Fixing the Mortgage System So It Works For Borrowers
September 5, 2005, Revised July 29, 2007

In some respects, the United States housing finance system is the best in the world. In other respects, it is unworthy of a banana republic.

Our housing finance system has a primary market and a secondary market. The primary market is the market the borrower sees, where loans are executed. The secondary market is where the loans originated in the primary market are sold to investors, the ultimate source of funds.

Our secondary market is the envy of the world. Investors acquire mortgage backed securities at the smallest possible margins over US Government securities. However, much of the benefit stemming from our efficient secondary market is eaten away by excessive charges paid by borrowers to third party settlement service providers, lenders, and mortgage brokers. Excessive charges persist because, for a variety of reasons, borrowers cannot shop effectively.

Third Party Settlement Charges Are Excessive

Third parties involved in the lending process include title insurance companies, mortgage insurance companies, appraisers, credit reporting agencies, flood insurance companies, and escrow companies. Their costs are generally higher than they would be if they were purchased in a normally competitive market.

The Reason: Third party service providers compete not for the favor of borrowers, who pay their fees, but for the favor of the lenders who select them. This type of competition is perverse because it drives up the costs of the service providers. This in turn raises prices to borrowers or prevents them from falling in response to improvements in technology.

For example, borrowers pay for private mortgage insurance but the insurance company (PMI) is selected by the lender. Lenders use their referral power primarily to benefit themselves. The process is much the same in the markets for other third party services.

The direct payment of referral fees has long been illegal under the Real Estate Settlements Procedures Act (RESPA). However, RESPA is ineffective because it does not eliminate referral power, which is the crux of the problem. Small players often ignore the rule because HUD, which is responsible for enforcement, cannot possibly police all the ways in which one party can transfer something of value to another.

Large lenders circumvent RESPA through circuitous but legal devices, such as reinsurance affiliates that share the insurance premiums paid by borrowers. The process of legalizing referral fees increases the costs that borrowers ultimately pay. So long as referral power is allowed to persist, the cost to borrowers might be lower if referral fees were paid openly in cash.

Why Do Borrowers Pay For Services Required by Lenders? We have lived with this practice for so long that it seems the natural state of affairs, but in fact, there is nothing natural about it. If automobiles had to be shopped in the same way as mortgages, the shopper might only receive the chassis from the dealer, purchasing tires, electrical system, and painting from third parties. Can there be any doubt what would happen to the price of these components if, instead of purchasing them as a package, they had to be purchased separately from vendors selected by the dealer?

The unbundled package of mortgage services is a historical relic of usury laws limiting the interest rates lenders could charge. When lenders could not raise interest rates to cover their costs, it seemed reasonable to law-makers to allow them to pass costs through to borrowers. They didn’t realize that this was a sure-fire recipe for referral abuse. When the abuses became too obvious to ignore, they responded with RESPA, which made referral fees illegal but left referral power unchanged. RESPA is essentially a make-work project for lawyers.

The Remedy Is to Eliminate Referral Power: This could be done by the enactment of one legal rule that is as simple as it is obvious: any third party service required by lenders must be paid for by lenders.

If lenders paid the charges, they would be included in the rate, of course, but would cost borrowers far less than now. Competition by third party providers to sell lenders would force the prices down, and rate competition by lenders would force them to pass the savings on to borrowers. Indeed, if lenders had to pay for all these services, they would discover that some that they had found essential when borrowers had to pay, were not really necessary after all.

Lender Fees Can Blindside the Borrower

Lender fees, sometimes referred to as "junk fees", are fees charged by lenders to cover specific lender costs. They are defined in dollars, as opposed to points which are defined as a percent of the loan. Where points are one number, junk fees can be a whole bunch of numbers, each covering a specific charge.

The problem is that some retail lenders increase these fees after it is too late for the borrower to back out. Often, the borrower finds out about it at the closing table. It happens because of borrower inattention, industry locking practices, and terrible disclosure rules.

Borrower Inattention: Borrowers are usually only dimly aware of lender fees. When they shop, their focus is mainly on interest rate and points, which are all that appear in media ads. The borrower’s first exposure to lender fees is likely to be when they receive a Good Faith Estimate of Settlement (GFE), but this typically doesn’t happen until after an application has been submitted. At that point, the borrower will be at least partially committed.

Industry Locking Practice: The mortgage market is highly volatile, with prices changing from day to day and sometimes within the day. Hence, rate/point quotes are not binding until the lender locks them. Lender fees, in contrast, are not volatile, and therefore the practice is not to include them in locks. The presumption is that at closing, they will be exactly what they were when the borrower received the GFE, and with honest lenders, they will be. But with dishonest lenders, the practice of excluding fees from the lock provides an opportunity to cheat.

