Markets don’t work well when one party to transactions has
much more information than the other party, especially when
the party with better information also controls the process.
The two best illustrations of this rule are the markets for
medical services and home mortgages.
In principle, Government regulation can make such markets
work better by 1) reducing the information gap between the
parties transacting with each other through a system of
mandatory disclosures; and 2) by limiting the ways that the
parties controlling the process can use that control to
benefit themselves. The all-important caveat is that the
regulations adopted work as intended. Bad regulations
increase transaction costs without accomplishing their
objective. This has been the case for forty years of
ill-advised efforts by the Federal Government to eliminate
referral fees in the home loan market.
Referrals Are Pervasive in the Home Mortgage Market
Real estate and mortgage transactions involve a large number
of diverse players who sell services that consumers
purchase. Since they are in the market very seldom,
consumers typically don’t know who all the players are, or
even what they do. They are thus heavily dependent on
referrals from those who have this knowledge.
Lenders usually select the appraiser and credit reporting
agency on home purchases, and all third party service
providers on a refinance. Mortgage insurers are always
selected by the lender. Realtors and builders have referral
power on home purchase transactions, referring consumers to
lenders and to title agencies.
Mortgage lenders are both referrers and recipients of
referrals. When they steer a borrower to a title company for
the purpose of purchasing title insurance, they act as
referrers, and the title insurance cost paid by the borrower
includes the referral fee to the lender.
When a real estate agent or builder sends a borrower
to a lender and receives something of value in exchange, the
lender is the recipient, and the benefit provided to the
agent is the referral fee. This article only deals with
lenders as referrers.
Why Are Referral Fees Considered "Bad?"
One reason is the widespread prejudice that charging for
something that takes no effort, or almost none, is like
being paid for nothing. We undervalue information.
A second reason for the hostility to referral fees is the
fear that payment for referrals will degrade the quality of
the service. If a real estate agent collects referral fees
from lenders, does he send borrowers to the best lenders, or
to the ones willing to pay the referral fee? This is a
legitimate concern.
The third reason is a concern that referral fees raise the
cost to the client. If service providers have to pay
referral fees, they are going to charge more in order to
cover that cost. This is the major concern with regard to
referral fees in the home mortgage market. It is why
referral fees in this market were made illegal under the
Real Estate Settlements Procedures Act (RESPA). Congress was
offended by high mortgage settlement costs and the
prevalence of referral fees, which they saw as related. The
rationale of the restrictions imposed by RESPA is that
"kickbacks or referral fees… tend to increase unnecessarily
the costs of certain settlement services . . . ." (RESPA,
Section 2601 (a)).
But Congress was wrong about that. Settlement costs are
raised by referral power, not by referral fees.
Referral Fees and Referral Power
Referral fees are payments made by service providers to
other parties as quid pro quo for referring customers.
Referral power is the ability to direct a client to a
specific vendor. Referral power is based on specialized
information possessed by the referrer, and the authority of
the referrer in the eyes of the client. Regulatory efforts
to reduce settlement costs to borrowers by eliminating
referral fees have not worked largely because they have left
referral power unchanged.
When there is referral power, service providers compete not
for the favor of consumers but for the favor of the referral
agents. Such competition raises the costs of service
providers, which are passed on to the consumer. If
regulations eliminate referral fees but referral power is
left untouched, service providers will find other ways to
market themselves to the same referrers. The resulting
expenses could well be higher than the referral fees.
The Failure of RESPA
The RESPA prohibition of referral fees has not reduced
settlement costs at all, a fact acknowledged by HUD which
had the unpleasant task of enforcing RESPA before creation
of the Consumer Financial Protection Bureau. One reason is
lack of effective enforcement. There are so many referral
agents in real estate markets, and so many ways they can
receive something of value from service providers that the
regulator would need an army of examiners to shut them all
down. HUD which administered RESPA for many years before
responsibility was shifted to the Consumer Financial
Protection Bureau (CFPB), never deployed an army of
examiners and it is doubtful that this will change under the
CFPB. Hence, thousands of small referral agents will
continue to receive referral fees, if in disguised form,
with impunity.
The other part of the problem is that the referral power of
firms that are too large to be overlooked by regulators has
not been reduced by RESPA, inducing them to find other ways
to use that power to their advantage without violating the
law. For this purpose, R ESPA has been most accommodating,
enabling large players to continue receiving payments that
are referral fees de facto but not de jure.
The Captive Affiliate
RESPA does not prevent a firm in one industry from entering
another industry, even when the express purpose is to
exploit referral power. For example, a Realtor or lender can
establish their own title company and refer business to that
company, which can be a joint venture or an entity wholly
owned by the referrer. The title agency must be a bona fide
company, meaning that it must have the capital required by a
title company, it must have its own employees and place of
business, and so on. A sham company that is actually
operated by another title company would be a RESPA
violation. Since the capital investment required is
considerable, this option is feasible only for firms able to
generate a volume of referral business large enough to
justify the investment.
Larger lenders have also invested in appraisal management
companies, which proliferated after the financial crisis as
a device to meet new regulatory requirements designed to
assure the independence of appraisals. The company stands
between the lender and the individual appraiser. Lenders
cannot influence appraisals, but they can and many do
collect referral fees through their ownership interest in
the companies. And while alert borrowers can select their
own title companies, and some do, they cannot select their
appraisal management company because the company must be
approved by the lender.
The bottom line of the RESPA rules governing referral fees is that payment of such fees is legal so long as it is done in ways that are extremely costly and inefficient. The rules are a bonanza for lawyers but a dead-weight loss for everyone else.
The Cure Is Simple
Referral fees now collected by mortgage lenders in
connection with title insurance, appraisals, credit reports
and all other services they require borrowers to purchase
could be eliminated by the adoption of one simple and easily
enforced rule: any service required by a lender in
connection with a home loan must be purchased by the lender
and included in the price of the mortgage. This rule would
eliminate the lender’s referral power, which is based
entirely on the mortgage being sold as an unbundled product.
If mortgages had to be sold as a bundled product with all
the inputs purchased by the lender, as is the case for
automobiles and most manufactured products, referral
fees would disappear and settlement costs would drop like a
rock. The cost of title insurance, appraisals and other
services would be included in the price of the mortgage,
just as tires are included in the price of automobiles, but
the incremental cost to the borrower would be small relative
to the unbundled price. Competition by third party providers
to sell lenders would force the prices down, and price
competition by lenders would force them to pass the savings
on to borrowers.
The problem with this simple solution is that it has no
political constituency. Lenders won’t support it because it
is not in their financial interest; title insurers and other
service providers won’t support it for the same reason. But
why consumer groups never propose it is more puzzling. The
only plausible reason that comes to mind is that converting
the mortgage into a bundled product would make the mortgage
market work effectively for borrowers, and effective markets
eliminate the need for consumer groups.
