By Jack Guttentag
Saturday, November 24, 2007

When a mortgage broker steers a borrower toward a high-rate loan for which the broker collects a rebate from the lender, that payment is called a yield spread premium. When the broker does so without the knowledge of the borrower, that's abusive.

Getting rid of yield-spread-premium abuse is one of the goals of legislation now moving through Congress, the Mortgage Reform and Anti-Predatory Lending Act. The legislation, co-sponsored by Rep. Barney Frank (D-Mass.), chairman of the Committee on Financial Services, was approved by the House just before Congress went on its holiday break. If it passes the Senate, will it accomplish its goal?

In my column last week, I suggested a simple and enforceable rule: Lenders should be required to credit all rebates to borrowers. The borrowers would then have to authorize payments to brokers. I still think such a rule would work much better than what is in the legislation.

The initial version of Frank's bill would indeed have prevented yield-spread-premium abuse, but it also would have eliminated mortgage brokers. The version that made it through the House, amended after feedback from brokers, would preserve the brokerage business but wouldn't prevent the abuse.

Here's the relevant part of the bill:

"Amount of originator compensation cannot vary based on terms: No mortgage originator may receive from any person, and no person may pay to any mortgage originator, directly or indirectly, any incentive compensation, including yield spread premium or any equivalent compensation or gain, that is based on, or varies with, the terms (other than the amount of principal) of any loan that is not a qualified mortgage."

Let's start with the clearest part of this statement, which is the last phrase. Whatever restrictions are called for, they will not apply to qualified mortgages.

A qualified mortgage, as defined elsewhere in the bill, is one with an interest rate no more than three percentage points above the comparable Treasury rate, or 1.75 percentage points above the average conventional rate.

This indicates that the framers of the bill believe that yield-spread-premium abuse is a problem only for the highest-rate loans, which is absurd. The problem cuts across the entire market. Indeed, high rate and high cost are not the same thing; a loan with a rate only two percentage points above the average could be loaded with superfluous fees and charges.

Will the restriction on incentive payments at least eliminate yield-spread-premium abuse on the high-rate loans to which it applies? The bill says that originators -- loan officers employed by lenders, as well as mortgage brokers -- cannot be paid more on high-rate loans than on low-rate loans. Because abuse is exactly that, this provision is on target. It defines yield-spread-premium abuse accurately and declares it illegal.

Unfortunately, this provision is unenforceable. The standard for determining whether compensation on a high-rate loan is excessive is the compensation received on a low-rate loan, which is unknown and in many cases unknowable. Originators collecting yield spread premiums on high-rate loans don't report what they would have charged on low-rate loans.

To enforce this rule, regulators would have to do a statistical analysis of the originator's charges on different loans to determine whether compensation is higher when a loan involves a yield spread premium.

This is not feasible because there are too many originators and not nearly enough regulators. Even if it were feasible, it would not work for brokers who get paid only by these rebates, which is common. It also wouldn't work for loan officers employed by lenders who originate at their own risk. For them, there is no yield spread premium.

Indeed, the only originators who would leave a trail for the enforcement police would be the brokers who give their customers the choice of whether they want to pay the broker out of pocket or have the broker paid with a premium.

Because these brokers offer borrowers a choice, fees will be shown with and without the yield spread premium, allowing analysis of whether there are any differences. There won't be, because these are the good guys. The bad guys will be beyond reach.

In contrast, a rule requiring lenders to credit rebates on high-rate loans to borrowers, who would have to explicitly authorize payment to the brokers, would affect all brokers alike and impose no huge enforcement burden on regulators. (To level the playing field between lenders and brokers, a comparable rule should prohibit loan officers from charging prices above those posted by the lender.)

Because wholesale lenders would welcome such a rule, there would be no regulatory burden. Poof! Yield-spread-premium abuse would disappear overnight.

Jack Guttentag is professor of finance emeritus at the Wharton School of the University of Pennsylvania. He can be contacted through his Web site, http://www.mtgprofessor.com.

Copyright 2007 Jack Guttentag

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