HUD and Yield Spread Premiums

October 3, 2001 The recent decision of the US 11th Circuit Court of Appeals in the case of Culpepper vs Irwin has suddenly swung the spotlight on HUD policy regarding yield spread premiums (YSPs) retained by mortgage brokers.  To this date, HUD has been impotent in dealing with a festering sore in the home loan market.  Suddenly, it has an opportunity to make a difference, if it acts wisely.  Or it can confirm its impotence, if it doesn�t.  This paper is designed to lay the groundwork for a wise decision.  What Are YSPs? YSPs are points paid by lenders for loans carrying interest rates above the par rate.  The par interest rate is the rate at zero points.  Points are an upfront charge expressed as a percent of the loan.  On rates below the par rate, lenders charge points whereas on rates above the par rate, lenders pay points.  YSPs are also called �negative points� or �rebates�. For example, a lender offering a 7% 30-year fixed-rate mortgage at par might offer the same loan at 6.5% with 2 points, and at 7.50% with a YSP of 1.5 points. What Good Are YSPs? YSPs provide a useful option to some borrowers.  For those with little cash, YSPs make possible no-cost mortgages, on which settlement costs are paid by the lender.  For those who expect to be in their house only a few years, YSPs permit a favorable exchange of higher rate for lower fees.   What is Problematic About YSPs? I have examined the details of hundreds of brokered transactions, and there is little doubt in my mind that YSPs increase costs to many borrowers.  The major reason is that borrowers don�t necessarily consent to paying them.  They frequently do not understand that they are paying the YSP in the interest rate.  Furthermore, the exact amount of the YSP is not known until the terms of the loan are locked with the lender, at which point the borrower is already committed to the transaction. Here is a common scenario where a broker collects a YSP from the lender without the knowledge or consent of the borrower.  Market interest rates decline during the period between the initial price quote to the borrower and the lock date, but the borrower is not aware of it.  For example, the price quote from the lender to the broker was 7% and zero points, and from the broker to the borrower 7% and 1.5 points; the 1.5 points was the broker�s markup.  When the loan is locked, market rates have come down and the lender is offering a YSP of 1 point for a 7% loan.  The broker retains the YSP as extra income.  The borrower may find out about it at closing, since the YSP is shown on the HUD1 report. Can Borrowers Avoid the Problem By Dealing Directly With Lenders? No.  Retail lenders dealing directly with borrowers can also exploit those who don�t shop, or who don�t monitor the market during the period prior to the lock.  In fact, it is easier for lenders because they leave no incriminating evidence.  Suppose the borrower in the example above had received the initial quote of 7% and 1.5 points from a retail lender instead of a broker.  If the lender locked those terms despite a decline in market rates, the borrower would be exploited in exactly the same way.  The only difference is that the broker leaves a paper trail � the YSP shows up in closing documents � but the increase in the lender�s income is not disclosed.  What Is the Attitude of Wholesale Lenders Toward YSPs? The wholesale lenders who acquire loans through mortgage brokers view brokers as independent contractors who they cannot (and do not want to) control.  While lenders will cease doing business with brokers who cheat them, they seldom if ever drop a broker for overcharging borrowers.  Some have tried to cap broker compensation, but if the cap is tight enough to pinch, the brokers just shift to other lenders.  Many lenders recognize a need for concerted action, but none are prepared to assume a leadership role because of fear of loss of business or concerns about anti-trust. What Has Been HUD�s Policy on YSPs? The Real Estate Settlement Procedures Act (RESPA) prohibits referral fees.  HUD, which administers RESPA, has taken the position that YSPs retained by brokers are legal if they are �reasonably related� to the value of the services provided to the borrower.  Otherwise, such payments are illegal referral fees, paid for steering borrowers to high-rate loans. However, HUD has never made any serious effort at enforcement.  I could find only a single enforcement action related to excessive broker charges, and the action was directed against the lender funding the loans rather than the brokers. There is no effective way to enforce the rule by examining broker compensation and the services performed in individual transactions.  Gathering the required data from brokers is far beyond HUD�s capacity.  It has never had more than 4 examiners for enforcing all RESPA rules, of which the broker compensation rule is just one.  Mortgage brokers will be involved in about 3 million transactions this year.  