The Sunset of Soft Servicing 

*This article appears in the third quarter 2025 issue of Bank Director magazine.

Since the onset of Covid-19, an unprecedented era of soft servicing practices has permeated loan servicing and loss mitigation. While many practices were necessary at the pandemic’s height, they have persisted long after — resulting in unresolved challenges, even after borrowers received generational levels of stimulus. Soft servicing has inflated asset prices and misallocated capital. A few of these practices are finally ending, setting the stage for a hard landing.

FHA Loans: Masking Delinquencies
Consider Federal Housing Administration loans. In 2020, the historical serious delinquency rate jumped from 4% to nearly 12%, before falling below 4% again. How did the FHA reduce the serious delinquency rate by more than two-thirds?

According to The Wall Street Journal in February 2025, “The FHA made 556,841 ‘incentive payments’ to servicers over the past year to prevent foreclosures — nearly as many as the new mortgages it insured. … Of the 52,531 FHA loans last year that went seriously delinquent within their first year, only nine resulted in foreclosure.”

Yet these modifications are not performing. As of Dec. 1, 2024, 45.3% of the modifications issued in 2023 and 2024 are delinquent again, according to the agency’s data. Overall, the FHA’s delinquency rate now stands at 11.3%, the highest since 2013. These outcomes reveal that short-term fixes are fueling long-term instability.
The federal government essentially kept loans current by paying mortgage servicers, transferring borrower risk to the taxpayer. These incentive payments were treated as second liens on the property.  That program is now ending next quarter. Increases in foreclosures, short sales and property listings are highly likely.

Student Loans: A Reality Check
Student loans tell a similar story. For the first time since 2020, the Department of Education resumed collections on delinquent student loan borrowers in May. With 60% of borrowers behind on payments, many now face the consequences of falling behind on their loan payments. These include wage garnishments, reduced FICO scores and diminished disposable income.

By waiting years to resume collections, the government fostered false hope among many of these borrowers. Some likely made life decisions based on the assumption their debts would disappear — compounding their difficulties now.

Commercial Loans: Hidden Risks
We see a similar dynamic in commercial loans, in which a combination of a thoughtful response to Covid-19 with respect to modifications and converting from the old troubled debt restructuring (TDR) rules to the current expected credit loss (CECL) model has resulted in a pileup of hidden problem loans.

During Covid-19, Congress allowed banks to modify loans without adverse regulatory consequences, leading to widespread “robo-mods” throughout their portfolios. Workout officers were not consulted or involved, and borrowers received modifications without any concessions or workout input.
Under the old TDR rules, a restructured loan stayed as TDR until maturity. “Once a TDR, always a TDR” was the mantra. Now, CECL rules allow banks to modify a loan and then upgrade the loan after just months — when the teeth of the modification begins.

For example, a bank grants a borrower a 12-month interest-only period, followed by a catch-up phase. If the borrower performs during the easy part, the loan is upgraded. But when payments rise, many will redefault. In short: The old rules were too harsh, and the new rules are too lenient.

Consider the data: The commercial mortgage-backed securities (CMBS) multifamily delinquency rate sits at 5.44% (Trepp), while banks report just 0.66%, according to the fourth-quarter banking profile from the Federal Deposit Insurance Corp. Are CMBS loans truly eight times riskier?

Unlikely. CMBS loans are typically stabilized at origination, while banks often lend on transitional properties. A more probable explanation: Bank reporting is slower and more forgiving. Over time, we expect these figures to converge — and the cracks to widen.

The Reckoning Ahead
Well-intentioned but overly forgiving post-Covid loan servicing has masked distress rather than cured it. The longer we delay price discovery and accountability, the more disorderly the eventual reckoning will be.

While it made sense to buy time for borrowers at the pandemic’s peak, these programs should have lasted months, not years. When the medicine outlasts the illness, it becomes the poison.

It’s time for regulators and lenders to reintroduce discipline into loan servicing — before the next wave of defaults crashes through this artificial dam.