HUD's Proposals to Reform Loan Originations
June 30, 2008
Since its last effort to reform market practices was defeated by the industry in 2002 (see Reforming RESPA: The HUD Proposals), HUD has been promising to come back with some less ambitious, but hopefully more acceptable, proposals. They finally did, in March of this year.
The proposals have three major thrusts: one is to convert the Good Faith Estimate of fees and charges (henceforth GFE) into a document that borrowers can use to shop alternative loan providers (henceforth LPs). That is the subject of this article. The second thrust is to protect borrowers against various types of opportunistic pricing that the current GFE facilitates. The third thrust is to make mortgage broker pricing transparent, which the current GFE does not.
The current GFE does not have the critical summary information on loan features that borrowers need to shop effectively. In addition, the fees and charges shown on the GFE are not totaled in meaningful ways and can change behind the borrower’s back. Even if the information was complete and dependable, furthermore, the borrower doesn’t get it until after submitting a loan application, which is too late to be useful in shopping.
For the GFE to become an effective shopping tool, it must 1) provide borrowers with critical information about the features and prices of the borrower’s desired loan; 2) limit the right of LPs to change the fees and charges shown on the GFE; and 3) require LPs to view issuance of the GFE as a loan approval, subject only to verification of the information provided by the borrower. The proposed GFE does all this.
The information on the proposed GFE includes the interest rate, total lender charges, and total third party charges, which are sufficient to shop effectively for fixed-rate mortgages. On adjustable rate mortgages, HUD plans to require additional information on the factors that affect future rate adjustments, and is seeking comments on how best to do this.
The fees and charges contained in the proposed GFE no longer depend entirely on the "good faith" of the LP. Changes between the numbers shown on the GFE and those contained in the HUD1 final closing document will be limited, as discussed below.
The GFE as a Conditional Loan Approval: The new GFE is also a conditional loan approval (my term, not HUD’s) based on 6 pieces of information provided by the borrower: name, social security number, property address, gross monthly income, loan amount and house value. HUD envisages borrowers seeking GFEs from multiple LPs, making a selection from among them, and then submitting a loan application. The application provides the much more detailed information required by lenders, but it cannot be rejected unless the new information is materially different from that submitted in applying for the GFE. The burden of proof is on the LP.
Some Loose Ends: Converting the GFE into a conditional loan approval is a major step and it is not clear that HUD has all the bugs out of it. One loose end I see in their procedure is verification of the borrower’s income. If the borrower cannot verify the income stated on the GFE application, the lender must be allowed to reject the application without becoming vulnerable to legal challenge. The best way to deal with this is to add a seventh item to the list required for the GFE: "Will you verify income?". If the borrower says "no", the LP can set the higher price of a "stated income" loan, and if the borrower says "yes", it is clear that the burden of proof shifts to the borrower.
Another loose end is verification of the borrower's assets. If it turns out that the borrower does not have the assets to close, the lender again must be allowed to reject the application without becoming vulnerable to legal challenge. The best way to deal with this is to add an eighth item to the list required for the GFE: "Cash available for down payment and settlement costs?". If the amount shown is insufficient, the LP can assume a smaller down payment, and if the amount is sufficient, it is clear that the burden of proof shifts to the borrower.
Protecting Borrowers Against Low-Balling: The proposed GFE does not protect the borrower against the practice of "low-balling" – offering a low quote to get the business, then raising it later when the borrower locks the price. The very first item on the new GFE reads "The interest rate for this GFE is available until…" followed by a blank space where the LP will place a date. In practice, that date will always be the current day, since in a volatile market no LP will ever commit to tomorrow’s price.
HUD’s aborted 2002 proposals included a rate-indexing provision for dealing with this problem, but this time they totally ignore it. While price volatility is not a problem that can be solved by regulation, borrowers should be placed on notice that the problem exists. HUD views the new GFE partly as an educational document, yet they leave the borrower wholly in the dark on this critical issue.
In addition to warning borrowers about this problem, HUD should encourage them to ask the LP how a new price will be determined after the borrower submits a loan application and looks to lock the price. When LPs realize that their answer to this question may well affect whether or not they get the loan, they will come up with their own solutions. One is to index their price quotes to the daily series on wholesale prices shown on my web site.
The proposed GFE along with new rules as to how it must be used will also eliminate critical weaknesses of the current GFE that encourage opportunistic pricing – the practice of many LPs of charging as much as they can get away with.
