The Mortgage Professor

The Mortgage Professor: Beware An Abusive Tactic From Mortgage Loan Originators

Jack Guttentag
Saturday, September 19, 2009

Of all the issues that have bedeviled regulators and legislators dealing with consumer protection, perhaps the most troublesome have been the abuses connected to the way mortgage loan originators are compensated.

Most reform proposals aimed at curbing abuses by mortgage brokers don't apply to loan-officer employees of lenders. And many of the less-thoughtful proposals for curbing broker abuses would eliminate the borrower's option to have the lender pay the broker's fee in exchange for a higher rate.

The good news is that there has been progress on this issue. Recent proposals by the Federal Reserve to amend truth-in-lending rules seek to address abuses by loan officers as well as brokers. The revised truth-in-lending rules would also retain the option borrowers currently have in how they pay mortgage brokers.

The problem is not how much loan originators make, but how they make it. Under existing arrangements, loan originators, who deal directly with borrowers, can often increase their income by inducing their customers to make bad choices. This works because most borrowers don't have the information and education needed to protect themselves. Many loan officers don't succumb to this temptation, but too many do.

The abusive tactic that has generated the most controversy centers on payments to brokers by wholesale lenders for delivering interest rates that are higher than the "par rate" -- the rate at zero points. For example, a lender delivering prices to a broker who quotes 5 percent on a 30-year fixed-rate mortgage at zero points might pay 1 point for 5.25 percent, or 2 points for 5.5 percent. (A point is 1 percent of the loan amount). These payments by a lender are called "rebates," or "negative points." When pocketed by a mortgage broker, they are called "yield spread premiums".

There is nothing inherently abusive about yield spread premiums -- quite the contrary, when properly used they help to provide a valuable option to borrowers. But they can be used abusively. Here are illustrations of proper use by an ethical broker, and abusive use by a deceitful one.

Ethical Broker: Mrs. Jones, my fee is 1 point. If you select the 5 percent loan, you will pay me at closing. As an alternative, you can take the 5.25 percent loan and the lender will pay my 1 percent fee.

Deceitful Broker: Mrs. Jones, your rate is 5.5 percent. The good news is that my fee is being paid by the lender so my services to you are free.

Loan officers who work for a single lender can also be abusive, but in a different way. They receive retail prices from their back offices, meaning that their commission is included in the posted price. But the loan officer typically has discretion to charge the borrower more than the posted price, termed an "overage," if he can get the borrower to accept it. The loan officer shares the overage with the firm. Overage abuse has attracted much less attention than yield spread premiums abuse, but there is no reason to believe that it is less pervasive.

The Fed proposal would prohibit payments to mortgage brokers and loan officers that are based on a loan's "terms and conditions," including the interest rate and points. The rule would bar a wholesale lender from paying a broker more for a loan with a higher interest rate than for the same loan with a lower rate. However, the rule would not keep lenders from offering rebates on loans with above-par rates, which brokers could offer to clients to cover their fee or other settlement costs.

The rules are a bit rigid in that a broker must be paid entirely by the borrower or entirely by the lender; he cannot be paid by both. The rationale is that borrowers may get confused if the broker fee is shared by the two parties.

The Fed's proposed rule would also bar lenders from offering higher commissions on loans carrying overages. It doesn't bar overages, but it removes all financial incentives for the originator to charge one. This undercuts claims by the National Association of Mortgage Brokers that efforts to rein in yield spread premiums abuse alone would create an "unequal playing field."

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

© 2009, Jack Guttentag

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