Furthermore, there are no generally accepted standards as to what constitutes �reasonable� compensation.  Is, say, $4500 on a transaction excessive?  A HUD examiner has no way of determining how many hours the broker spent educating the client, or how much money the broker may have saved the client through astute loan selection and shopping.  In addition, any fair assessment should take into account small loans made by the same broker on which the fee might be only $500.  These quandaries would defeat the wisest examiners.  Bottom line: HUD has to this point been YSP-impotent. How Has Culpepper vs Irwin Changed the Situation? The recent decision of the 11th Circuit Court held that lenders who had paid YSPs to brokers could be vulnerable to class action suits by borrowers.  The  court also held that whether YSPs were compensation for services or illegal referral fees could be determined by the general conditions under which the lender pays the broker.  Assessment of individual transactions was not necessary. This decision has put the industry in a dither.  Wholesale lenders feel that unless it is reversed or counteracted in some way, they are vulnerable to potential claims on existing loans where brokers retained YSPs, and they will be forced to stop offering YSPs through most brokers in the future. They are now looking to HUD for relief. What Would Be the Consequences If Wholesale Lenders Stopped Offering YSPs to Brokers? Not good.  A major class of loan provider, and the borrowers who use them, would be deprived of a valuable option.  The option would not disappear from the market, however.  Business would shift from brokers to retail lenders, where the abuses would disappear from sight, even though they would still be there. In addition, many brokers would join �net branches� of small retail lenders as loan officer employees.  Since net branches allow their loan officers to maintain their operating independence, the predators among them could abuse borrowers just as they did before.  But because their employers are lenders who are not required to disclose their income from loans the way brokers are, their abuses would be invisible. The only positive would be that wholesale lenders would continue offering YSPs to Upfront Mortgage Brokers (UMBs).  Since UMBs credit YSPs to borrowers, they avoid abuses that might generate legal liability for lenders.  Long-term, the growth of UMBs would be encouraged, which would be good for borrowers.  Right now, however, there are only a handful of UMBs, so in the short-term, this would be far outweighed by the shift of brokers to net branches. What Should HUD Do Now? Making the Reasonable Compensation Rule Enforceable:  There is a simple way that HUD could make its rule, that YSPs are legal if they constitute  �reasonable compensation� for broker services, enforceable.  HUD could define �reasonable compensation� as any compensation that borrowers have explicitly agreed to in advance. More concretely, HUD should declare a broker to be in compliance if borrowers on whose account the broker receives YSPs acknowledge the broker�s total compensation, in writing, before the broker has submitted an application to a lender.  Total compensation is the amount paid the broker by the borrower and the lender. Suppose, for example, the borrower agrees to total compensation of $4500, and the broker estimates the YSP at $3000, leaving a direct borrower-paid fee of $1500.  If the YSP turns out to be $4000 when the terms are locked instead of $3000, the direct fee is cut to $500. HUD could provide brokers with a standard form.  The form I developed in collaboration with Upfront Mortgage Brokers (UMBs), who voluntarily follow the compensation rule proposed above, is appended to this paper. Enforcement by Lenders: HUD�s rule will be enforced by wholesale lenders.  Since lenders will be safe in offering YSPs only to brokers who comply, they have an incentive to monitor broker compliance.  Wholesalers should welcome this.  For the first time they will have a way of constraining broker pricing, without the danger of losing business to other lenders.  If they wish, lenders can delegate responsibility to the Upfront Mortgage Brokers Association, a non-profit corporation set up for the express purpose of certifying and monitoring UMBs. Enforcement by Borrowers:  Borrowers will also do their part to constrain broker pricing -- in the time-honored way, by shopping and haggling.  For the first time, borrowers will become aware of how much brokers are making at an early enough stage to do something about it. Leveling the Playing Field:  For purposes of this rule, HUD should define �mortgage broker� to include loan providers who fund loans but have price commitments from wholesale lenders.  They receive the equivalent of YSPs from their lenders, and should be subject to the same rules.  Otherwise, brokers who don�t want to comply with HUD�s rule will begin funding loans, or become employees of firms that do.  The problem will disappear from sight, but it won�t go away.   