(This is Part 3 of a three-part series. See Part 1 and Part 2.)
Q: “What should be done about high settlement costs and referral fees in the home mortgage market?”
In previous articles, I made the point that both high settlement costs and referral fees arise out of referral power–the power to direct a client to a specific vendor–that is pervasive in the home mortgage market. Congress attempted to deal with the problem in 1974 by passing the Real Estate Settlement Procedures Act (RESPA), which among other things, made referral fees paid in connection with real estate transactions illegal.
But RESPA did nothing about referral power. Eliminating referral fees by law, assuming it is possible, which it isn’t, would no more reduce settlement costs than putting a match under the thermometer will warm the room.
Consider: a consumer (C) is required to purchase a service and looks to referrer (R), who directs him to service provider (S). S prices the service well above the lowest price he would be willing to accept because he must market to R and R is not sensitive to a price he doesn’t have to pay. Indeed, the high price allows S to pay R a referral fee. If the referral fee cannot be paid, S has to find another way to induce R to refer him to C, and that could cost S more than the referral fee. Elimination of referral fees, therefore, would not cause S to reduce his price.
Reducing settlement costs requires either that referral power be eliminated, or that it be redirected to benefit consumers. One approach is to suspend the prohibition of referral fees for any firm that combines a mortgage loan and all settlement services connected to it in one package offered at a single guaranteed price. Lenders who are packagers, for example, instead of referring customers to title insurers and the like, would negotiate the best prices they could with each service provider so that they could offer competitively-priced packages to consumers.
Housing and Urban Development proposed this approach in 2002. I supported it, even though the details were devilishly complicated, but most industry groups didn’t and their opposition killed it.
My 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 (this and the HUD proposals are discussed in detail on my Web site under “Public Policy”).
If lenders paid the charges, they would be included in the rate, of course, but would cost borrowers far less than they do 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.
I am confident that this proposal would garner no more industry support than the HUD proposal. Hence, I’m proposing a second-best approach, which has the virtues of simplicity and (likely) industry support. It is to scrap the RESPA prohibition on referral fees. The prohibition was misguided to begin with and never reduced settlement costs, which was the rationale for enacting it.
What the RESPA prohibition has done is it has encouraged wasteful affiliations, the sole purpose of which is to legally sanitize referral fees. If unchecked, for example, there soon won’t be a lender or Realtor of any consequence who does not have its own title agency. Another consequence is disrespect for the law, which can only be enforced selectively.
With the growth of the Internet, the social cost of RESPA has ballooned because it is now preventing the market innovations that would reduce settlement costs. Here are two examples:
1.) As a way of generating more loan business, lender X wants to credit borrowers with referral fees collected from a title insurer. RESPA prevents this.
2.) As a way of generating more loan business, lender Y wants to guarantee all third-party settlement costs. If Y itemizes these costs, however, cost shortfalls in one item cannot be offset by surpluses on another because the surpluses would be a referral fee.
Unlike the other proposals, scrapping the prohibition on referral fees won’t change the market overnight. But by giving free rein to the application of the newest technology by innovative competitors, settlement costs will gradually come down. It is time HUD proposed to Congress that the RESPA prohibition on referral fees be scrapped.
The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at http://www.mtgprofessor.com.
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