Of all the issues that have bedeviled regulators and legislators dealing with consumer protection, perhaps the most troublesome have been abuses connected to mortgage loan originator compensation. Most reform proposals have been directed at abuses by mortgage brokers, and don’t apply to loan-officer employees of lenders. And many of the less thoughtful proposals for curbing broker abuses would eliminate the borrower’s option to have the lender pay the broker’s fee in exchange for a higher rate.
I am pleased to report that the recent proposals of the Federal Reserve to amend the Truth in Lending Act (TILA) deal with abuses by loan officers as well as brokers. In addition, the revised TILA would retain the option borrowers now have in how they pay mortgage brokers.
Loan originators (henceforth LOs) are those individuals who deal directly with borrowers. The problem is not how much LOs make, but how they make it. Under existing arrangements, LOs can often increase their income by inducing borrowers to make bad choices. This works because most borrowers don’t have the information and education needed to protect themselves. Many LOs don’t succumb to this temptation, but too many do.
The abusive tactic that has generated the most attention, as well as controversy, centers on payments to brokers by wholesale lenders for delivering interest rates that are higher than the "par rate" — the rate at zero points. For example, a lender delivering prices to a broker who quotes 5 percent on a 30-year fixed-rate mortgage at zero points might pay 1 point for 5.25 percent, or 2 points for 5.5 percent. (A point is 1 percent of the loan amount.) These payments by a lender are called "rebates," or "negative points." When pocketed by a mortgage broker, they are called "yield spread premiums," or YSPs.
There is nothing inherently abusive about YSPs. Quite the contrary — when properly used they provide a valuable option to borrowers. But they can and are used abusively. Here are illustrations of proper use by an ethical broker, and abusive use by a deceitful one.
Ethical Broker: Mrs. Jones, my fee is 1 point. If you select the 5 percent loan, you will pay me at closing. As an alternative, you can take the 5.25 percent loan and the lender will pay my 1 percent fee.
Deceitful Broker: Mrs. Jones, your rate is 5.5 percent. The good news is that my fee is being paid by the lender so my services to you are free.
Upfront Mortgage Brokers follow the first model, disclosing their fee to the borrower while explaining how the fee is related to the interest rate. Deceitful brokers don’t explain this, because the borrower’s ignorance allows the broker to charge more, as in my example. …CONTINUED
Loan officers who work for a single lender can also be abusive, but in a different way. These LOs receive retail prices from their back offices, meaning that the LO’s commission is included in the posted price. But the LO typically has discretion to charge the borrower more than the posted price, termed an "overage," if he can get the borrower to accept it. The LO shares the overage with the firm. Overage abuse has attracted much less attention than YSP abuse, but there is no reason to believe it is less pervasive.
The Fed proposes to prohibit payments to mortgage brokers and to LO employees of lenders that are based on a loan’s "terms and conditions," which include the interest rate and points. This rule will bar a wholesale lender from paying a broker more for a loan with a higher interest rate than for the same loan with a lower rate.
However, the rule will not prohibit lenders from offering rebates on loans with above-par rates, which brokers could offer to clients to cover their fee and/or other settlement costs.
A rigidity in these rules is that a broker must be paid entirely by the borrower or entirely by the lender; he cannot be paid by both. The rationale is that borrowers may get confused if the broker fee is shared by the two parties.
The Fed’s proposed rule would also bar lenders from offering higher commissions on loans carrying overages. It doesn’t bar overages, but it removes all financial incentives for the originator to charge one. This undercuts the allegation of the National Association of Mortgage Brokers (NAMB) that efforts to rein in YSP abuse alone would create an "unequal playing field."
I don’t know whether NAMB will sign off on the Fed’s proposed rules, but the proposals create no problem for the smaller Upfront Mortgage Brokers Association (UMBA), whose members are already in full compliance. By removing a major source of ambiguity regarding how much the borrower is paying the broker, these rules will bring the industry closer to the UMBA standard of complete fee disclosure.
Note: Thanks to Chris Cruise for helpful suggestions.
The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.
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