(This is Part 2 of a three-part series. Read Part 1, “New mortgage underwriting rules will be tough to enforce.”)

Last week, I criticized the Federal Reserve Board’s proposed rule to prohibit lenders from making loans that were not affordable, and to require lenders to verify the information on which they base loan decisions. These rules are too vague to be enforceable, and it is too late for them to do any good even if they were enforceable.

This week I look at the board’s proposed approach to curbing abuses by mortgage brokers. Timeliness is not an issue here, but doing it right is.

Mortgage brokers abuse borrowers when they collect a rebate from the lender for delivering a high-interest-rate loan without the knowledge of the borrower. I developed the Upfront Mortgage Broker program largely to deal with this problem.

Upfront Mortgage Brokers (UMBs) agree in writing with borrowers to a specified total fee, which includes any payment received by the broker from the lender. The borrower elects how to pay the fee, either in cash at closing or in a rate high enough that the lender will pay a rebate to the broker.

Under the board’s proposal, lenders would be prohibited from making a payment to a broker unless the borrower and broker had agreed in advance on the broker’s total compensation. The obligation imposed on the broker by this rule is thus identical to that imposed on a UMB.

However, the UMB program is voluntary whereas the board would impose the obligation on all brokers, most of whom don’t want it. This makes enforcement a challenge.

The board would impose enforcement responsibility on wholesale lenders. Before paying a rebate to a broker, the lender would have to check the agreement between the broker and the borrower, as well as the HUD1 closing statement, to make sure that the total amount received by the broker does not exceed the amount agreed upon.

But there is a better way to prevent brokers from getting paid by lenders behind the borrower’s back that has no compliance burden. Lenders would simply be required to credit all rebates to borrowers. Lenders would inform their settlement agents that this is now the rule, and that would be it. There would be no need for case-by-case investigation because there would be nothing to investigate.

This approach would also be more effective. Under the board’s proposal, glib brokers will still be able to get trusting borrowers to sign off on rebates. This will be much more difficult if rebates are credited to borrowers, because then borrowers must be persuaded to sign over what they already have.

The rule should be applied not only to brokers but also to “correspondent lenders,” who operate in the same way as brokers except that they close loans in their own name. Correspondent lenders receive rebates just like brokers, and should be subject to the same rules. If they are not, brokers who don’t want to comply will become employees of correspondent lenders, who will allow them to function much as they had as brokers.

The board’s proposal, however, applies only to brokers, reflecting its failure to recognize that while correspondent lenders may be lenders under the law, operationally they more closely resemble brokers. Like brokers, they receive rebates from wholesale lenders on higher-rate loans, and are similarly positioned to abuse borrowers.

Lenders who originate loans at their own risk raise a different issue. Such lenders don’t receive rebates, but their loan officer employees can abuse borrowers just as easily as brokers. Where opportunistic pricing by brokers usually involves pocketing rebates, opportunistic pricing by retail loan officers takes the form of overages — prices above the retail prices posted by the firm. A loan officer who can induce a borrower to accept a rate above the rate posted by the firm will typically share the value of the overage.

To maintain a level playing field between brokers and loan officers, rebates on loans delivered by brokers and correspondent lenders should be credited to borrowers, and overages on loans delivered by loan officers at other lending firms should be prohibited.

Next week: how the board would curb servicing abuses.

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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