(This is Part 1 of a two-part series.)

The Mortgage Reform and Anti-Predatory Lending Act of 2007 (HR 3915) is now winding its way through Congress. According to the bill’s sponsor, Rep. Barney Frank, D-Mass, one of its important objectives is to prevent mortgage brokers from steering borrowers into higher-cost loans.

Brokers steer borrowers into high-cost loans so they can collect a rebate from the lender. Lenders pay rebates on high-rate loans, and charge points on low-rate loans. Points are upfront payments to — and rebates are upfront payments from — the lender. A rebate retained by the broker is called a “yield spread premium,” or YSP.

On Nov. 7, 2007, wholesale lenders quoted the following prices to brokers for a 30-year fixed-rate mortgage: 6 percent at zero points, 5.75 percent at 1.25 points, 6.25 percent at 1 point rebate, and 6.5 percent at 2 points rebate. This means that the lender wants to be paid 1.25 percent of the loan amount for 5.75 percent loans, and will pay 1 percent or 2 percent rebates for 6.25 percent and 6.5 percent loans, respectively.

Brokers who operate with full disclosure, including Upfront Mortgage Brokers, tell the borrower their fee, and allow the borrower to select the rate/point combination they prefer. If the broker’s fee is 1 point, for example, the borrower who wants the 5.75 percent loan will pay 2.25 points — 1.25 to the lender and 1 to the broker. If the borrower selects the 6.25 percent loan, the broker’s fee will be covered by the lender rebate.

Indeed, a borrower strapped for cash might select the 6.5 percent, or go even higher to get a rebate large enough to cover all miscellaneous lender and third-party charges. “No-cost” loans are created using the lender rebates offered on high-rate loans. Legislators don’t want to enact any rules that will deprive borrowers of this valuable option.

Most brokers don’t practice full disclosure because they can make more money by pricing opportunistically. Most often, they quote the highest rate they think the borrower will accept, and pocket the rebate, usually without the borrower’s knowledge. The borrower may discover it after the fact in closing documents, if they know where to look.

The challenge to legislators is to eliminate opportunistic pricing without eliminating rebates. The obvious remedy appears to be a disclosure requirement — mandate that brokers disclose their fees upfront, as Upfront Mortgages Brokers now do voluntarily.

For a disclosure requirement to be useful, however, borrowers need information about broker fees at or before their first contact with the broker, which is earlier than any enforceable rule can provide it. Incorporating the fee in the Good Faith Estimate of Settlement (GFE), which is the rule in California, is too late because the borrower has already applied for a loan. Furthermore, even if early disclosure were feasible, borrowers who don’t understand the process would not be helped.

Fortunately, there is a better rule. It is simple, easily enforceable, and would help the naive as well as the informed borrower. The rule is that lenders must credit all rebates to borrowers. The borrowers would then have to authorize the payment to brokers. The broker in my previous example, who would like to pocket a 2 point YSP on a 6.5 percent loan, could no longer do it behind the borrower’s back.

Loan officers working for lenders also price opportunistically. If they are ignored while brokers are constrained, brokers will move en masse to net branches, a type of entity designed to convert brokers into loan officer employees, while allowing them to operate much as before.

Assume a lender has the same cost of funds as the broker above. If they try to make 2 points, their price on the 6.5 percent loan would be zero, same as the broker, except that the lender has no YSP to report — its markup is it own business and need not be reported to anyone. Neither a YSP disclosure rule nor the YSP credit rule I proposed above would apply to them.

However, lenders are constrained in their markups because, while some borrowers will pay the high markup, others will shop around and find a better deal. So what many lenders do is price conservatively but give their loan officers the discretion to charge more than the posted prices if they can. These opportunistic price increments are called “overages,” and like YSPs the borrower doesn’t know about them. Curbing YSPs without curbing overages would be a mistake.

Overages could be eliminated very easily by the following rule: Loan officer employees of lenders must charge the prices posted by the lender.

Some lenders don’t allow overages, and some brokers disclose their fees upfront. Both groups are a minority, because the adoption of consumer-friendly practices is costly when competitors are not obliged to follow suit. Good legislation converts the best practices of the industry into rules for all. Next week I will examine whether the current version of HR 3915 does this for YSP abuse.

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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