July 6, 1998
"In my recent
home purchase, I bought title, property hazard, and mortgage insurance
policies from 3 different companies that I did not know, at prices given
to me by my lender. Judging from the circumstances, I am guessing that I
was overcharged. Am I right?"
It is impossible to prove,
but your guess is almost certainly correct.
Consider what would happen if
automobiles were sold like mortgages. When you asked the price, the dealer
would say "This is the price of the body and motor only. The
transmission system, tires, electrical system, and upholstery must be
purchased from "A," "B", "C" and
"D". The price you pay at delivery will include the payments to
these other 4 firms, and right now we can only provide an estimate of what
these payments will be."
The result of this would
almost certainly be an increase in the total price of the automobile. If
the automobile manufacturer only provided the chassis and motor, it would
become indifferent to the prices of the other components because the
consumer would be buying them from other firms. Instead, the automobile
manufacturer (or its dealers) would have an incentive to use its access to
the consumer to collect referral fees from the component manufacturers.
Component manufacturers would compete for referrals, which would raise
referral fees, and with them the prices paid by the consumer.
In fact, automobile
manufacturers bundle all the components,
selling a complete
automobile at a single price. To sell to them, component
manufacturers must compete in terms of price and quality, rather than
referral fees. Competition among the automobile manufacturers forces them
to pass on most of the benefit to the consumer.
In contrast, the home
mortgage market is an unbundled market. The consumer must transact
separately with providers of component services, as you did. And the
entities who control access to the consumer -- the lender, the real estate
broker or both -- have no incentive to push down the prices of component
services to the consumer. Before passage of The Real Estate Settlement
Procedures Act of 1974 ("RESPA"), referral fees were widespread
throughout the industry. RESPA, however, made referral fees illegal in
real estate transactions.
The weakness of the REPSPA
approach is that it does not change the underlying market incentives.
While RESPA has eliminated the overt payment of referral fees, the less
scrupulous still do it under the table. The more scrupulous seek
alternative business practices that allow them to profit from referrals of
customers to third party service providers while staying within the law.
This has created a good living for RESPA lawyers, but a regulatory
nightmare for everyone else including the beleaguered Department of
Housing and Urban Development which must administer RESPA.
But even if RESPA worked
perfectly, lenders and real estate brokers would be indifferent to the
prices paid by consumers for third party services. To foster competition
that would benefit the consumer requires the same bundled-product approach
that works in the automobile market. Lenders should be authorized to
bundle all the services connected to the real estate transaction and sell
them as a package. If lenders competed for customers by quoting prices for
the entire package of services, they would bargain aggressively with third
party service providers for the lowest possible prices. And competition
between lenders would force them to pass on the benefits to consumers.
A group called the Consumer
Mortgage Coalition which includes many large lenders has been developing a
proposal to the Congress to implement just such a scheme. I will keep you
posted on its progress.
October 10, 2001 Postscript
The proposal never flew, and
prospects for it are dim.
Copyright Jack Guttentag