September 5, 2005
In some respects, the United States housing
finance system is the best in the world. In other respects, it is unworthy of a
Our housing finance system has a primary
market and a secondary market. The primary market is the market the borrower
sees, where loans are executed. The secondary market is where the loans
originated in the primary market are sold to investors, the ultimate source of
Our secondary market is the envy of the
world. Investors acquire mortgage backed securities at the smallest possible
margins over US Government securities. However, much of the benefit stemming
from our efficient secondary market is eaten away by excessive charges paid by
borrowers to third party settlement service providers, lenders, and mortgage
brokers. Excessive charges persist because, for a variety of reasons, borrowers
cannot shop effectively.
Third Party Settlement
Charges Are Excessive
Third parties involved in the lending process
include title insurance companies, mortgage insurance companies, appraisers,
credit reporting agencies, flood insurance companies, and escrow companies.
Their costs are generally higher than they would be if they were purchased in a
normally competitive market.
Third party service providers compete not for the favor of borrowers, who pay
their fees, but for the favor of the lenders who select them. This type of
competition is perverse because it drives up the costs of the service providers.
This in turn raises prices to borrowers or prevents them from falling in
response to improvements in technology.
For example, borrowers pay for private
mortgage insurance but the insurance company (PMI) is selected by the lender.
Lenders use their referral power primarily to benefit themselves. The process is
much the same in the markets for other third party services.
The direct payment of referral fees has long
been illegal under the Real Estate Settlements Procedures Act (RESPA). However,
RESPA is ineffective because it does not eliminate referral power, which
is the crux of the problem. Small players often ignore the rule because HUD,
which is responsible for enforcement, cannot possibly police all the ways in
which one party can transfer something of value to another.
Large lenders circumvent RESPA through
circuitous but legal devices, such as reinsurance affiliates that share the
insurance premiums paid by borrowers. The process of legalizing referral fees
increases the costs that borrowers ultimately pay. So long as referral power is
allowed to persist, the cost to borrowers might be lower if referral fees were
paid openly in cash.
Why Do Borrowers Pay For Services Required by
Lenders? We have lived with this
practice for so long that it seems the natural state of affairs, but in fact,
there is nothing natural about it. If automobiles had to be shopped in the same
way as mortgages, the shopper might only receive the chassis from the dealer,
purchasing tires, electrical system, and painting from third parties. Can there
be any doubt what would happen to the price of these components if, instead of
purchasing them as a package, they had to be purchased separately from vendors
selected by the dealer?
The unbundled package of mortgage services is
a historical relic of usury laws limiting the interest rates lenders could
charge. When lenders could not raise interest rates to cover their costs, it
seemed reasonable to law-makers to allow them to pass costs through to
borrowers. They didn�t realize that this was a sure-fire recipe for referral
abuse. When the abuses became too obvious to ignore, they responded with RESPA,
referral fees illegal but left referral power unchanged. RESPA is essentially a
make-work project for lawyers.
The Remedy Is to Eliminate Referral Power:
This could be done by the enactment of one legal rule that is as simple as it is
obvious: any third party service
required by lenders must be paid for by lenders.
If lenders paid the charges, they would be
included in the rate, of course, but would cost borrowers far less than 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. Indeed, if lenders had to pay for all these services, they would
discover that some that they had found essential when borrowers had to pay, were
not really necessary after all.
Lender Fees Can
Blindside the Borrower
Lender fees, sometimes referred to as "junk
fees", are fees charged by lenders to cover specific lender costs. They are
defined in dollars, as opposed to points which are defined as a percent of the
loan. Where points are one number, junk fees can be a whole bunch of numbers,
each covering a specific charge.
The problem is that some retail lenders
increase these fees after it is too late for the borrower to back out. Often,
the borrower finds out about it at the closing table. It happens because of
borrower inattention, industry locking practices, and terrible disclosure rules.
Borrowers are usually only dimly aware of lender
fees. When they shop, their focus is mainly on interest rate and points, which
are all that appear in media ads. The borrower�s first exposure to lender fees
is likely to be when they receive a Good Faith Estimate of Settlement (GFE), but
this typically doesn�t happen until after an application has been submitted. At
that point, the borrower will be at least partially committed.