The current GFE is an open-ended list of settlement costs with no meaningful sub-totals, encouraging lenders to invent new charges. Further, all of the charges on the current GFE are "estimates" subject to change, the only barrier to abuse being the "good faith" of the LP. In all too many cases, charges are raised in bad faith and there is nothing that HUD can do about it.
Proposed Categorization of Settlement Costs: In the proposed GFE, settlement costs are divided into three categories. Category one includes all charges by the lender and mortgage broker, tabbed "Our Service Charge", and Government recording and transfer charges. At settlement, these charges must be the same as those on the GFE. This rule is completely appropriate regarding lender’s own charges; it is also long overdue. Charges by governmental entities, are another matter, my experience suggests that these charges belong in category two, where the LP has a little latitude.
The second category now consists of services provided by third parties who are selected or identified by the LP. The most important of these is title insurance. The total of such charges can be as much as 10% higher at settlement than the total shown on the new GFE. This limit is better than no limit, but it doesn’t touch the dysfunctional system that makes third party settlement services far more costly than they should be. I comment on this further below.
The third category consists of services that the borrower has elected to shop among service providers not selected or identified by the LP. It includes homeowners insurance, which borrowers typically purchase on their own, and it can include title insurance if the borrower solicits title agencies on his own. These charges are not subject to any limits on price increases. This is a reasonable exemption.
Facilitating Comparison With Closing Documents: To help borrowers police their own transactions, HUD has proposed to change the HUD1 closing document so that it corresponds closely with the new GFE. It will then be easy for borrowers to compare the final charges on the HUD1 with those on the GFE. Good idea.
HUD also intends to seek authority to require that the HUD1 form be made available 3 days before closing, rather than 1 day, which is the current requirement. Another good idea, but they ought to include the mortgage note in this requirement. There is no excuse for forcing borrowers to confront a complicated contract for the first time at the closing table.
No Action Against Rigged Prices: The most disappointing part of the proposed new GFE is that it leaves untouched the odious network of relationships between loan providers and third party service providers, which raise the cost of these services to borrowers. Mandating that a title charge of $1,000 on the GFE can’t be more than $1,100 on the HUD1 closing document doesn’t accomplish much if the charge ought to be $300.
While it is not possible to know what the charge would be in a properly functioning competitive market, we do know that the perversely competitive markets we have now encourage high prices. Competition is perverse when service providers market not to purchasers but to the entities who refer the purchasers to them. The LPs who refer mortgage borrowers to third party service providers share in the overcharges -- sometimes legally, sometimes not.
The remedy is well-known and well-tested. It is to require lenders to pay for all services that they require from borrowers. If lenders want title protection, they should buy it and pay for it, passing the cost to borrowers in the rate and points. The cost passed through will be a small fraction of what borrowers pay now, since lenders are large and knowledgeable purchasers who can buy in bulk.
This is not a pie-in-the-sky idea. Indeed, since Bank of America adopted it last year, it can be viewed as an industry "best practice". Yet HUD, despite its legal mandate to lower settlement costs, ignores it. If this reflects HUD’s concern that they will receive no support, they are surely mistaken. If it were placed on the table, community groups would have to support it -- how could they not?
To be sure, the mortgage bankers would oppose the idea, because trade groups can’t advocate best practices without alienating a major segment of their membership. But the fact that a leading lender has adopted it voluntarily and successfully will make it difficult for them to argue that the market will collapse.
Perhaps the most important change in the GFE proposed by HUD – certainly the most controversial -- is the way it handles payments by lenders to mortgage brokers on higher-rate loans, referred to as yield spread premiums, or YSPs. It is alleged that YSPs are often excessive because they are embedded in the interest rate and borrowers are not always aware of them.
An Illustration of YSP Abuse: Consider the broker who receives wholesale price quotes on a $200,000 fixed-rate mortgage that includes the following possibilities: 6% at zero points, 5.75% at 2 points, and 6.25% at -1.5 points. On the last option, the lender pays 1.5 points, the YSP, to get the 6.25% rate.
At 6%, the wholesaler does not expect to receive any points, and will not pay any either. If the broker selects the 6% rate, he must tell the borrower what his fee is because the borrower will have to pay that fee out-of-pocket, "Charley, the price is 6%, zero points, and $3,000 for me".
It can and does happen this way, but most brokers find the 6.25% option with the 1.5% YSP more attractive. It allows the broker to say "Charley, the price is 6.25%, with no points and no broker fee." The statement is not correct, there is a broker fee, but the borrower is not told what it is.
