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HUD's Proposals For Reform

HUD's Proposals For Reform

October 19, 2002

On July 29, 2002, HUD released a set of proposals to substantially change the ways in which home loans are originated in the US.  As usual, the proposals were open for comment, and many thousands of them were received.  Mine was among them, and is shown below with minor revisions.

For the most part, HUD's proposals are very well thought out, and would benefit consumers in every segment of the home loan market. They would especially benefit less-sophisticated borrowers, who most need help.


The first proposal would change the way in which the compensation of mortgage brokers is reported. The objective is to make a broker�s total compensation transparent to borrowers.

The Problem: The major concern underlying the proposals for revealing broker compensation is "rebate abuse" � the practice of steering unwary borrowers into high-rate loans on which they should receive a rebate from the lender but don�t. A rebate is negative points. Points are an upfront charge to the borrower expressed as a percent of the loan, and a rebate is an upfront credit to the borrower from the lender. Rebates are used to cover settlement costs.

For example, the loan officer�s price sheet shows 6% at zero points, 5.75% at 2 points, and 6.25% at a 2-point rebate. If the borrower is willing to pay 6.25% without argument, the rebate is retained by the loan provider, which could be a mortgage broker or a lender. Most of the attention has been directed at rebate abuse by brokers.

Lenders working through mortgage brokers (called "wholesale lenders") transmit their price information to brokers, not to borrowers. With few exceptions, borrowers are not privy to this information. Borrowers are quoted prices by brokers that include the broker�s markup.

For example, the lender�s quote to the broker is 6% plus a rebate of 1%, and the broker�s quote to the borrower is 6% plus a broker fee of .5%. The broker�s total compensation is 1.5%, 1% from the lender rebate and .5% from the borrower fee, but the borrower does not know about the 1% rebate unless the broker tells him. By the time borrowers become aware of rebates retained by brokers, they are often too far along in the transaction to back out.

Rebates collected by mortgage brokers are known in the trade as "yield spread premiums" -- terminology that is designed to obscure rather than reveal.

Rebate abuse is not practiced by Upfront Mortgage Brokers (UMBs). UMBs set their total compensation in advance, revealing and passing through the price quoted by the lender. But there are only 47 of them.

The Proposal: Under the proposed new rules, rebates would be reported on the GFE as a payment by the lender to the borrower. The borrower would have to authorize the rebate to be paid to the broker � as if it was coming directly out of the borrower�s pocket. In effect, all brokers would become UMBs. The result will be greater borrower resistance to rebate abuse by brokers.

Broker Objections: It is not surprising that most brokers are against it, claiming an injustice on two grounds. First, they ask why, of all the many intermediaries in our economy, they alone should be required to disclose their wholesale prices? Grocers, for example, don�t disclose the cost to them of the produce they sell, and nobody cares.

Brokers would have a point if borrowers could comparison shop for home loans as easily as they can shop for groceries. In such case, they would have no need to know broker compensation in order to protect themselves. Broker compensation is relevant only because many borrowers are intimidated by the difficulties of shopping for a home loan, and place themselves in the hands of a broker.

The brokers� second argument, that no comparable disclosure rule is proposed for retail lenders, has more force. The same disclosure rule should be applied to all loan providers who receive rebates, which includes some smaller lenders who mark up the prices quoted to them by wholesale lenders in the same way as brokers. But even if HUD extended its disclosure rule to cover these lenders, it would leave the major retail lenders unaffected.

The good news is that HUD has a proposal for disclosure of "interest rate dependent payments" which, if properly implemented, would curb rebate abuse by lenders. This will be discussed below.


HUD�s proposal to make borrower payments to mortgage brokers transparent is one part of a broader plan to make the Good Faith Estimate (GFE), on which lenders and mortgage brokers disclose settlement costs, more useful to borrowers as a shopping tool.

The GFE Now: The existing GFE lists each individual settlement charge, which encourages borrowers to focus on individual charges. I continually receive letters from borrowers asking, e.g., "What is such and such a charge for?" "Is $400 reasonable for this charge?" "Is it negotiable?" Such questions distract them from what should be their major focus, which is the total of shoppable settlement charges.

