Are Settlement Services Overpriced?
July 6, 1998, Revised March 14, 2011, April 8, 2015
"In my recent home purchase, I bought title, property hazard, and mortgage insurance policies from 3 different companies that I did not know, at prices given to me by my lender. Judging from the circumstances, I am guessing that I was overcharged. Am I right?"
It is impossible to prove, but your guess is almost certainly correct. The companies from which you purchased these services had to compete for the referrals from your lender, which raised the price to you. This is called "perverse competition".
Consider what would happen if automobiles were sold like mortgages. When you asked the price, the dealer would say "This is the price of the body and motor only. The transmission system, tires, electrical system, and upholstery must be purchased from "A," "B", "C" and "D". The price you pay at delivery will include the payments to these other 4 firms, and right now we can only provide an estimate of what these payments will be."
The result of this would almost certainly be an increase in the total price of the automobile. If the automobile manufacturer only provided the chassis and motor, it would become indifferent to the prices of the other components because the consumer would be buying them from other firms. Instead, the automobile manufacturer (or its dealers) would have an incentive to use its access to the consumer to collect referral fees from the component manufacturers. The manufacturers of the components would compete for referrals, which would raise referral fees, and with them the prices paid by the consumer.
In fact, automobile manufacturers bundle all the components, selling a complete automobile at a single price. To sell to them, component manufacturers must compete in terms of price and quality, rather than referral fees. Competition among the automobile manufacturers forces them to pass on most of the benefit to the consumer.
In contrast, the mortgage borrower must transact separately with providers of component services, as you did. And the entities who control access to the consumer -- the lender, the real estate broker or both -- have no incentive to push down the prices of component services to the consumer. On the contrary, these entities are incented to use their market power to benefit themselves, by collecting referral fees or in a myriad of other ways. Before passage of The Real Estate Settlement Procedures Act of 1974 ("RESPA"), referral fees were widespread throughout the industry. While RESPA made the direct payment of referral fees illegal in real estate transactions, it did not eliminate them.
The weakness of the REPSPA approach is that it does not change the underlying market incentives. While RESPA has eliminated the overt payment of referral fees, the less scrupulous still do it under the table. The more scrupulous seek alternative business practices that allow them to profit from referrals of customers to third party service providers while staying within the law. This has created a good living for RESPA lawyers, but a regulatory nightmare for everyone else including the beleaguered Department of Housing and Urban Development which must administer RESPA. See Where Are the Settlement Cost Savings?
Even if RESPA worked perfectly, lenders and real estate brokers would be indifferent to the prices paid by consumers for third party services. Using the threat of penalties to take the profit out of referrals is costly and ineffective.
To foster competition that would benefit the consumer requires the same bundled-product approach that works in the automobile market. Lenders should be authorized to bundle all the services connected to the real estate transaction and sell them as a package. If lenders competed for customers by quoting prices for the entire package of services, they would bargain aggressively with third party service providers for the lowest possible prices. And competition between lenders would force them to pass on the benefits to consumers.
In 2002, in a package of reform proposals, HUD included authorization for lenders and others to offer borrowers complete (or almost complete) packages of loans and settlement services at a single price. The package was overly ambitious, encountered intense opposition, and was never enacted. See Reforming RESPA: the HUD Proposals.
Much the simplest approach, which would sidestep RESPA altogether, is to enact a legal rule that is as simple as it is obvious: any third party service required by lenders must be paid for by lenders. This would be mandatory rather than voluntary as in the HUD approach. See Mortgage Referral Fees and the Public Interest.
But there is no political support for this approach, not even among consumer groups, who ought to be pushing it. The problem is that this measurer would make the market work a lot better, and better-functioning markets reduce the need for consumer groups.
"In my recent home purchase, I bought title, property hazard, and mortgage insurance policies from 3 different companies that I did not know, at prices given to me by my lender. Judging from the circumstances, I am guessing that I was overcharged. Am I right?"
It is impossible to prove, but your guess is almost certainly correct. The companies from which you purchased these services had to compete for the referrals from your lender, which raised the price to you. This is called "perverse competition".
The Automobile Market is a Bundled Market
Consider what would happen if automobiles were sold like mortgages. When you asked the price, the dealer would say "This is the price of the body and motor only. The transmission system, tires, electrical system, and upholstery must be purchased from "A," "B", "C" and "D". The price you pay at delivery will include the payments to these other 4 firms, and right now we can only provide an estimate of what these payments will be."
The result of this would almost certainly be an increase in the total price of the automobile. If the automobile manufacturer only provided the chassis and motor, it would become indifferent to the prices of the other components because the consumer would be buying them from other firms. Instead, the automobile manufacturer (or its dealers) would have an incentive to use its access to the consumer to collect referral fees from the component manufacturers. The manufacturers of the components would compete for referrals, which would raise referral fees, and with them the prices paid by the consumer.
In fact, automobile manufacturers bundle all the components, selling a complete automobile at a single price. To sell to them, component manufacturers must compete in terms of price and quality, rather than referral fees. Competition among the automobile manufacturers forces them to pass on most of the benefit to the consumer.
The Home Loan Market Is an Unbundled Market
In contrast, the mortgage borrower must transact separately with providers of component services, as you did. And the entities who control access to the consumer -- the lender, the real estate broker or both -- have no incentive to push down the prices of component services to the consumer. On the contrary, these entities are incented to use their market power to benefit themselves, by collecting referral fees or in a myriad of other ways. Before passage of The Real Estate Settlement Procedures Act of 1974 ("RESPA"), referral fees were widespread throughout the industry. While RESPA made the direct payment of referral fees illegal in real estate transactions, it did not eliminate them.
The weakness of the REPSPA approach is that it does not change the underlying market incentives. While RESPA has eliminated the overt payment of referral fees, the less scrupulous still do it under the table. The more scrupulous seek alternative business practices that allow them to profit from referrals of customers to third party service providers while staying within the law. This has created a good living for RESPA lawyers, but a regulatory nightmare for everyone else including the beleaguered Department of Housing and Urban Development which must administer RESPA. See Where Are the Settlement Cost Savings?
The Proposed Voluntary Bundling Approach
Even if RESPA worked perfectly, lenders and real estate brokers would be indifferent to the prices paid by consumers for third party services. Using the threat of penalties to take the profit out of referrals is costly and ineffective.
To foster competition that would benefit the consumer requires the same bundled-product approach that works in the automobile market. Lenders should be authorized to bundle all the services connected to the real estate transaction and sell them as a package. If lenders competed for customers by quoting prices for the entire package of services, they would bargain aggressively with third party service providers for the lowest possible prices. And competition between lenders would force them to pass on the benefits to consumers.
In 2002, in a package of reform proposals, HUD included authorization for lenders and others to offer borrowers complete (or almost complete) packages of loans and settlement services at a single price. The package was overly ambitious, encountered intense opposition, and was never enacted. See Reforming RESPA: the HUD Proposals.
The Mandatory Bundling Approach
Much the simplest approach, which would sidestep RESPA altogether, is to enact a legal rule that is as simple as it is obvious: any third party service required by lenders must be paid for by lenders. This would be mandatory rather than voluntary as in the HUD approach. See Mortgage Referral Fees and the Public Interest.
But there is no political support for this approach, not even among consumer groups, who ought to be pushing it. The problem is that this measurer would make the market work a lot better, and better-functioning markets reduce the need for consumer groups.
