Where Are the Settlement Cost Savings?
Where Are the Settlement Cost Savings?

July 8, 2002

"In a recent speech, associate general counsel of HUD John Kennedy said that ‘the various fees and junk fees lenders and settlement providers charge have not changed in 30 years.’ Can you explain why, with all the technological innovations in the mortgage business, settlement costs have not come down?"

The market for settlement services works very badly, and Federal legislation designed to fix the problems has instead made them worse.

Settlement service charges fall into two broad categories. The first are charges made by lenders, expressed in dollars rather than as a percent of the loan. These are sometimes referred to as "junk fees" and are discussed in other columns, including Legal Thievery at the Closing Table. The second category of charges, discussed below, are those made by third parties involved in the lending process. Third-party service providers (TPSPs) include firms offering mortgage insurance, title insurance, appraisals and credit reports.

The market for third party settlement services works poorly because the borrower pays for the services, but the lender selects the TPSP. This results in "perverse" competition – competition that raises prices to consumers, or prevents them from falling as they should when technology drives down the costs of TSPSs.

Competition by TPSPs is perverse because it is directed to the lenders who select them, rather than to the borrowers who pay them. TPSPs compete by providing services free or below-cost to lenders, or by finding legal ways to pay the lenders. All such methods of competing for the favor of lenders drive up the costs of TPSPs, who pass on the costs to borrowers.

As one example, lenders would benefit very little from negotiating lower mortgage insurance premiums for borrowers, but sharing the profit in excessively high premiums can be very profitable. A legal way to do this is for lenders to create mortgage reinsurance affiliates that share the mortgage insurance premium revenue paid by borrowers. Of course, the affiliates also share the risk, but since the insurance is over-priced, it is profitable to the lender.

The remedy for perverse competition is remarkably simple. All it requires is a rule that all third-party services that are required in connection with a mortgage loan must be paid for by lenders and cannot be billed separately to borrowers. Lenders would then include the cost as part of the price of the mortgage.

If lenders had to pay for third-party services, TPSPs would have to compete for lender business by lowering prices rather than offering kickbacks. Effective competition would replace perverse competition. As the cost of services fell with development of better technology, the price to lenders would fall. Competition in the loan market would force lenders to pass on the savings to borrowers.

Such a rule would force the mortgage industry to operate in the same way as the automobile industry. Automobile manufacturers don’t force buyers to purchase tires, transmission systems, electrical systems, and upholstery separately. If they did, the price of automobiles would be substantially higher. Rather, the manufacturers purchase the components themselves at highly competitive prices, and bundle them into a complete automobile that is sold for one price.

Unfortunately, Congress took a different tack when it passed the Real Estate Settlement Procedures Act (RESPA) in 1974. RESPA was based on two fallacies. The first was that the proper way to deal with payments from TPSPs to lenders that raised settlement costs to borrowers was to declare them illegal. This was bound to fail because it left intact the incentives for TPSPs to compensate lenders.

HUD was made the policeman, but with thousands of potential violators, the funds available for enforcement have never been even close to adequate. Small players routinely violate a law they don’t respect, while large players find legal (if costly) ways around it – such as the reinsurance affiliate I mentioned earlier.

The second RESPA fallacy was that borrowers could drive down the cost of settlement services if they were armed with the proper information. RESPA thus decreed that borrowers be provided with the estimated cost of each settlement service in a HUD-designed "Good Faith Estimate" of settlement costs (GFE).

This was also bound to fail because borrowers don’t want to negotiate separately for each settlement service, and they couldn’t do it effectively, even if they wanted to. Lenders continue to select the TPSPs under RESPA, and borrowers continue to be impotent.

But the GFE has proved to be less than useless. The GFE designed by HUD hinders effective shopping of lender fees. See Legal Thievery at the Closing Table.
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