The GFE is also open-ended, inviting lenders to add new charges, which some do. In addition, the existing GFE makes no distinction between charges that lenders can, and those they cannot, control. All are "estimates" subject to change. And they often are changed, after borrowers pass the point of no return, and always to the borrower�s disadvantage.

Consolidation and Commitment: Under the proposed GFE, settlement costs are consolidated into several major groups, and only the total is reported for each group. The new GFE also limits the extent to which the costs may change. These limits are different for services controlled by the lender and services for which the borrower may shop independently.

Settlement charges that cannot be changed "except in unforeseeable and extraordinary circumstances..." include "origination charges", which are all charges by the lender and broker; "lender required and selected third party services", which are all third party services required by the lender (such as appraisals) where the lender selects the service provider; and "title services and title insurance" when selected by the lender. Lenders will no longer be able to manipulate these charges with impunity.

Charges for services required by the lender for which borrowers can shop third-party providers, including title-related services, can vary up to 10%. The same leeway applies to reserves for escrows.

Other settlement charges can vary as circumstances dictate because they are not subject to lender manipulation. These include hazard insurance and owners title insurance, which borrowers always select; and per diem interest -- interest for the period between the closing date and the first day of the following month -- which is determined by formula.

Interest Rate Dependent Payments (IRDP): Another important feature of the proposed GFE is a table that shows the interest rate and points selected by the borrower, and two other rate/point combinations available to him. (Points are an upfront charge expressed as a percent of the loan). The purpose is to let borrowers know their options. One such combination is a higher rate with lower points, the other is a lower rate with higher points. HUD is not clear, however, on how loan providers select these rate/point combinations.

The selection should aim at protecting borrowers from rebate abuse by lenders.  Borrowers are already protected against rebate abuse from mortgage brokers by the new rules for broker disclosure, discussed above. Those rules, however, do not protect borrowers against rebate abuse by lenders who don�t reveal their rebates.

The most effective way to curb rebate abuse by lenders would be to have the first column of the IRDP table show the interest rate that is closest to zero points, the second and third columns show rates that are plus and minus �% from the rate in the first column, and the fourth column show the combination selected by the borrower. This would put borrowers on notice that they should receive compensation for a higher rate. It would also lead to consistent treatment among loan providers, making it easier to shop.

Interest Rate on the GFE: The proposed GFE also requires loan providers to show the interest rate, mortgage insurance and APR. In contrast to the settlement costs, however, the new GFE says nothing about the extent to which the loan provider is committed to these terms. Hence, it is not clear whether the new GFE would curb the most pervasive abuse in the home loan market: "float abuse".

Float Abuse: Assume that after shopping prices at several lenders, Jane Doe selects lender X and submits an application. The prices quoted by X, upon which Jane based her decision, "float" with the market until they are locked by the lender.

Floating is mandatory between the initial price quote and the time when the lender is willing to lock. This period can range from a day to several weeks or longer, depending on the lender�s requirements to lock, and on how long it takes Jane to comply.

Jane might elect to wait, even after the lender is willing to lock, if she believes that interest rates will fall. This begins a voluntary float period, which can run until a few days before the scheduled closing.

At the end of the float period, lender X is supposed to lock at the market price. But since the market price is what X says it is, the process is extremely vulnerable to abuse.

In principle, lender X should lock at the price that X would quote to Jane�s identical twin if the twin walked through the door on the lock date as a new customer shopping the exact same deal. In practice, Jane may get a higher price than her twin because Jane is at least partially committed while her twin is only shopping.

Float abuse is a violation of the twin sibling principle. It consists of understating the decline in interest rates that occurred during the float period, or overstating the rise. For example, a loan provider instructs its loan officers to deduct one point from the market price quoted to a shopper, and add a point to the market price on the lock day. Float abuse is pervasive, practiced by mortgage brokers as well as lenders, and often institutionalized.

Using the GFE to Curb Float Abuse: The new GFE eliminates the incentive for brokers to practice float abuse. Since the new GFE fixes the mortgage broker�s fee to whatever the borrower has agreed to pay, the broker cannot profit by overstating the price on the lock day. All that would do is benefit the lender at the expense of the borrower.

Under HUD�s current proposal, however, float abuse by lenders is not curbed by the GFE at all. Lenders can adjust the interest rate shown on the GFE to the "market rate" on the lock date with the same impunity they enjoy now. That is disappointing, but hopefully HUD will remedy it.