Why does it matter? Because in the 6% case, Charley might question whether $3,000 wasn’t too much, and whether $2,000 might not be more appropriate. In the 6.25% case, the broker avoids this question. The proof of the pudding is that in general, borrowers who pay brokers directly pay less than borrowers who pay through YSP.
Proposal by the Fed: Under recent proposals by the Federal Reserve Board (see The Fed's Proposals For Fixing the Market), a lender would be prohibited from making a payment to a broker unless the borrower and broker had agreed in advance on the broker’s total compensation. Before paying a YSP to a broker, the lender would have to check the agreement between the broker and the borrower, as well as the HUD1 closing statement, to make sure that the total amount received by the broker did not exceed the amount agreed upon.
The Board’s approach would work, but it is clumsy and places a non-trivial enforcement burden on the lender.
HUD's Proposal: Under HUD’s approach, any YSP must be included in the new GFE item, "Our Service Charge," which is total broker and lender fees exclusive of points. If the 6.25% rate with YSP was selected, Our Service Charge would include the $3,000 YSP and any other LP charges.
The next item on the form is "Your credit or charge for the specific interest rate chosen (points)". The GFE here shows whether the borrower is paying points or receiving them. In the case at hand, it would show the $3,000 as a credit for the 6.25% rate.
The third item on the GFE is "Your Adjusted Origination Charge", which consists of Our Service Charge plus any charge or less any credit for the rate selected. In the case at hand, the Our Service Charge of $3,000 less the $3,000 credit for the 6.25% rate leaves an adjusted origination charge of zero.
The borrower thus knows that the 6.25% rate generates a $3,000 credit to him, and he also knows that the credit is used to compensate the broker. Any inclination to negotiate the broker fee should be the same as in the 6% rate case, where the borrower knows he must pay the broker out of pocket.
Concluding Comment: This set of disclosure requirements will pose no problems for Upfront Mortgage Brokers (UMBs), and many other brokers who follow UMB principles. They practice full disclosure now. But the industry trade groups, which defend the ways in which most brokers operate, are moaning that the new GFE will mean the end of mortgage brokerage. Stuff and nonsense, it will merely mean the end of broker deception.
Since its last effort to reform market practices was defeated by the industry in 2002 (see Reforming RESPA: The HUD Proposals), HUD has been promising to come back with some less ambitious, but hopefully more acceptable, proposals. They finally did, in March of this year.
The proposals have three major thrusts: one is to convert the Good Faith Estimate of fees and charges (henceforth GFE) into a document that borrowers can use to shop alternative loan providers (henceforth LPs). That is the subject of this article. The second thrust is to protect borrowers against various types of opportunistic pricing that the current GFE facilitates. The third thrust is to make mortgage broker pricing transparent, which the current GFE does not.
Converting the Good Faith Estimate Into a Shopping Tool
The current GFE does not have the critical summary information on loan features that borrowers need to shop effectively. In addition, the fees and charges shown on the GFE are not totaled in meaningful ways and can change behind the borrower’s back. Even if the information was complete and dependable, furthermore, the borrower doesn’t get it until after submitting a loan application, which is too late to be useful in shopping.
For the GFE to become an effective shopping tool, it must 1) provide borrowers with critical information about the features and prices of the borrower’s desired loan; 2) limit the right of LPs to change the fees and charges shown on the GFE; and 3) require LPs to view issuance of the GFE as a loan approval, subject only to verification of the information provided by the borrower. The proposed GFE does all this.
The information on the proposed GFE includes the interest rate, total lender charges, and total third party charges, which are sufficient to shop effectively for fixed-rate mortgages. On adjustable rate mortgages, HUD plans to require additional information on the factors that affect future rate adjustments, and is seeking comments on how best to do this.
The fees and charges contained in the proposed GFE no longer depend entirely on the "good faith" of the LP. Changes between the numbers shown on the GFE and those contained in the HUD1 final closing document will be limited, as discussed below.
The GFE as a Conditional Loan Approval: The new GFE is also a conditional loan approval (my term, not HUD’s) based on 6 pieces of information provided by the borrower: name, social security number, property address, gross monthly income, loan amount and house value. HUD envisages borrowers seeking GFEs from multiple LPs, making a selection from among them, and then submitting a loan application. The application provides the much more detailed information required by lenders, but it cannot be rejected unless the new information is materially different from that submitted in applying for the GFE. The burden of proof is on the LP.
