(This is Part 1 of a four-part series. See Part 2: Eliminating mortgage lender fee surprises; Part 3: Mortgage brokers struggle with consumer distrust and Part 4: Cost consolidation improves real estate loan shopping.)
“The impression I get from reading your articles is that our mortgage system doesn’t work well for borrowers…Isn’t there any way to fix it?”
In some respects, the United States housing finance system is the best in the world. In other respects, it is unworthy of a banana republic.
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 funds.
Our secondary market is the envy of the world. Investors acquire mortgage-backed securities at the smallest possible margins over U.S. government securities. However, much of the benefit stemming from our efficient secondary market is eaten away by excessive costs in the primary market.
The first three articles in this series focus on excessive charges paid by borrowers to third-party settlement service providers, lenders and brokers. The fourth article is directed toward making it easier for borrowers to shop effectively.
Why third-party settlement service charges are too high:
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.
The reason is that 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 prices 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 and 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 lawmakers 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, which made 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.
The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.
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