Industry Locking Practice:
The mortgage market is highly volatile, with prices changing from day to day and
sometimes within the day. Hence, rate/point quotes are not binding until the
lender locks them. Lender fees, in contrast, are not volatile, and therefore the
practice is not to include them in locks. The presumption is that at closing,
they will be exactly what they were when the borrower received the GFE, and with
honest lenders, they will be. But with dishonest lenders, the practice of
excluding fees from the lock provides an opportunity to cheat.
The Good Faith Estimate:
The GFE makes it all too easy for the cheaters.
Lenders are not bound by any of the numbers on the GFE, which are "estimates".
This is ridiculous, since lenders know their own charges. In addition, the GFE
confuses borrowers by showing each individual lender fee but no total, when the
total is all that really matters. If the GFE were deliberately designed to take
the borrower�s eye off the ball, it couldn�t have been done better.
Mortgage Brokers Provide Protection:
Excessive junk fees generally are not a problem on loans that go through
mortgage brokers. Brokers know the fees charged by all the lenders with whom
they do business, and they would not accept fee surprises at the closing table
that put no money in the broker�s pocket. Broker fees are another matter, to be
discussed in article 3 of this series.
Home Purchases Are Most Vulnerable:
Excessive junk fees are more likely to arise on a home purchase transaction than
on a refinance. On a home purchase, a buyer cannot walk away from the mortgage
without walking away from the house. On a refinance, in contrast, a borrower can
usually begin anew at any point without much loss.
A mandatory fixed-dollar fee on all mortgage transactions, proposed below as the
way to make it possible for borrowers to shop effectively, would also eliminate
fee escalation at the closing table. A less comprehensive approach that would
also work is a rule stipulating that when lenders lock the rate and points, they
also lock their fees.
Mortgage Broker Fees
Because brokers deal with multiple lenders,
they play a critical role in helping a borrower find a lender who offers a
particular type of loan program. When the needed loan is one offered by many
lenders, brokers are able to shop among them to find the lowest price. That�s
the good news.
The bad news is that, broker charges per transaction are generally excessive. In
part, this is due to low productivity. Brokers spend a lot of time looking for
clients, and they also spend a lot of time with potential clients who don�t
close and waste their time. Low productivity generates pressure to earn more on
the deals that do close.
Brokers are able to charge a lot per
transaction because borrowers usually don�t know at the outset how much the
broker will make. If they find out, usually the deal is too far advanced to do
anything about it.
Only the loosest relationship exists,
furthermore, between broker charges and the amount of work the broker does for
the borrower. The general rule is that brokers charge what the market will bear.
Unsophisticated borrowers who visit a single broker will generally pay more than
knowledgeable borrowers who shop alternative sources.
The Independent Contractor Model of the
Industry: The dominant ideology
of mortgage brokerage, as promulgated by the National Association of Mortgage
Brokers and the various state associations, is that brokers are independent
contractors. They view themselves as merchants who buy at one price and sell at
another price, and how much they make on a transaction is no one�s business but
their own. The independent contractor model supports the view that brokers are
entitled to make as much per transaction as they can.
The Independent Contractor Model Generates
Distrust, Which Increases Costs:
Distrust runs like a red line through the hundreds of letters I receive every
month from borrowers relating experiences with brokers. And distrust translates
into higher costs.
Brokers detest borrowers who flit from one
broker to another, submit applications through multiple brokers, or pump them
for information and then deal elsewhere. Yet these practices arise from attempts
by borrowers to protect themselves against brokers they don�t trust. Borrower
reactions to distrust raise broker costs, which pressures brokers to make more
per transaction, which generates more distrust in a vicious circle.
Other Fallacies of the Independent Contractor
Model: The fact is that brokers
are service providers, not merchants; they do not buy and resell anything.
Furthermore, shopping mortgages is so difficult that few borrowers can do it
effectively. Brokers are the experts at shopping mortgages, not borrowers. The
optimal arrangement for most borrowers, therefore, is to purchase the shopping
expertise of brokers for a fixed fee. Fortunately, it is now possible to do
The Agency Approach of Upfront Mortgage
Brokers: Upfront Mortgage Brokers (UMBs) operate according to a different set of rules than the remainder of the
industry. UMBs view themselves as the agent of the borrower, to whom they owe a
fiduciary responsibility. A UMB agrees with the borrower on total broker
compensation from the transaction, and passes through the best price from the
The advantage of the UMB approach is that it
breeds confidence, which lowers costs and increases productivity. I know UMBs
who charge half the industry average per transaction but close 3-4 times as many
loans. Their secret is a continuous stream of referrals from previous clients --
and from me.
