The Mortgage Professor

How Congress Can Rein In Opportunistic Steering by Brokers

By Jack Guttentag
Saturday, November 17, 2007

One of the important objectives of the mortgage legislation winding its way through Congress is to prevent brokers from steering borrowers to costlier loans, according to the bill's sponsor, Rep. Barney Frank (D-Mass.).

Such steering sounds like one of those things no one could support. Why do brokers do it? So they can collect rebates from lenders.

Lenders pay rebates on high-rate loans, just as they charge points on low-rate loans. (One point is 1 percent of the loan amount.) Points are upfront payments to the lender, and rebates are upfront payments from the lender. A rebate retained by the broker is called a yield spread premium, or YSP.

One day last week, wholesale lenders were quoting 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 and 2 percent rebates for 6.25 percent and 6.5 percent loans, respectively.

Rebates are not necessarily evil. Brokers don't work for nothing. Those who operate with full disclosure -- a minority -- tell borrowers their fees, then allow the borrowers to select the rates and point combinations they prefer. If the fee is 1 point, for example, a 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.

A borrower strapped for cash might select the 6.5 percent loan, or go even higher to get a rebate large enough to cover miscellaneous lender and third-party charges. "No-cost" loans are created using the lender rebates offered on high-rate loans. Legislators shouldn't enact any rules that would deprive borrowers of that valuable option.

However, most brokers don't practice full disclosure. They can make more money by pricing opportunistically. Most often, they quote the highest rate they think a borrower will accept, and pocket the rebate. A broker who can get the borrower to accept a 6.5 percent loan will pocket the 2-point rebate, usually without the borrower's knowledge. The borrower may discover it afterward in closing documents, if he knows where to look.

The challenge to legislators is to eliminate opportunistic pricing without eliminating rebates. The obvious remedy appears to be a disclosure requirement: a mandate that brokers disclose their fees upfront.

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. Even if early disclosure were feasible, borrowers who don't understand the process would not be helped.

Fortunately, a better rule is possible. It is simple and easily enforceable and would help the naive as well as the informed borrower. The rule would be that lenders must credit all rebates to borrowers. The borrowers would then have to authorize the payment to brokers. The broker in my example who would like to pocket a 2-point YSP on a 6.5 percent loan could no longer do so 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 what are known as 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 it tries to make 2 points, the price on its 6.5 percent loan would be zero, the same as the broker's, 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. That makes brokers livid.

However, lenders are constrained in their markups because, while some borrowers will pay high markups, others will shop around and find better deals. So many lenders price conservatively but give their loan officers the discretion to charge more than the posted prices if they can. Such opportunistic price increments are called "overages." As with YSPs, borrowers don'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 lenders.

There are some lenders that don't allow overages, just as there are some brokers who disclose their fees upfront. Both are minorities because the adoption of consumer-friendly practices is costly when competitors are not obliged to follow suit. Legislation that converts the best practices of the industry into rules for all will be supported by the most forward-looking elements in the industry.

Jack Guttentag is professor of finance emeritus at the Wharton School of the University of Pennsylvania. He can be contacted through his Web site,

Copyright 2007 Jack Guttentag

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