The Good Faith Estimate: The GFE makes it all too easy for the cheaters. Lenders are not bound by any of the numbers on the GFE, which are "estimates". This is ridiculous, since lenders know their own charges. In addition, the GFE confuses borrowers by showing each individual lender fee but no total, when the total is all that really matters. If the GFE were deliberately designed to take the borrower’s eye off the ball, it couldn’t have been done better.

Mortgage Brokers Provide Protection: Excessive junk fees generally are not a problem on loans that go through mortgage brokers. Brokers know the fees charged by all the lenders with whom they do business, and they would not accept fee surprises at the closing table that put no money in the broker’s pocket. Broker fees are another matter, to be discussed in article 3 of this series.

Home Purchases Are Most Vulnerable: Excessive junk fees are more likely to arise on a home purchase transaction than on a refinance. On a home purchase, a buyer cannot walk away from the mortgage without walking away from the house. On a refinance, in contrast, a borrower can usually begin anew at any point without much love had a deal changed on them from what they understood was promised earlier, can use the threat of rescission to obtain redress at the closing table.

The Remedy: A mandatory fixed-dollar fee on all mortgage transactions, proposed below as the way to make it possible for borrowers to shop effectively, would also eliminate fee escalation at the closing table. The maximum fixed-dollar fee could, indeed, be zero. Bank of America has adopted zero fees on purchase transactions as a competitive strategy, which is demonstration enough that it is practical. See NoFee Mortgage Plus.

A less comprehensive approach that would also work is a rule stipulating that when lenders lock the rate and points, they also lock their fees.

Mortgage Broker Fees Are Excessive

Because brokers deal with multiple lenders, they play a critical role in helping a borrower find a lender who offers a particular type of loan program. When the needed loan is one offered by many lenders, brokers are able to shop among them to find the lowest price. That’s the good news.

Excessive Fees: The bad news is that, broker charges per transaction are generally excessive. In part, this is due to low productivity. Brokers spend a lot of time looking for clients, and they also spend a lot of time with potential clients who don’t close and waste their time. Low productivity generates pressure to earn more on the deals that do close.

Brokers are able to charge a lot per transaction because borrowers usually don’t know at the outset how much the broker will make. If they find out, usually the deal is too far advanced to do anything about it.

Only the loosest relationship exists, furthermore, between broker charges and the amount of work the broker does for the borrower. The general rule is that brokers charge what the market will bear. Unsophisticated borrowers who visit a single broker will generally pay more than knowledgeable borrowers who shop alternative sources.

The Independent Contractor Model of the Industry: The dominant ideology of mortgage brokerage, as promulgated by the National Association of Mortgage Brokers and the various state associations, is that brokers are independent contractors. They view themselves as merchants who buy at one price and sell at another price, and how much they make on a transaction is no one’s business but their own. The independent contractor model supports the view that brokers are entitled to make as much per transaction as they can.

The Independent Contractor Model Generates Distrust, Which Increases Costs: Distrust runs like a red line through the hundreds of letters I receive every month from borrowers relating experiences with brokers. And distrust translates into higher costs.

Brokers detest borrowers who flit from one broker to another, submit applications through multiple brokers, or pump them for information and then deal elsewhere. Yet these practices arise from attempts by borrowers to protect themselves against brokers they don’t trust. Borrower reactions to distrust raise broker costs, which pressures brokers to make more per transaction, which generates more distrust in a vicious circle.

Other Fallacies of the Independent Contractor Model: The fact is that brokers are service providers, not merchants; they do not buy and resell anything. Furthermore, shopping mortgages is so difficult that few borrowers can do it effectively. Brokers are the experts at shopping mortgages, not borrowers. The optimal arrangement for most borrowers, therefore, is to purchase the shopping expertise of brokers for a fixed fee. Fortunately, it is now possible to do this.

The Agency Approach of Upfront Mortgage Brokers: Upfront Mortgage Brokers (UMBs) operate according to a different set of rules than the remainder of the industry. UMBs view themselves as the agent of the borrower, to whom they owe a fiduciary responsibility. A UMB agrees with the borrower on total broker compensation from the transaction, and passes through the best price from the broker’s lenders.

The advantage of the UMB approach is that it breeds confidence, which lowers costs and increases productivity. I know UMBs who charge half the industry average per transaction but close 3-4 times as many loans. Their secret is a continuous stream of referrals from previous clients -- and from me.

Implementation of the Agency Approach: The way to break the circle of distrust is to change the operating model, from independent contractor to agency. The broker trade associations will never do this, because they cater to the lowest common denominator of member opinion.

