Dealing With Yield Spread Premium Abuse
23 January, 2007
The controversy over yield spread premium (YSP) abuse has generated much more heat than light. This paper is designed to provide some light. It argues that while YSP abuse is associated in most people’s minds with mortgage brokers, in fact it is not limited to them. The potential for the same or a very similar abuse exists in connection with all types of mortgage loan providers.
For my purpose here, loan providers can be placed into three groups: mortgage brokers, correspondent lenders and true lenders.
Mortgage brokers typically perform all loan origination functions except underwriting and funding. Some brokers underwrite and some fund with money provided at the closing table by the wholesale lender ("table funding"), but such exceptions don’t matter. What matters is that all brokers deliver loans at prices set by the wholesale lenders with which the brokers deal. Borrowers pay the wholesale price plus the broker’s markup. YSP arises in this process, as explained below.
Correspondent lenders do everything that brokers do, but unlike brokers they fund loans, with money they usually borrow from banks. See What Are Correspondent Lenders? This is what makes them lenders rather than brokers. However, correspondent lenders deliver loans at prices set by the wholesale lenders with which they deal, in exactly the same way as brokers. And YSP arises in this process in exactly the same way.
It is important to understand that the line distinguishing brokers from correspondent lenders is often quite murky. Some broker firms evolve into correspondent lender firms as they grow, acting as a correspondent on some transactions and as a broker on others. Some quite large correspondent firms may continue to broker loans of a particular type or in a particular state.
What distinguishes brokers and correspondent lenders from true lenders is that they do not take market risk. By market risk, I mean the risk involved in making loans at one price and selling them later at the market prices prevailing at that time. The market risk is taken by the wholesale lenders with which the brokers and correspondent lenders deal.
True lenders do take market risk. They originate loans to resell in the secondary market, or to hold in their portfolios. Because they do not lend against prices set by others, there is no YSP, and therefore no YSP abuse. However, such lenders may commit overage abuses, which are closely related.
The line between correspondent lenders and true lenders can also be fuzzy. A correspondent lender can evolve into a true lender by degrees, originating certain categories of loans at its own risk while continuing to originate others as a correspondent.
Let me anticipate the argument developed later in this paper. Because the different types of loan providers overlap each other in terms of their ways of doing business, any remedial legal actions taken against YSP and overage abuses should be transaction-based rather than institution-based. Rules directed at curbing YSP abuse should be applicable to any transaction in which there is YSP, regardless of the legal status of the loan provider involved.
Mortgage brokers and correspondent lenders base their prices to borrowers on the prices they receive every morning from their wholesale lenders. These lenders price varying combinations of interest rate and points on every loan program they offer. For example, on a 30-year fixed-rate mortgage, they might offer the following:
For a rate below 6%, the wholesale lender expects to be paid points, for a rate above 6%, the wholesaler will pay a rebate. In common parlance, a rebate is a YSP when it is pocketed by a broker. In actuality, it is equally a YSP when it is pocketed by a correspondent lender.
Suppose the loan provider aims to make a 1.5 markup on this loan. If he puts his markup on the 6% loan, he must charge 1.5 points, which is cash out-of-pocket to the borrower, who may resist it for that reason. If the loan provider adds the markup to the 6.375% loan, in contrast, the borrower pays nothing out of pocket because the broker is paid the YSP by the lender.
Most borrowers are less resistant to a higher rate, which hits them in the future, than to a fee that must be paid at closing. As a result, most fees take the form of YSP.
YSP compensation is not abusive if the borrower knows what is going on. A borrower dealing with an Upfront Mortgage Broker (UMB) is told what the broker’s fee is, and is given a choice as to how it is paid – in cash or as YSP. The great majority of brokers, however, don’t offer this choice because they can make more if they keep the YSP to themselves. The borrower may learn about it in the documents they receive, but disclosure comes late and it is extremely unclear.
Similarly, some correspondent lenders including Upfront Mortgage Lenders show their rate/point offerings on their web site, where borrowers can make their own selections. Most of them don’t, however. Further, while YSP disclosure requirements for brokers are poor, there are no disclosure requirements at all for correspondent lenders. Their deals with wholesale lenders are viewed as secondary market transactions, which are not subject to disclosure requirements.
YSP abuse could be eliminated by making rebates illegal, but that is a bad idea. Rebates are a very useful option for borrowers who are cash short and need help in paying settlement costs, including broker fees. It is particularly useful for borrowers who don’t plan to be in their house very long, and therefore won’t be paying the higher rate, which is the quid pro quo for the rebate, very long.
Lenders who do not receive YSP originate loans at their own risk, to hold in their portfolios or to sell in the secondary market. Such lenders have loan officer employees (LOs) who receive price sheets every morning, just like mortgage brokers. The difference is that the price sheets of the LO are those of one firm, and the prices are retail rather than wholesale. The markup, including the LO’s commission (usually about ½ a point), is already included in the prices.