HUD need not, and should not set rules that limit the ability of lenders to adjust the rate set on the GFE. That could be a disaster. But with little risk HUD could require lenders to show how the rate will be determined on the lock day, and leave it for competition to do the rest.

The requirement should be divided into two categories: "conditions", and "market adjustment." Conditions are future events that must be fulfilled for the rate to remain valid. The fewer and more reasonable the conditions, the more attractive is the rate on the GFE. For example, borrowers will prefer a rate subject to "an appraisal of $300,000 or more" to one subject to a "satisfactory appraisal".

In a similar way, borrowers will prefer lenders who provide an objective procedure for implementing the twin sibling principle. Perhaps the best would be a web-based pricing program on which borrowers can price their own deal on any day. A low-tech equivalent would be to identify the borrower�s price niche on the lender�s daily price sheet, repeating the process on the lock date. Lenders who say "Trust us to give you the market rate on the day you lock", will not last long.


The most far-reaching of HUD�s proposals is to authorize lenders and others to offer borrowers complete (or almost complete) packages of loans and settlement services at a single price. This is permissive rather than obligatory. Lenders who package would use a Guaranteed Mortgage Price Agreement (GMPA) in lieu of the proposed new obligatory GFE, which I discussed above.

The Problem: The major purpose of the GMP is to drive down settlement costs. Under existing arrangements, competition in the markets for settlement services is "perverse" -- it tends to drive up prices, or prevent them from falling in response to deployment of more efficient technology. Perverse competition arises whenever one party selects the seller of the service and another party pays for it.

For example, lenders select the mortgage insurer but borrowers pay the premiums. Instead of competing for customers by lowering prices and improving service, service providers compete for the favor of the lenders.

While direct "kickbacks" to lenders for the referral of business are illegal, mortgage insurers and others have found legal ways to accomplish the same thing. These include the provision of services to lenders at favorable prices, or the sharing of insurance premiums with reinsurance affiliates owned by lenders. Such practices increase the costs of service providers and keep the prices charged to borrowers from falling.

The Proposal: GMPs could be offered by lenders or other entities such as real estate companies or title insurers. A package must include a loan at a guaranteed interest rate plus a guaranteed dollar price for all settlement services excepting per diem interest, hazard insurance, and escrows. Packagers can deal freely with their own affiliates and are exempt from kickback prohibition rules.

The rationale is that competition among packagers will force down the prices they pay for services. Competition will be effective because the price of a package will consist solely of the interest rate plus a single dollar price for all settlement services. This will make it easy for borrowers to shop and compare. It won�t work, however, if borrowers remain vulnerable to float abuse -- the practice of understating the rate when quoting to shoppers, and overstating it on the day the rate is locked.

Rate Indexing: HUD is focused on preventing float abuse with the GMP. It proposes a rule that the interest rate can change between the quote date and the lock date only "based on observable market changes, or based on other data or appropriate means to ensure the guarantee". This is deliberately vague as HUD is looking for further guidance before trying to pin it down.

The way to pin it down is to establish the twin sibling principle I noted above. This says that the packager must lock at the rate that it would quote to the borrower�s identical twin if the twin walked through the door on the lock date as a new customer shopping the exact same deal.

The twin sibling principle allows the lender full leeway to adjust to general changes in the market, and also to narrower changes applying to certain types of borrowers or transactions. What this principle does not allow is the lender to lock at a higher rate solely because the borrower is too far committed to back out.

There are at least half a dozen methods packagers could use to comply with the twin sibling principle, some better than others from a borrower�s perspective. Nonetheless, it would be a mistake for HUD to define the methods that are "acceptable". It would be far better simply to require the packager to explain the method that is used. Competitive pressures will immediately favor the packagers who provide the best protection.

There are other problems. Among the prices that will be consolidated are mortgage broker fees, mortgage insurance premiums, and points. All are problematic.

Mortgage Broker Fees: Under HUD�s proposal, mortgage broker fees are included in the GMP price. Hence, a broker involved in helping a borrower select from among competing GMPs must accept whatever broker fee each packager has decided on in advance.

Brokers, however, sell an individualized service to borrowers, and the broker�s investment of time varies from loan to loan. The two parties should be free to negotiate the price of the broker�s service. If prices are preset by packagers, brokers may opt not to play.