Implementation of the Agency Approach:
The way to break the circle of distrust is to change the operating model, from
independent contractor to agency. The broker trade associations will never do
this, because they cater to the lowest common denominator of member opinion.
Government should but probably won�t mandate
the agency approach because it would be opposed not only by the broker
associations, but also by the wholesale lenders, who are as short-sighted as the
brokers. They support the independent contractor model in order to limit their
own liability for broker misdeeds.
The agency approach will have to win the
battle in the marketplace, which will be a slow process but I am committed to
it. When this was written, there were 116 UMBs.
Mortgage Shopping by
Borrowers Is Ineffective
Shopping is extremely difficult now because
mortgages have so many price dimensions. Even if lenders paid for all the
services provided by third parties, which I proposed above, a borrower shopping
for an FRM would have three prices to juggle: interest rate, points, and fixed
dollar fee. (On ARMs, there are more, but I�ll ignore that for now). This is
confusing and makes shopping difficult.
Mandating a Fixed Fee:
Government should mandate the same fixed-dollar charge for all lenders and all
programs. Then borrowers would have to shop only rate and points, which is
easily manageable. For example, a borrower can shop for the lowest rate at zero
points, or the fewest points on a 6% loan.
Within reasonable limits, the exact amount of
the fixed charge is not important, provided the charge is the same for every
lender and every loan. It is the variability in these costs that makes it
difficult to shop.
This is price-fixing by Government, but in a
good cause. When a service carries one price, price-fixing invariably reduces
the supply of the service. When a service carries three prices, however, fixing
one price merely channels market adjustments into the remaining prices, making
it easier for consumers to shop.
A Fixed Fee Would Discourage Predatory
Lending: Perhaps the greatest
benefit of the one-price rule would be in the sub-prime market, where predatory
practices are widespread. Under a fixed-charge rule, these practices become much
more difficult to execute.
A common feature of price gouging, for
example, is the inclusion of large fees in the loan balance, which borrowers
often know nothing about until they get to the closing table. With a fixed-price
rule, along with a rule that limits the financing of points, any gouging would
have to be in the interest rate, where the potential for snookering the borrower
is limited. Even unsophisticated borrowers understand the difference between 7%
In a similar vein, making loans that
borrowers can�t repay, or churning loans in successive cash-out refinances, are
profitable only if the lender can load heavy fees into the balance. The
fixed-charge rule should eliminate both practices.
Enforcement of a Fixed Fee Rule Would Be
Easy: Law-makers sometimes give
little consideration to whether, and at what cost, the rules they promulgate can
be enforced. This is certainly true of the existing law against the payment of
referral fees, which couldn�t be effectively enforced with an army of examiners.
State laws directed at predatory lending that bar loans that "fail to benefit
the borrower," or that "borrowers do not have the capacity to repay," present
similar enforcement problems.
In contrast, the fixed-charge rule would be
virtually self-enforcing, because it is unambiguous, and every borrower would be
a potential enforcement agent. Borrowers would know what the allowable charge
was, and the closing documents would reveal whether or not the lender was in
How Much Should the Fixed Fee Be?
The fee should not be so high that lenders can make money on the origination
process, regardless of what happens later. That encourages abusive practices.
Nor should it be so low that early prepayment will cause the lender serious loss
because then there won�t be any loans made without prepayment penalties. $3,000
is about right for now. This is the fee set by Innovation Mortgage, a sub-prime
lender out of California, which has adopted a one-price rule voluntarily as a
Eliminating Low-Ball Price Quotes:
If price quotes can�t be depended on, price shopping goes for naught. Some
lenders and brokers routinely offer low-ball price quotes designed to capture
the customer, which they retract at the time the price is locked. Because the
market is so volatile, borrowers are rarely positioned to contest a loan
provider�s statement that market rates increased more, or decreased less, than
they did in fact.
Full protection against this common tactic
requires a "twin sibling rule." Lenders must lock at the same rate that they
would quote to the borrower�s twin who is shopping the same loan on the lock
date. This rule would also be easy to enforce, since loan providers do quote
prices to shoppers on the same days that they lock prices to borrowers in
Copyright Jack Guttentag 2005