophisticated client/server technology that makes the vast array of servicing information in a mortgage servicing portfolio readily available to virtually anyone who asks for it. Hunter emphasizes how such a system could help identify and cure delinquencies earlier, cross-sell other financial products, spot economic trends and ultimately permit better decisions by portfolio managers. From the article, it appears that such a system is apparently available now, at least in limited form and for residential portfolios.

What appears to be a similar system for commercial portfolios has been implemented by Midland Loan Services in Kansas City, Missouri, according to an article in the May 1, 1995, issue of National Mortgage News. The Midland system offers on-line access to investors to examine collateral performance on a daily basis. Certificate holders of CMBS transactions and the general public are restricted to portfolio-level information updated monthly, while loan- and property-level information is available to market participants who sign a confidentiality agreement.

Midland considers the system part of its servicing and a competitive necessity. Accordingly, there is no additional cost to investors. Responding to the same competitive pressures, other servicers have set up similar systems. Some offer a "bulletin board" that's accessible with a password that expires when the investor's interest is transferred. Others have phone-in programs, and at least one servicer is making servicing information available on the Internet.

But perhaps the most intriguing development, because of the obvious conflicts of interest involved, is the joint venture formed by REIS Reports Inc. and Standard & Poor's Corp. as reported in the June 19, 1995, issue of Commercial Mortgage Alert. The venture is intended to provide investors with an "early warning" about the likelihood of losses on commercial MBS. Responding to what they term strong investor demands for timely delinquency and remittance data, updated rent rolls, borrower financial statements and improved cash-flow forecasting, REIS and S&P have apparently decided to "fill a void" in the market themselves rather than waiting for servicers to do so.

In offering the service, REIS is supposed to be tapping its own data base, although the published report on the venture states that "information on property financial statements and rent rolls...can be plugged in if servicers make it available." It would be interesting to find out whether servicers are being asked to provide such nonpublic information on a confidential basis like other information is usually provided. The motivation for servicers to comply with such requests, even when they are not on a confidential basis, are obvious. There is quite apparent impetus for compliance when the servicer is being rated by the very agency urgently requesting the information, and that rating is essential for the servicer's survival.

In addition to these efforts, a number of trade industry initiatives are also under way to help streamline the information disclosure process and create solutions to the various conflict-of-interest problems outlined in this article. These include the development of standardized data collection and reporting formats such as the Commercial Real Estate Asset Management (CREAM) data base developed by the Mortgage Bankers Association of America's (MBA) Commercial Real Estate Finance Committee; and the Sample Certificate holder/Rating Agency Report, developed separately by the Making the Market Work group, a committee of a joint industry group called the Capital Consortium, which is composed of representatives from the MBA, the National Realty Committee and the National Association of Realtors.

One of the groups that may be the furthest along in providing concrete guidelines for servicers in the management and disclosure of nonpublic servicing information is the Disclosure Subcommittee of the Real Estate Capital Resources Association (RECRA), which has had the participation of the some of the industry's leading commercial servicers and trustees.

At RECRA's September meeting in New York, the group presented a detailed data element matrix with specific suggestions for what data should be disclosed to whom, along with sample clauses for insertion into a complete model Pooling and Servicing Agreement, which is also near completion. Input was solicited from investors, trustees, other servicers and rating agencies, and refinements based on that input are now under way to both the matrix and sample agreement.

A legal void

The absence of established case law clearly defining the rights and obligations of servicers, borrowers, investors, rating agencies and the public on the handling of normally nonpublic information allows for no certainty about where the legal boundaries lie. Meanwhile the voracious demand for more increasingly specific information is driving servicers either to provide it or lose out to those who can and will. Everyone is complaining about the cost, but many are still willing to pay it, even though some commercial master servicing contracts this year were being bid at annual fees as low as 4.25 basis points of the outstanding principal balance (see Commercial Mortgage Alert, June 5, 1995).

Because the demands of the marketplace are far outpacing development of clear legal standards to guide participants, most are choosing to answer to whatever voice is the most insistent, hoping that somehow the various conflicts of interest swirling around them will all work out for the best. Right now, institutional investors, the secondary market agencies and Wall Street are making the rules. It remains to be seen, however, how long it will be before another judge echoes the words of the York case: "The Court fails to see how Salomon Brothers' role in any transaction at issue is relevant in any meaningful way to the Court's findings."

Michael R. Pfeifer is a partner with the Newport Beach, California, law firm of Wolf & Pfeifer, where he concentrates his practice on loan servicing, bankruptcy and real estate finance litigation for clients in the mortgage banking industry. Wolf & Pfeifer is a charter member of the USFN.

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