Taking the example above and assuming a retail-wholesale spread of 1 point, the LO’s price sheet will appear as follows:
With an acceptable profit margin already built in, these are the prices the lender will accept. However, the LO may use the rebate to generate an overage – a price above the posted price. If the LO can get the borrower to accept 6.375% with no rebate, the lender makes an overage of .625 points, part of which goes to the LO.
Overages are the counterpart of the YSP of the broker or correspondent lender. Both are used to exploit the borrower’s ignorance. In one case, the borrower is ignorant of the rebate paid by the wholesale lender to the broker or correspondent lender. In the other, the borrower is ignorant of the rebate the lender is willing to accept. Overages are not subject to any disclosure requirements.
The appropriate remedy for YSP abuse is to require that YSPs be credited to borrowers, who would have to agree to sign them over to loan providers. This would empower borrowers in negotiating fees, and lead to better decisions about the combination of rate and points that best meets the borrower’s needs.
This rule should apply to any transaction on which the loan provider will deliver the loan against a firm commitment from another firm to pay a rebate for the loan. The legal status of the loan provider, whether broker or lender, should not matter.
The appropriate remedy for overage abuse is to make overages illegal. Lenders should be prohibited from granting discretion to LOs to price off the price sheet. Lenders should be free to charge what they want, but they should not be free to take advantage of ignorance and naïveté to charge some borrowers more than others just because they can.
The proposed legal remedies should not be limited to one group of loan providers. This is a matter not only of equity, but also of effectiveness. The lines between these groups are not rigid -- especially the line between mortgage brokers and correspondent lenders.
Brokers always have the option of joining lender groups where they can operate pretty much the same way they do as brokers except that their parent funds the loans. Many brokers have made such a shift just to avoid the weak YSP disclosure rules they face as brokers. Any tightening of the rules, such as the one I propose, if it applied only to brokers, would result in a massive movement of brokers to lender groups that were not covered by the rule.
The controversy over yield spread premium (YSP) abuse has generated much more heat than light. This paper is designed to provide some light. It argues that while YSP abuse is associated in most people’s minds with mortgage brokers, in fact it is not limited to them. The potential for the same or a very similar abuse exists in connection with all types of mortgage loan providers.
The Various Types of Mortgage Loan Providers
For my purpose here, loan providers can be placed into three groups: mortgage brokers, correspondent lenders and true lenders.
Mortgage brokers typically perform all loan origination functions except underwriting and funding. Some brokers underwrite and some fund with money provided at the closing table by the wholesale lender ("table funding"), but such exceptions don’t matter. What matters is that all brokers deliver loans at prices set by the wholesale lenders with which the brokers deal. Borrowers pay the wholesale price plus the broker’s markup. YSP arises in this process, as explained below.
Correspondent lenders do everything that brokers do, but unlike brokers they fund loans, with money they usually borrow from banks. See What Are Correspondent Lenders? This is what makes them lenders rather than brokers. However, correspondent lenders deliver loans at prices set by the wholesale lenders with which they deal, in exactly the same way as brokers. And YSP arises in this process in exactly the same way.
It is important to understand that the line distinguishing brokers from correspondent lenders is often quite murky. Some broker firms evolve into correspondent lender firms as they grow, acting as a correspondent on some transactions and as a broker on others. Some quite large correspondent firms may continue to broker loans of a particular type or in a particular state.
What distinguishes brokers and correspondent lenders from true lenders is that they do not take market risk. By market risk, I mean the risk involved in making loans at one price and selling them later at the market prices prevailing at that time. The market risk is taken by the wholesale lenders with which the brokers and correspondent lenders deal.
True lenders do take market risk. They originate loans to resell in the secondary market, or to hold in their portfolios. Because they do not lend against prices set by others, there is no YSP, and therefore no YSP abuse. However, such lenders may commit overage abuses, which are closely related.
The line between correspondent lenders and true lenders can also be fuzzy. A correspondent lender can evolve into a true lender by degrees, originating certain categories of loans at its own risk while continuing to originate others as a correspondent.
Let me anticipate the argument developed later in this paper. Because the different types of loan providers overlap each other in terms of their ways of doing business, any remedial legal actions taken against YSP and overage abuses should be transaction-based rather than institution-based. Rules directed at curbing YSP abuse should be applicable to any transaction in which there is YSP, regardless of the legal status of the loan provider involved.
What is YSP?