The competition that HUD is looking to drive down settlement costs will not work as effectively if brokers are not available to help borrowers assess competing packages. If brokers don�t play, furthermore, it reduces the ranks of potential packagers. The only practical way for most non-lender institutions to become packagers is to work through mortgage brokers.

HUD should explicitly recognize a distinction between retail and wholesale packages. A wholesale package would be one offered through mortgage brokers. The GMP agreement used by wholesale packagers would include a slot for a broker fee, which would allow brokers to negotiate their fee with borrowers.

The broker�s fee would be transparent, just as it is in the proposed new GFE. By adding the broker fee to the lender�s wholesale package price, borrowers could easily compare a package obtained through a broker with one offered directly by a packager.

NOTE: I discovered after writing the above that HUD was assuming that brokers would themselves become packagers, in which capacity they could add any fee for themselves they wished. But whether or not this will happen is very unclear. And even if some brokers can become successful packagers, others will prefer to work as package assemblers, which is closer to their traditional function.

Mortgage Insurance Premiums: Mortgage insurance paid for with a financed single premium (the premium is included in the loan) fits neatly into HUD�s single price scheme. For example, a single premium of 2.35% on a $100,000 loan would amount to $2350, which would be added to total settlement costs.

Premiums paid monthly, however, don�t fit. For example, the monthly premium on the same loan would be .39%/12, or $32.50 a month. If monthly premiums are permitted in the package, the GMP will have to include the premium as a separate price -- as is the practice now.

HUD could permit only single premiums. This has the additional merit that single premiums are less costly to borrowers than monthly premiums. For example, if the interest rate on the loan with a single premium of $2350 is 8%, the monthly payment would increase by $17.25, of which $15.66 is additional interest that is tax deductible. None of the $32.50 monthly premium is deductible. [Note: Why single-premium mortgage insurance is not used more widely is discussed in What Must Be Disclosed About PMI].

The alternative is to allow monthly premiums, and prompt borrowers to use the APR in selecting among GMPs. The APR is a single measure of credit cost that takes account of mortgage insurance premiums, whether paid upfront or monthly. The case for this approach is strengthened by the fact that consolidating points also would cause serious problems.

Points: HUD would consolidate points -- upfront credit charges expressed as a percent of the loan -- in total settlement charges. This would eliminate the current practice of quoting interest rates in increments of 1/8%, and using points to adjust to small changes in the market. If points are frozen in the package price, the 1/8% convention will be discarded and lenders will quote rates to 3 odd decimals, such as 6.274%. That isn�t a disaster, just an inconvenience.

More serious is that borrowers must know the points because points are tax deductible. Indeed, they should know the points early on because taxes can figure importantly in selection decisions. All the calculators on my web site designed to help borrowers make the right selections take account of taxes.

If points are not consolidated, each GMP would have an interest rate, points, and other settlement costs. On some GMPs, monthly mortgage insurance premiums would be a fourth price. And if real estate services are broken out from lender services, as proposed below, it would be yet another price. Nonetheless, this would be far more manageable than the 20 to 30 separate cost items the typical home purchaser must deal with today.

In sum, HUD has taken consolidation too far -- some fees should be separately identified. These include broker fees, because borrowers should be able to negotiate them separately with brokers; points, which borrowers need to know for tax and other reasons; and monthly mortgage insurance premiums, which can�t be added to other settlement charges because they are paid over time.

APR: These exceptions to consolidation highlight the need for a single measure of cost to the borrower, which pulls together all the separate price components. In principle, such a measure is already available to borrowers. It is called the "Annual Percentage Rate", or APR, and it is a part of Truth in Lending (TIL) disclosures, which are administered by the Federal Reserve. Until now, however, HUD, has never included an APR, or anything like it, in its required disclosures.

HUD includes an APR in its proposed new GMP, and also in its proposed revision to the GFE. In addition, HUD would include everything else of value on the TIL, such as prepayment penalties, while leaving behind much junk. It is reasonable to conclude that HUD is looking to displace the Federal Reserve in mortgage loan disclosure, although this would have to be sanctioned by Congress.

Divided responsibility between the HUD and the Fed has worked very poorly. For example, it has never been possible to reconcile the figures on the TIL with those on the GFE. If Congress centralized responsibility in HUD, it could be a blessing, but only if HUD redesigns the APR so that it fits into the new scheme.

