(This is Part 2 of a three-part series. See Part 1 and Part 3.)

Last week I made the point that referral power — the power to direct a client to a specific service provider — is pervasive in the home mortgage market. Referral power raises prices to consumers. Competition for the favor of referral agents raises the costs of service providers, which are passed on to consumers in higher prices.

Referral power also results in referral fees paid by service providers to those from whom they receive referrals. In the mistaken belief that the elimination of referral fees would reduce prices to consumers, Congress enacted the Real Estate Settlement Procedures Act (RESPA), which, among other things, makes referral fees illegal.

Q: “Has RESPA prevented referral fees?”

A: No. There are too many referral agents and too many ways they can receive something of value from service providers. HUD, the enforcement agency, would require an army of examiners to shut it down, and it has never had such an army. The fact is that thousands of small referral agents continue to receive referral fees, if in disguised form, with impunity.

HUD does what it can, and in 2005 it stepped up its enforcement efforts. It settled enforcement actions against 12 referrers, all major players, who included lenders, title insurers and real estate brokerage firms (In 2004, there were only two such cases). While small players continue to operate below HUD’s radar screen, these enforcement actions do encourage larger players to find legal ways to exploit their referral power.

Q: “My Realtor owns its own title company to which it refers all its clients. Does RESPA allow that?”

A: Yes, RESPA does not prevent a firm in one industry from entering another industry, even when the express purpose is to exploit referral power. For example, a Realtor or lender can establish his or her own title company and refer business to that company. However, the title company must be a bona fide company, meaning that it must have the capital required by a title company, it must have its own employees and place of business, and so on. A sham company that is actually operated by another title company would be a RESPA violation.

Indeed, there are firms that will put any lender or Realtor in the title insurance business by creating a title agency for them, which can be a joint venture or an entity wholly owned by the referrer. These firms guarantee that the title companies they create are RESPA compliant. Since the capital investment required is considerable, this option is available only to firms able to generate a volume of referral business large enough to justify the investment.

Q: “Does this mean that if the title company is legitimate, the income the Realtor earns from it is not a referral fee?”

A: In the eyes of HUD and RESPA, it is not a referral fee. The reality, however, is that the income the Realtor derives from the title company continues to be based on the Realtor’s referrals; indeed, the title company would not exist except for such referrals. You can change the name of an animal from “elephant” to “dog,” but that animal remains a ponderous pachyderm with big ears, and so it is with referral fees.

Q: “What public purpose is served by requiring firms to spend a lot of money to legalize referral fees?”

A: I suppose enforcing the law is a public purpose, even when the law is a stupid one. All the other consequences are negative.

Setting up a RESPA-compliant firm to legalize referral fees is an option available only to fairly sizeable firms. Smaller firms have to choose between observing the law at their loss and violating it.

Requiring a referrer to incur the expense of creating a new service provider, when they would otherwise prefer to deal with an existing provider, is a waste. New firms should be formed when there is a real market need for them, not to enable existing firms to collect referral fees without violating RESPA.

But by far the worst consequence of requiring referrers to create new firms in order to collect referral fees is that it eliminates all possibility that referral power will be used to lower costs to consumers. A lender, for example, might want to expand its mortgage business by merchandising its willingness to rebate the referral fees collected from its third-party service providers. But it can’t. RESPA, fashioned by Congress to protect borrowers, prevents it.

The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at http://www.mtgprofessor.com.

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