Government should but probably won’t mandate the agency approach because it would be opposed not only by the broker associations, but also by the wholesale lenders, who are as short-sighted as the brokers. They support the independent contractor model in order to limit their own liability for broker misdeeds.

One misgiving I have about enacting an agency requirement into law is that it will be defined so vaguely as to be useless. At worst, it could be an indirect way to enact a suitability requirement into law. Any definition that requires extensive investigation to determine whether or not a violation has occurred will not work in an industry with 50,000 or so players, most of which are very small. The UMB requirements are quite precise, in effect allowing the borrower to be the effective enforcement agent. See Commitment of an Upfront Mortgage Broker.

An Alternative Approach: Yield Spread Premiums Credited to Borrowers: A simpler approach that does not carry the risk of insinuating a suitability standard into the marketplace is to require that all yield spread premiums (YSPs) paid by wholesale lenders to brokers and to correspondent lenders be credited to borrowers. The borrowers would have to authorize their payment to the loan provider. Since overcharges arise almost entirely from YSPs, this would do the trick in a very direct way: the borrower would know exactly how much is being paid out of his pocket. See Dealing With Yield Spread Premium Abuse.

Mortgage Shopping by Borrowers Is Ineffective

Shopping is extremely difficult now because mortgages have so many price dimensions. Even if lenders paid for all the services provided by third parties, which I proposed above, a borrower shopping for an FRM would have three prices to juggle: interest rate, points, and fixed dollar fee. (On ARMs, there are more, but I’ll ignore that for now). This is confusing and makes shopping difficult.

Mandating a Fixed Fee: Government should mandate the same fixed-dollar charge for all lenders and all programs. Then borrowers would have to shop only rate and points, which is easily manageable. For example, a borrower can shop for the lowest rate at zero points, or the fewest points on a 6% loan.

Within reasonable limits, the exact amount of the fixed charge is not important, provided the charge is the same for every lender and every loan. It is the variability in these costs that makes it difficult to shop.

This is price-fixing by Government, but in a good cause. When a service carries one price, price-fixing invariably reduces the supply of the service. When a service carries three prices, however, fixing one price merely channels market adjustments into the remaining prices, making it easier for consumers to shop.

A Fixed Fee Would Discourage Predatory Lending: Perhaps the greatest benefit of the one-price rule would be in the sub-prime market, where predatory practices are widespread. Under a fixed-charge rule, these practices become much more difficult to execute.

A common feature of price gouging, for example, is the inclusion of large fees in the loan balance, which borrowers often know nothing about until they get to the closing table. With a fixed-price rule, along with a rule that limits the financing of points, any gouging would have to be in the interest rate, where the potential for snookering the borrower is limited. Even unsophisticated borrowers understand the difference between 7% and 12%.

In a similar vein, making loans that borrowers can’t repay, or churning loans in successive cash-out refinances, are profitable only if the lender can load heavy fees into the balance. The fixed-charge rule should eliminate both practices.

Enforcement of a Fixed Fee Rule Would Be Easy: Law-makers sometimes give little consideration to whether, and at what cost, the rules they promulgate can be enforced. This is certainly true of the existing law against the payment of referral fees, which couldn’t be effectively enforced with an army of examiners. State laws directed at predatory lending that bar loans that "fail to benefit the borrower," or that "borrowers do not have the capacity to repay," present similar enforcement problems.

In contrast, the fixed-charge rule would be virtually self-enforcing, because it is unambiguous, and every borrower would be a potential enforcement agent. Borrowers would know what the allowable charge was, and the closing documents would reveal whether or not the lender was in compliance.

How Much Should the Fixed Fee Be? The fee should not be so high that lenders can make money on the origination process, regardless of what happens later. That encourages abusive practices. Nor should it be so low that early prepayment will cause the lender serious loss because then there won’t be any loans made without prepayment penalties. $3,000 is about right for now. This is the fee set by Innovation Mortgage, a sub-prime lender out of California, which has adopted a one-price rule voluntarily as a marketing tool.

Note: since the above was written, Bank of America has voluntarily adopted a zero fee on purchase loans, and without a prepayment penalty. They don't offer sub-prime loans under this program, however.

Eliminating Low-Ball Price Quotes: If price quotes can’t be depended on, price shopping goes for naught. Some lenders and brokers routinely offer low-ball price quotes designed to capture the customer, which they retract at the time the price is locked. Because the market is so volatile, borrowers are rarely positioned to contest a loan provider’s statement that market rates increased more, or decreased less, than they did in fact.

Full protection against this common tactic requires a "twin sibling rule." Lenders must lock at the same rate that they would quote to the borrower’s twin who is shopping the same loan on the lock date. This rule would also be easy to enforce, since loan providers do quote prices to shoppers on the same days that they lock prices to borrowers in process.
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