The APR as it is currently defined is close to worthless and few borrowers use it. For one thing, there is no rhyme or reason to the settlement cost items that are included. For example, the current APR does not include the cost of a credit report, appraisal, or lender inspection, all of which are included in both the GMP and the proposed GFE (where they are consolidated into Lender Required and Third Party Services). On the other hand, per diem interest is included in the APR but not consolidated in the GMP or GFE.

If the cost items covered by the APR don�t correspond exactly with the cost categories HUD is using in the GMP and GFE, the borrower will be confused and the APR will be worthless. On the other hand, changing the definition while Truth in Lending is still in force would mean that there would be a Fed APR and a HUD APR, which might be even more confusing. If HUD can�t find a way to get rid of the Fed APR, it should consider renaming its measure � perhaps to "true interest cost" or TIC.

HUD also needs to fix the other major weakness of the Fed�s APR, which is the assumption that all loans run to term. In fact, very few loans run to term, and an increasing proportion are paid off within 5 years. The APR is a treacherous guide for such borrowers.

For example, John Doe in borrowing $300,000 for 30 years is choosing between 6.5% with zero APR fees and 6% with $12,000 in fees. The APR on the 6.5% loan is 6.5%, regardless of when the loan is paid off. On the second loan, the Fed�s APR calculated over 30 years is 6.39%, suggesting that this is the better choice. But an APR calculated over 5 years is 6.98%, leading to the opposite conclusion.

By far the best way to set the time period over which the APR is calculated is to leave it up to the individual borrower. Lenders and brokers will resist this, although modern mortgage technology makes it extremely simple to do. A reasonable compromise would be to require two TIC�s, one at term and one at 5 years. This would be an immense step forward.

One Package Versus Two: HUD�s proposal to consolidate all settlement services into a GMP would be a substantial break with the ways in which mortgages are delivered today, and how it will work out exactly is not clear.

Lenders expect to profit from having the complete freedom to package the services of their own affiliates, without having to warn borrowers about the relationship or offer them alternatives. Lenders without affiliates would be free to use their buying clout to negotiate the most favorable terms with independent third-party service providers. HUD is gambling that competition between GMP packagers will force them to pass on most of the cost savings to borrowers.

The way to make this less of a gamble, closer to a sure thing, is to expand the number of players, and there is a very simple way to do this. Instead of requiring one package that includes everything, HUD could allow two packages, which could be offered separately or together.

One package, offered only by lenders, would consist of lender-related services. These are services provided directly by the lender, or by third parties, such as independent appraisers, at prices known by the lender. This package would have the same rate guarantee as the GMP, but the price guarantee would cover only lender-related services.

The second package, offered by title insurance, real estate or other non-lender firms, would consist of all real estate-related services. These are all the services needed in settlement of the real estate transaction. The price of real estate-related services would also be guaranteed. Both groups of packagers would have the same type of exemptions (from restrictions on referral fees, for example) as GMP packagers.

This breakdown corresponds to a natural division of labor between lenders and real estate service providers. Lenders by themselves can�t guarantee the prices of real estate services because they are not themselves involved in that process. Lenders offering GMPs, therefore, will subcontract with firms involved in real estate to provide real estate service packages for inclusion in GMPs. There is no good reason why these firms should not be able to offer the same packages to borrowers, directly or through mortgage brokers.

The two-package approach would materially increase the number of competitive options available to borrowers. Many lenders reluctant to offer GMPs will be willing to offer lender packages because, except for the guarantee, it is what they do now. A few forward-looking lenders already guarantee their settlement service package. Real estate firms that are disinclined to become subcontractors to lenders offering GMPs will take advantage of the opportunity to develop their own distribution networks.

Under the two-package approach, borrowers could buy a complete GMP, or they could buy separate lender and real estate packages. It would be a simple matter to compare the price of a GMP package to the sum of the prices on a lender package and a real estate package.

Indeed, mortgage brokers would do the arithmetic for them. Putting the two packages together is a natural mortgage broker function. It is similar to what they often do now in combining a first and second mortgage in one deal. The lender package should include a slot for the broker�s fee, which would be negotiated with the borrower and fully disclosed.

Copyright Jack Guttentag 2003


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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