Mortgage brokers and correspondent lenders base their prices to borrowers on the prices they receive every morning from their wholesale lenders. These lenders price varying combinations of interest rate and points on every loan program they offer. For example, on a 30-year fixed-rate mortgage, they might offer the following:
| Rate | Points |
| 6.375 | -1.625 |
| 6.25 | -1.125 |
| 6.125 | -.625 |
| 6 | 0 |
| 5.875 | .875 |
| 5.75 | 1.5 |
For a rate below 6%, the wholesale lender expects to be paid points, for a rate above 6%, the wholesaler will pay a rebate. In common parlance, a rebate is a YSP when it is pocketed by a broker. In actuality, it is equally a YSP when it is pocketed by a correspondent lender.
How YSP Abets Abuse
Suppose the loan provider aims to make a 1.5 markup on this loan. If he puts his markup on the 6% loan, he must charge 1.5 points, which is cash out-of-pocket to the borrower, who may resist it for that reason. If the loan provider adds the markup to the 6.375% loan, in contrast, the borrower pays nothing out of pocket because the broker is paid the YSP by the lender.
Most borrowers are less resistant to a higher rate, which hits them in the future, than to a fee that must be paid at closing. As a result, most fees take the form of YSP.
YSP compensation is not abusive if the borrower knows what is going on. A borrower dealing with an Upfront Mortgage Broker (UMB) is told what the broker’s fee is, and is given a choice as to how it is paid – in cash or as YSP. The great majority of brokers, however, don’t offer this choice because they can make more if they keep the YSP to themselves. The borrower may learn about it in the documents they receive, but disclosure comes late and it is extremely unclear.
Similarly, some correspondent lenders including Upfront Mortgage Lenders show their rate/point offerings on their web site, where borrowers can make their own selections. Most of them don’t, however. Further, while YSP disclosure requirements for brokers are poor, there are no disclosure requirements at all for correspondent lenders. Their deals with wholesale lenders are viewed as secondary market transactions, which are not subject to disclosure requirements.
Eliminating YSP Abuse By Eliminating Rebates
YSP abuse could be eliminated by making rebates illegal, but that is a bad idea. Rebates are a very useful option for borrowers who are cash short and need help in paying settlement costs, including broker fees. It is particularly useful for borrowers who don’t plan to be in their house very long, and therefore won’t be paying the higher rate, which is the quid pro quo for the rebate, very long.
Overage Abuses by True Lenders
Lenders who do not receive YSP originate loans at their own risk, to hold in their portfolios or to sell in the secondary market. Such lenders have loan officer employees (LOs) who receive price sheets every morning, just like mortgage brokers. The difference is that the price sheets of the LO are those of one firm, and the prices are retail rather than wholesale. The markup, including the LO’s commission (usually about ½ a point), is already included in the prices.
Taking the example above and assuming a retail-wholesale spread of 1 point, the LO’s price sheet will appear as follows:
| Rate | Points |
| 6.375 | -.625 |
| 6.25 | -.125 |
| 6.125 | 325 |
| 6 | 1 |
| 5.875 | 1.875 |
| 5.75 | 2.5 |
With an acceptable profit margin already built in, these are the prices the lender will accept. However, the LO may use the rebate to generate an overage – a price above the posted price. If the LO can get the borrower to accept 6.375% with no rebate, the lender makes an overage of .625 points, part of which goes to the LO.
Overages are the counterpart of the YSP of the broker or correspondent lender. Both are used to exploit the borrower’s ignorance. In one case, the borrower is ignorant of the rebate paid by the wholesale lender to the broker or correspondent lender. In the other, the borrower is ignorant of the rebate the lender is willing to accept. Overages are not subject to any disclosure requirements.
Appropriate Legal Remedies
The appropriate remedy for YSP abuse is to require that YSPs be credited to borrowers, who would have to agree to sign them over to loan providers. This would empower borrowers in negotiating fees, and lead to better decisions about the combination of rate and points that best meets the borrower’s needs.
This rule should apply to any transaction on which the loan provider will deliver the loan against a firm commitment from another firm to pay a rebate for the loan. The legal status of the loan provider, whether broker or lender, should not matter.
The appropriate remedy for overage abuse is to make overages illegal. Lenders should be prohibited from granting discretion to LOs to price off the price sheet. Lenders should be free to charge what they want, but they should not be free to take advantage of ignorance and naïveté to charge some borrowers more than others just because they can.
Concluding Comment
The proposed legal remedies should not be limited to one group of loan providers. This is a matter not only of equity, but also of effectiveness. The lines between these groups are not rigid -- especially the line between mortgage brokers and correspondent lenders.
Brokers always have the option of joining lender groups where they can operate pretty much the same way they do as brokers except that their parent funds the loans. Many brokers have made such a shift just to avoid the weak YSP disclosure rules they face as brokers. Any tightening of the rules, such as the one I propose, if it applied only to brokers, would result in a massive movement of brokers to lender groups that were not covered by the rule.