July 16, 2007

Mortgage brokers should be required to be agents of borrowers, but the requirements should run in terms of operationally specific rules that can be largely enforced by borrowers. The most critical rule is that brokers operate like other service providers by disclosing in advance how much they are charging for their services. Upfront Mortgage Brokers are subject to such a rule now.

Requiring Brokers to Be Agents

“According to the National Mortgage News of July 9, 2007, ‘Several Democratic senators want to impose a fiduciary duty on mortgage brokers so they are obliged to serve the best interests of the borrower and can be held accountable for violations of that trust’. I assume you support this effort.”

I do, brokers operating now as independent contractors can earn as much on transactions as they can induce borrowers to pay and have no obligation to deliver the mortgages best suited to borrowers’ needs. As agents of the borrower, in contrast, broker fees will have to be reasonable and the mortgages they offer will have to meet borrowers’ needs.

At least, that’s the theory. In practice, agency obligations defined as I just did are not enforceable and would accomplish nothing. California has had such an agency law for years, it has never been enforced and California brokers ignore it.

The critical challenge is formulating agency rules that can be enforced at a reasonable cost per incident. No Federal agency has the capacity to enforce agency laws applicable to more than 50,000 mortgage brokers if each enforcement action requires extensive investigation and time-consuming legal processes. Brokers are too small to attract class action suits, and private suits by aggrieved borrowers seeking redress usually cost more in legal fees than the contested damages.

Requirements For an Agency Rule to Be Effective

Enforceability requires that the borrower be the principal enforcement agent. That is possible only if the agency rules are so operationally specific that the borrower will know whether or not they have been violated, and will have the evidence at hand to document it.

Fortunately, there are agency obligations that meet this requirement. The most important would require that brokers operate like all other service providers by disclosing in advance how much they are charging for their services. The rule would read something like this:

The broker will establish a price for services upfront which includes any payment to the broker from the lender or other third parties, and which the borrower must acknowledge in writing.

This rule would work because borrowers would be able to document any violation. A violation occurs if a) The borrower has not acknowledged a written statement of price, or b) The price on the statement is lower than the broker’s total compensation shown on the HUD1 settlement statement that the borrower receives at closing.

This operational simplicity is a critical requirement of effectiveness. Rules that say that broker charges must be “reasonable”, or that loans must be “suitable” for the borrower, would be dead on arrival.

The Upfront Mortgage Broker Model

About 200 brokers voluntarily act as agents of borrowers now. They are called Upfront Mortgage Brokers (UMBs), and the operational rule described above is based on their commitment to borrowers.

I started the UMB movement several years ago with several brokers who subscribed to upfront principles. Because our enforcement capacities were limited, the rules we developed had to be easily enforceable and therefore operationally specific. Of the 8 parts of the commitment, only 2 are general principles that are not designed to be enforced. The full commitment is shown at Commitment of an Upfront Mortgage Broker, and on www.upfrontmortgagebrokers.org, the site of UMBA, the trade association of UMBs.

Broker charges today average over 2% of loan amounts, which is about twice as high as they should be. A major reason for high fees is low productivity, and a reason for low productivity is distrust, which leads borrowers to flit from broker to broker and submit multiple applications. Such actions raise broker costs, which pressures brokers to make more per transaction, which generates more distrust in a vicious cycle.

Forcing the advance disclosure of broker prices would break this cycle. Broker prices would drop and productivity would rise. But there is a caveat, having to do with exactly who would be affected by the rule.

Defining Who Is a Mortgage Broker

Assume that X and Y are both loan providers who deal with wholesale lender W. They both receive price sheets from W, and add their markup. The markup is the price they are charging the borrower for their services. X brings the loan package to W who closes and funds the loan. Y closes and funds the loan itself, then delivers the completed loan to W.

Under existing rules, X is a broker while Y is a lender. X must report its markup in closing documents, but Y does not. To avoid this, thousands of brokers have joined “net branches”, which close loans for them so that they can legally be classified as lenders.

If an agency rule required only brokers to disclose their fees upfront, the stream into net branches would become a flood. To be effective, therefore, an agency law must cover all loan providers except those who lend at their own risk and therefore have no markup to disclose.