Portfolio lenders and large mortgage banks that sell directly into the secondary market would escape the enforcement net described above.  A simple way to subject them to comparable market discipline is to require a new item on the Good Faith Estimate of Settlement: the par interest rate.  It should be placed right next to the actual interest rate.  A par rate below the actual rate will capture borrowers� attention and put them on their guard. What Not to Do The danger is that HUD, under political pressure, will take the path of least resistance, enacting a disclosure rule acceptable to brokers and lenders but worthless to borrowers.  Such rules abound at the state level. Warning Rules:  The largest group of states has enacted warning rules. These require that brokers disclose exactly how they can take advantage of the borrower, without doing anything to prevent it.  California falls into this group.  The California borrower learns that:   �        The retail price a mortgage broker offers you�your interest rate, total points and fees�will include the broker�s compensation. �        In some cases, either you or the lender may pay the mortgage broker all of its compensation. �        Alternatively, both you and the lender may pay the mortgage broker a portion of its compensation.  For example, in some cases, if you would rather pay a lower interest rate, you may pay higher upfront points and fees. �        Also, in some cases, if you would rather pay less upfront, you may wish to have some or all of our fees paid directly by the lender, which will result in a higher interest rate and higher monthly loan payments than you would otherwise be required to pay. �        The mortgage broker also may be paid by the lender based on (i) the value of the mortgage loan or related servicing rights in the marketplace or (ii) other services, goods or facilities performed or provided by the mortgage broker to the lender. Among the states, California requires the largest number of words to say that the broker may be paid both by the borrower and the lender.  But even when the point is made concisely, it doesn�t help the borrower who is trying to compare broker fees.  Knowing that the broker may be paid by the lender helps only if the borrower knows what that payment is, and he doesn�t learn that until the loan closes, if then. Range of Compensation: An alternative approach requires brokers to specify the range of total compensation from both borrower and lender.  In Florida, for example, the required disclosure states that �Business will receive a sum in range of          % to         % of the total loan amount�the exact amount of which will be disclosed at closing�� This may appears to protect the borrower, but appearances are deceiving.  The prevailing practice among brokers in Florida is to enter a range of 0% to 5%.  One broker told me that he was taught to do this in the course he took in mortgage brokerage.  This leaves the broker with complete freedom of action, while providing the borrower with no usable information.    Nor would it be any better to require disclosure of the maximum fee alone.  In that case, the brokers would all enter 5% and the result would be the same. Bottom Line The only approach that will really help the borrower compare broker fees is to require that the broker disclose total compensation from the borrower and the lender.  I hope that HUD grasps this obvious truth in its forthcoming disclosure rule, and has the political courage to adopt it.  If it adopts one of the half-baked approaches described above, it will create more paperwork but not help borrowers a whit.   Broker Compensation Agreement  The broker will quote a price to you before submitting an application to a lender. The price may be a fixed dollar amount, a percent of the loan, an hourly charge for the broker's time, or a combination of these.  The price quoted by an UMB is the broker�s total compensation from the transaction.  Any payments made to the broker by the lender reduce the borrower�s payment by the same amount.  For example, if the broker sets compensation at $3,000 and the broker receives $1500 as a rebate from the lender, the borrower would pay only the difference of $1500.  The broker will inform you if there will be a separate charge for processing by a third party.  On other third party services ordered by the broker but paid by the customer, the broker will provide the invoice from the third party service provider at the customer�s request.  Alternatively, the broker may have the payment made directly by the customer to the third party service provider. *** The total compensation paid to [Name of Broker] will be:_____________     Signature of broker                             Acknowledgement by borrower ___________________________        __________________________   Date:                                                  Date:

Jack Guttentag is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Visit the Mortgage Professor's web site for more answers to commonly asked questions.

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