Every consumer taking a home mortgage today pays a tax in unnecessary charges for the various third-party services required to deliver the mortgage. These include services provided by title insurance companies, mortgage insurance companies, appraisers, credit reporting agencies, flood insurance companies, and escrow companies.
The taxes don’t go to government, and in most cases the service providers don’t keep them. Rather, they are paid to those who are positioned to direct which service provider will receive the business; these referral agents are mainly lenders, Realtors and builders. The payments include referral fees, which are sometimes legal and sometimes illegal. Some of the tax is absorbed by marketing expenses directed to the same referral agents.
The problem is not that there isn’t competition in these industries, as the competition is actually intense, but it is directed to referral agents rather than to the consumers who pay for the service. Competition directed to referral agents drives prices up rather than down, since most agents are more interested in being paid for the referral than in negotiating lower prices for consumers.
Under the Real Estate Settlement Procedures Act (RESPA), referral fees are illegal, but this rule has been completely ineffective because it has left the power to refer business unchanged. Small referral agents often ignore the rule and large ones develop affiliated business arrangements, which convert illegal referral payments into legal referral payments.
There are several ways to eliminate or neutralize referral power. Much the most effective way is to require lenders to pay for all third-party services that they require, passing the cost on to borrowers in their rates and fees. Competition by third-party providers to sell lenders would then force the prices down, and rate competition by lenders would force them to pass the savings on to borrowers. This would require federal legislation, however, and the prospect of that ever happening is remote.
An approach proposed by HUD several years ago, which did not require new legislation, would have allowed lenders and others to package third-party services with loans, selling the package at an all-inclusive price. I supported this concept, but it was done in by its complexity, which included something to hate by every interest group in the country.
A third approach, which I recently proposed to HUD, aims to induce some referral agents to become agents of borrowers as a competitive strategy. A lender who negotiates lower prices with third-party providers and passes those prices on to its borrowers can gain a competitive advantage. There are, in fact, lenders who would do this now if not for a well-intentioned HUD rule that prevents it.
To use lower third-party fees as a competitive tool, loan providers must guarantee those fees. Otherwise, they have no way of distinguishing the fees they quote to borrowers from those quoted by competitors. Indeed, without an explicit guarantee, the low fees quoted are indistinguishable from those of low-balling competitors who have no intention of delivering.
But guaranteeing third-party fees is hampered by a HUD rule against marking up the prices of third-party services. Consider a loan provider who guarantees an appraisal fee of $400. If the actual cost comes in at $500, he must take the $100 loss, but if the actual comes in at $300, he must charge $300 to comply with the markup rule.
My proposal is for HUD to revise its rule toward markups on third-party charges as follows: Markups would be permitted by any loan provider that guarantees its own and all third-party charges.
The goal is to encourage loan providers to guarantee their own and all third-party fees. (I use the term “loan provider” because it covers both lenders and brokers, since the proposed rule should apply to both). On refinances, this would be all third-party fees. On purchase transactions, the guarantee would cover charges of service providers selected by the loan provider.
As loan providers offering fee guarantees become a force in the marketplace, borrowers will discover that they can shop rate and total guaranteed fees. This would fundamentally change the way the market works, and put downward pressure on all fees.
On purchase transactions, where the title agency is usually selected by the Realtor or builder, a new and in many cases lower-cost option would become available. In states where home sellers are obliged to purchase title policies for buyers, the availability of a lower-cost policy available through the buyer’s loan provider could change the way business is done.
HUD could make the necessary rule change on its own, with minimum political flak. But HUD is a very politically sensitive agency, and I have no political clout. My hope is that others who do have clout will chime in to make it happen.
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.