In a May 2011 Supervisory Insights article, the Federal Deposit Insurance Corporation reiterated a fact many bankers know well:  Residential mortgage foreclosure numbers have increased substantially over the last several years and will likely continue to do so in 2011 and beyond. This increase creates increased potential for errors in the foreclosure process and increased regulatory and legal issues.

On June 7, 2011, the State of New York Supreme Court, Appellate Division overturned a previous ruling that favored the Mortgage Electronic Registration Systems (MERS) and Bank of New York. In this case, the borrower consolidated two mortgages into one note. Countrywide was the named lender and note holder on the consolidation agreement, but MERS executed the document in its capacity of the mortgagee on record on behalf of Countrywide. The corrected mortgage assignment was appointed to Bank of New York, which initiated the foreclosure. The court agreed with the borrower’s stance that the consolidation agreement “broke the chain” of ownership of the notes to Bank of New York, which did not give the bank legal standing to foreclose on the property.

While this case may be unique, it brings to light potential pitfalls financial institutions may face when processing foreclosures.

Servicing problems related to foreclosures have become more common at large institutions. Federal banking agencies have taken notice of these institutions’ failure to properly manage the foreclosure process. The agencies reviewed foreclosure procedures and practices at the 14 largest mortgage servicers and two third-party service providers and uncovered numerous unsafe and unsound practices, including poor documentation, ineffective controls and related quality control programs and failure to commit adequate resources to handling the growing number of foreclosures.

Community banks generally have fewer past-due rates on residential mortgages loans (and therefore fewer foreclosures), but several lessons can be learned from the interagency findings.

Appropriate oversight and governance are important risk management tools in the foreclosure process. As the number of foreclosures increases, a financial institution must work to be sure:

• Its policies and procedures allow it to identify all risks, e.g., legal, financial or reputational, associated with the foreclosure process
• “Audit trails” exist for all information related to the foreclosure process
• Adequate, qualified manpower is devoted to the process

A sound quality control program also is a crucial part of the governance process regarding foreclosures. The interagency findings identified poor internal audit and review processes that led to widespread issues of missing documents, failure to properly notarize information and inaccurate information. Implementing a rigorous quality control and internal audit program to systematically review foreclosures and related information could alleviate many of these documentation issues. A financial institution with increased foreclosures also should work to comply with all laws and regulations by dedicating adequate staffing and training for collections, collateral management and foreclosure activities. A review of MERS and Lender Processing Services, Inc. found these third-party foreclosure service providers did not dedicate adequate resources to various risks and had inadequate documentation standards; therefore, financial institutions also should review the internal controls and procedures of any third-party servicers.

Early and frequent communication with borrowers is crucial to help avoid costly foreclosures. A foreclosure often can be prevented by considering loan restructuring or other workout options, which are more affordable for the financial institution. If loan modification is considered practical and advantageous for the borrower and financial institution, a single point of contact should be encouraged and referenced on all correspondence with the borrowers. Providing individuals involved in the loan modification with appropriate oversight and training can alleviate many issues brought up by the interagency reviews.

While loan modification and workouts are often the most advantageous situation for the financial institution and borrower, they are not always possible. By making sure appropriate oversight and documentation standards are followed during foreclosure proceedings, a financial institution can avoid unnecessary litigation and further losses. For further information or assistance, contact your BKD advisor.

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