MBA NewsLink Q&A: Donna Schmidt of DLS Servicing on the FHA Loss Mitigation Waterfall

Donna Schmidt is the managing director and founder of DLS Servicing, a trusted provider of default servicing consulting services, training and technology for mortgage servicers. A seasoned servicing professional with four decades of industry leadership, Donna is a sought-after authority on loss mitigation compliance. She is also the co-founder of WaterfallCalc, an online loss mitigation decision and calculation tool that enables services to streamline loss mitigation calculations while ensuring investor and regulatory compliance. Donna can be reached at DSchmidt@DLS-Servicing.com.

MBA NewsLink: Is there any difference between loss mitigation on GSE loans and government loans?

Donna Schmidt: For sure. For both loan types, there are specific guidelines and options designed to help borrowers avoid foreclosure. However, for FHA, VA and USDA loans, there are a lot more ‘I’s to dot and ‘T’s to cross when a claim is filed. If there is any misstep along the way, and the servicer doesn’t strictly follow the government agency’s specific requirements, the claim will be denied. The FHA, in particular, has a very strict waterfall for loss mitigation options that used to require extensive financial documentation to establish borrower hardship. The rules have been prone to change as well, as we’ve seen during the COVID-19 pandemic and its aftermath.

NewsLink: Was the FHA waterfall recently determined?

Schmidt: Actually, the FHA first implemented its own waterfall over a decade ago, during the housing crisis. The FHA took the lead among the government insurers in establishing a waterfall—it was basically the adult in the room. The FHA was smart about it, too. The agency took its time and provided the most explicit guardrails for lenders to determine loan modification terms and when a principal reduction/deferment should be utilized. Their goal was to achieve a target payment based on the borrower’s income, as well as payment relief–a very pragmatic approach.

The FHA’s waterfall framework is not static, however. It has been revised multiple times over the years to adapt to economic conditions. Over the past several years, there were significant updates and revisions in response to the COVID-19 pandemic to provide more flexible options for struggling homeowners. To ensure compliance and provide the most effective assistance to borrowers, it’s critical for mortgage servicers to stay updated on the latest FHA policies. Yet this is no simple task. In addition, the need to respond quickly to changing market conditions meant that some procedural changes have caused conflicting goals and confusion.

For example, servicers are given an overall tier ranking score that impacts the rate of claim reimbursement and loss mitigation incentive fees. One category that is evaluated is the rate at which loans reinstated by loss mitigation redefault. Servicers would utilize the budget information submitted by the borrower in their loss mitigation application to assure the borrower could afford the proposed payment and counsel the borrower on discretionary spending that could lead to a redefault. The latest streamlined FHA processes remove any ability for the servicer to manage future redefaults. Not just because they no longer have data to evaluate the borrower’s financial condition, but there are no limits to how often a borrower may request assistance. Previous rules stated that the borrower could not qualify for a major workout (FHA HAMP) within 24 months of the last reinstatement by HAMP. There is no such rule now. So servicers are seeing repeated redefaults within a short period of time.

FHA will either need to remove the redefault consideration in its future tier ranking or give servicers flexibility to move beyond the streamlined process if they feel it is in the best interests of the FHA fund.

NewsLink: What drives FHA’s policymaking?

Schmidt: FHA’s policymaking is driven by a variety of factors, including the need to maintain the stability and integrity of the housing market, protect consumers and ensure the agency’s financial viability. Changes in technology and industry practices can also prompt policy changes as well. However, one major factor is Ginnie Mae, which also operates under the umbrella of HUD.

Since most FHA-insured mortgages are securitized in Ginnie Mae pools, how a loan balance or note rate is changed impacts mortgage-backed securities purchased by investors. In addition, Ginnie Mae’s ability to successfully guarantee its MBS pools are safe investments can be impacted by the FHA’s underwriting standards and default rates. So, while Ginnie Mae doesn’t directly dictate FHA policies, it does have an indirect influence.

NewsLink: Can’t servicers just make arrangements with delinquent borrowers to bring their loans current through additional repayment over time?

SCHMIDT: One would think so. But with today’s borrowers often having front-end debt-to-income ratios exceeding 40%, the financial wiggle room to accommodate a feasible repayment plan is extremely limited. A ratio this high indicates the borrower is already stretched thin, so adding additional payments could push them further into hardship. Helping distressed borrowers not only requires a nuanced understanding of their complete financial picture, but also compliance with the various loss mitigation guidelines set by government agencies and the GSEs.

NewsLink: Is there any difference between servicing an FHA-insured loan and GSE-backed loans?

Schmidt: FHA loans are much more complicated to service. As I said, servicers must adhere to HUD’s very strict loss mitigation waterfall, which has its own specific eligibility criteria, timelines and documentation requirements. The FHA also requires a more exhaustive audit trail for claims and loss mitigation actions. This often entails more administrative steps that can be very difficult and time consuming. There can be what seems like an infinite number of special programs for which distressed borrowers must be considered, which means there are an equally infinite number of opportunities to make mistakes. With the GSEs, generally there are more streamlined options for loss mitigation, but there is still a need for rigorous compliance to their rules as well.

NEWSLINK: Why are FHA loans so much more difficult than Fannie Mae and Freddie Mac mortgages to service?

SCHMIDT: It goes back to how these entities are structured. The GSEs, for instance, operate on completely different profit margins. Fannie Mae and Freddie Mac earn most of the ongoing interest from the loans they guarantee, so they have revenue streams that can potentially offset the risks and costs associated with defaults. This gives them a bit more latitude when setting servicing guidelines. On the other hand, the FHA only collects an insurance premium, so the agency is much more risk averse. This translates to more stringent requirements and exhaustive procedures aimed at minimizing the risk of a default and triggering a claim.

NewsLink: Are there any plans for improvement at FHA?

Schmidt: There is currently a movement within the industry to convince FHA to be more streamlined and reduce the amount of documentation needed to help distressed borrowers. There has been some progress, too. For example, the FHA no longer requires documentation for unemployment forbearances or imminent default modifications.

Another positive step is the FHA’s new 40-year loan modification option for distressed borrowers. Truthfully, however, that hasn’t necessarily made things much easier. FHA attempts to restructure the mortgage by reducing the principal and interest payment by up to 25%. It will allow a servicer to use up to 30% of the loan balance as a partial claim, to pay past due arrears and reduce the principal to achieve that target. But with today’s high interest rates, restructuring a loan tends to exhaust the entire 30% available claim funds with just one workout. This leaves nothing else available for the remainder of the loan life.

While there are promising signs that the FHA is willing to revisit and revise its policies, navigating them can be an extremely daunting task, particularly for small- and medium-sized servicers that lack the type of resources and in-house expertise that larger servicers have. Partnering with an experienced third-party like DLS Servicing can have a huge impact. By getting expert help for loss mitigation reviews, regardless of loan type, smaller servicers can ensure they stay compliant with all servicing requirements and gain a competitive edge in a complex market.

(Views expressed in this article do not necessarily reflect policies of the Mortgage Bankers Association, nor do they connote an MBA endorsement of a specific company, product or service. MBA NewsLink welcomes your submissions. Inquiries can be sent to Editor Michael Tucker or Editorial Manager Anneliese Mahoney.)