Some Loose Ends: Converting the GFE into a conditional loan approval is a major step and it is not clear that HUD has all the bugs out of it. One loose end I see in their procedure is verification of the borrower’s income. If the borrower cannot verify the income stated on the GFE application, the lender must be allowed to reject the application without becoming vulnerable to legal challenge. The best way to deal with this is to add a seventh item to the list required for the GFE: "Will you verify income?". If the borrower says "no", the LP can set the higher price of a "stated income" loan, and if the borrower says "yes", it is clear that the burden of proof shifts to the borrower.
Another loose end is verification of the borrower's assets. If it turns out that the borrower does not have the assets to close, the lender again must be allowed to reject the application without becoming vulnerable to legal challenge. The best way to deal with this is to add an eighth item to the list required for the GFE: "Cash available for down payment and settlement costs?". If the amount shown is insufficient, the LP can assume a smaller down payment, and if the amount is sufficient, it is clear that the burden of proof shifts to the borrower.
Protecting Borrowers Against Low-Balling: The proposed GFE does not protect the borrower against the practice of "low-balling" – offering a low quote to get the business, then raising it later when the borrower locks the price. The very first item on the new GFE reads "The interest rate for this GFE is available until…" followed by a blank space where the LP will place a date. In practice, that date will always be the current day, since in a volatile market no LP will ever commit to tomorrow’s price.
HUD’s aborted 2002 proposals included a rate-indexing provision for dealing with this problem, but this time they totally ignore it. While price volatility is not a problem that can be solved by regulation, borrowers should be placed on notice that the problem exists. HUD views the new GFE partly as an educational document, yet they leave the borrower wholly in the dark on this critical issue.
In addition to warning borrowers about this problem, HUD should encourage them to ask the LP how a new price will be determined after the borrower submits a loan application and looks to lock the price. When LPs realize that their answer to this question may well affect whether or not they get the loan, they will come up with their own solutions. One is to index their price quotes to the daily series on wholesale prices shown on my web site.
Protecting Borrowers Against Opportunistic Pricing.
The proposed GFE along with new rules as to how it must be used will also eliminate critical weaknesses of the current GFE that encourage opportunistic pricing – the practice of many LPs of charging as much as they can get away with.
The current GFE is an open-ended list of settlement costs with no meaningful sub-totals, encouraging lenders to invent new charges. Further, all of the charges on the current GFE are "estimates" subject to change, the only barrier to abuse being the "good faith" of the LP. In all too many cases, charges are raised in bad faith and there is nothing that HUD can do about it.
Proposed Categorization of Settlement Costs: In the proposed GFE, settlement costs are divided into three categories. Category one includes all charges by the lender and mortgage broker, tabbed "Our Service Charge", and Government recording and transfer charges. At settlement, these charges must be the same as those on the GFE. This rule is completely appropriate regarding lender’s own charges; it is also long overdue. Charges by governmental entities, are another matter, my experience suggests that these charges belong in category two, where the LP has a little latitude.
The second category now consists of services provided by third parties who are selected or identified by the LP. The most important of these is title insurance. The total of such charges can be as much as 10% higher at settlement than the total shown on the new GFE. This limit is better than no limit, but it doesn’t touch the dysfunctional system that makes third party settlement services far more costly than they should be. I comment on this further below.
The third category consists of services that the borrower has elected to shop among service providers not selected or identified by the LP. It includes homeowners insurance, which borrowers typically purchase on their own, and it can include title insurance if the borrower solicits title agencies on his own. These charges are not subject to any limits on price increases. This is a reasonable exemption.
Facilitating Comparison With Closing Documents: To help borrowers police their own transactions, HUD has proposed to change the HUD1 closing document so that it corresponds closely with the new GFE. It will then be easy for borrowers to compare the final charges on the HUD1 with those on the GFE. Good idea.
HUD also intends to seek authority to require that the HUD1 form be made available 3 days before closing, rather than 1 day, which is the current requirement. Another good idea, but they ought to include the mortgage note in this requirement. There is no excuse for forcing borrowers to confront a complicated contract for the first time at the closing table.
No Action Against Rigged Prices: The most disappointing part of the proposed new GFE is that it leaves untouched the odious network of relationships between loan providers and third party service providers, which raise the cost of these services to borrowers. Mandating that a title charge of $1,000 on the GFE can’t be more than $1,100 on the HUD1 closing document doesn’t accomplish much if the charge ought to be $300.
