Escrow Could Help Subprime Borrowers

With an important exception, lenders price mortgage loans on the assumption that borrowers will include taxes and insurance premiums in their monthly payments. These payments are placed in an escrow account under the lender's control. When a payment is due, it is made by the lender.

The escrow requirement protects the lender. If the taxes are not paid, the tax authority could place a lien on the property that would have a higher priority than the lender's lien. Similarly, if the insurance premiums are not paid and the house burns down or is washed away, the lender's protection goes with it.

Escrow is not an absolute requirement. Borrowers who want to pay their own taxes and insurance can waive the requirement by paying a modest fee. Most borrowers offered the choice accept the escrow -- I suspect less to save the fee than because they find that the payment discipline is useful. I escrowed on both my mortgages because it simplified my life.

In the subprime market, however, most borrowers are not offered the choice. They need not pay a fee to have the requirement waived because there is no requirement. In this market, loans are marketed to relatively unsophisticated borrowers on the basis of monthly payments, which are lower when they don't include escrows. Lenders who insist on escrows would lose business to those who don't.

The upshot is that borrowers who have shown themselves to be the least capable of managing their credit affairs and who are most in need of the discipline provided by the escrow system don't have it offered to them.

With the recent jump in subprime foreclosures, this feature of the market has emerged as one contributor to the problem. Legislators hearing about it are understandably outraged. Some have proposed that escrows be required on all mortgages.

In deliberating this idea, lawmakers should understand that the companies that manage escrow accounts, called servicing agents, sometimes abuse borrowers. Servicing agents are not selected by borrowers and cannot be fired by them.

For one thing, servicing agent systems sometimes fail and the borrower's tax and insurance payments don't get made. Because some servicers don't disclose the payments they make (or don't make) on a timely basis, borrowers can be in the dark for an extended period before they discover that the servicing agent has screwed up. Meanwhile, they may find themselves with a canceled insurance policy or a tax lien.

I have heard many similar horror stories from borrowers. Outside of legal action against the servicing agent, which few borrowers can afford, there is no effective recourse. Borrowers who pay to waive escrows often do it to avoid this risk.

A second risk arises in connection with an increase in the required escrow payment, which the borrower, for any number of reasons, including lack of proper disclosure by the servicing agent, can fail to make. Many servicing agents in this situation place the entire payment in a suspense account, resulting in unnecessary delinquencies and late payments.

Unfortunately, to make escrows the norm in the subprime market would require that escrows be made mandatory for all mortgage borrowers. Escrows can't be required for only subprime loans because that term can't be precisely defined. And if the law requires simply that escrows be offered to borrowers, loan officers and mortgage brokers could work around it.

But the requirement for an escrow could be short-term. Its purpose would be to force borrowers at the outset to confront their ability to afford the major expenses of homeownership. This would be served by an escrow requirement that applies only to the first year. After that, borrowers should be allowed to opt out if they want.

But it would be irresponsible to require borrowers to escrow, even if only for a year, without protecting them against escrow abuses. Servicing agents should be required to provide easy-to-understand monthly statements showing everything that occurred to affect the borrower's account. This should include payments out of and credits to escrow, balance changes and their sources, rate adjustments and fees. In addition, servicing agents should be prohibited from placing scheduled payments of principal and interest in suspense accounts when only the escrow payment is short.

Jack Guttentag is professor of finance emeritus at the Wharton School of the University of Pennsylvania. He can be contacted through his Web site, http://www.mtgprofessor.com.

Copyright 2007, Jack Guttentag

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