While it is not possible to know what the charge would be in a properly functioning competitive market, we do know that the perversely competitive markets we have now encourage high prices. Competition is perverse when service providers market not to purchasers but to the entities who refer the purchasers to them. The LPs who refer mortgage borrowers to third party service providers share in the overcharges -- sometimes legally, sometimes not.
The remedy is well-known and well-tested. It is to require lenders to pay for all services that they require from borrowers. If lenders want title protection, they should buy it and pay for it, passing the cost to borrowers in the rate and points. The cost passed through will be a small fraction of what borrowers pay now, since lenders are large and knowledgeable purchasers who can buy in bulk.
This is not a pie-in-the-sky idea. Indeed, since Bank of America adopted it last year, it can be viewed as an industry "best practice". Yet HUD, despite its legal mandate to lower settlement costs, ignores it. If this reflects HUD’s concern that they will receive no support, they are surely mistaken. If it were placed on the table, community groups would have to support it -- how could they not?
To be sure, the mortgage bankers would oppose the idea, because trade groups can’t advocate best practices without alienating a major segment of their membership. But the fact that a leading lender has adopted it voluntarily and successfully will make it difficult for them to argue that the market will collapse.
Making Broker Pricing Transparent
Perhaps the most important change in the GFE proposed by HUD – certainly the most controversial -- is the way it handles payments by lenders to mortgage brokers on higher-rate loans, referred to as yield spread premiums, or YSPs. It is alleged that YSPs are often excessive because they are embedded in the interest rate and borrowers are not always aware of them.
An Illustration of YSP Abuse: Consider the broker who receives wholesale price quotes on a $200,000 fixed-rate mortgage that includes the following possibilities: 6% at zero points, 5.75% at 2 points, and 6.25% at -1.5 points. On the last option, the lender pays 1.5 points, the YSP, to get the 6.25% rate.
At 6%, the wholesaler does not expect to receive any points, and will not pay any either. If the broker selects the 6% rate, he must tell the borrower what his fee is because the borrower will have to pay that fee out-of-pocket, "Charley, the price is 6%, zero points, and $3,000 for me".
It can and does happen this way, but most brokers find the 6.25% option with the 1.5% YSP more attractive. It allows the broker to say "Charley, the price is 6.25%, with no points and no broker fee." The statement is not correct, there is a broker fee, but the borrower is not told what it is.
Why does it matter? Because in the 6% case, Charley might question whether $3,000 wasn’t too much, and whether $2,000 might not be more appropriate. In the 6.25% case, the broker avoids this question. The proof of the pudding is that in general, borrowers who pay brokers directly pay less than borrowers who pay through YSP.
Proposal by the Fed: Under recent proposals by the Federal Reserve Board (see The Fed's Proposals For Fixing the Market), a lender would be prohibited from making a payment to a broker unless the borrower and broker had agreed in advance on the broker’s total compensation. Before paying a YSP to a broker, the lender would have to check the agreement between the broker and the borrower, as well as the HUD1 closing statement, to make sure that the total amount received by the broker did not exceed the amount agreed upon.
The Board’s approach would work, but it is clumsy and places a non-trivial enforcement burden on the lender.
HUD's Proposal: Under HUD’s approach, any YSP must be included in the new GFE item, "Our Service Charge," which is total broker and lender fees exclusive of points. If the 6.25% rate with YSP was selected, Our Service Charge would include the $3,000 YSP and any other LP charges.
The next item on the form is "Your credit or charge for the specific interest rate chosen (points)". The GFE here shows whether the borrower is paying points or receiving them. In the case at hand, it would show the $3,000 as a credit for the 6.25% rate.
The third item on the GFE is "Your Adjusted Origination Charge", which consists of Our Service Charge plus any charge or less any credit for the rate selected. In the case at hand, the Our Service Charge of $3,000 less the $3,000 credit for the 6.25% rate leaves an adjusted origination charge of zero.
The borrower thus knows that the 6.25% rate generates a $3,000 credit to him, and he also knows that the credit is used to compensate the broker. Any inclination to negotiate the broker fee should be the same as in the 6% rate case, where the borrower knows he must pay the broker out of pocket.
Concluding Comment: This set of disclosure requirements will pose no problems for Upfront Mortgage Brokers (UMBs), and many other brokers who follow UMB principles. They practice full disclosure now. But the industry trade groups, which defend the ways in which most brokers operate, are moaning that the new GFE will mean the end of mortgage brokerage. Stuff and nonsense, it will merely mean the end of broker deception.