New loan-originator compensation rules promulgated by the Federal Reserve Board make three sweeping changes in the way residential lending business will be conducted. Although they were designed to enhance consumer protection, it is not at all clear yet whether these changes will improve conditions for borrowers more than they detract from them.
First, loan originators are now prohibited from being paid on the basis of the interest rate of the loan they sell to a borrower. Second, if a borrower pays the loan originator, that loan originator cannot receive compensation from any other party. Third, loan originators are prohibited from steering consumers toward loans that will benefit the originator to the detriment of the borrower. The purpose of these changes is to protect consumers from unfair or abusive lending practices.
Until April 1, it was perfectly legal, and in fact customary, for a mortgage broker to collect points (one point equals 1 percent of the loan amount) from a borrower and additional points (called yield-spread premiums) from the lender. Lenders were willing to pay mortgage brokers yield-spread premiums because the mortgage brokers had sold loans to the borrowers with interest rates higher than the rate commonly available on the market. The more the interest rate exceeded the market rate, the greater was a broker’s yield-spread bounty.
These yield-spread premiums were disclosed to borrowers in the margins of the HUD-1 settlement statement. Because these payments were not coming out of the borrowers’ pockets at closing, borrowers often overlooked the significance that they were funding those yield-spread premiums in the form of higher interest rates.
The new rules are designed to outlaw this type of unfair and abusive lending practice. Now, the only factor that may affect the amount to be paid by lender to loan originators is the amount of money loaned. With greater loan amounts, lenders may pay more to the loan originator. This, of course, may still unduly influence loan originators to try to lend borrowers more than they can comfortably afford. No one said these new rules were perfect.
The second sweeping change is that a loan originator can no longer “double dip” — that is, collect fees from both borrower and lender. On its face, this seems like a good rule. However, in a classic case of unintended consequences, the new rule actually may penalize borrowers, because loan originators are not able to use any portion of their compensation to reimburse borrowers for their closing costs or to pay for any closing costs for the borrowers’ benefit.
In the past, it was not uncommon for mortgage brokers to provide a broker credit to the borrower, reimbursing them for certain unexpected settlement fees or lender costs that might have arisen prior to closing. For example, if a loan were taking longer to conclude than expected and an interest-rate lock provided by the lender was expiring, the mortgage broker, in order to save the deal and keep his borrower happy, might pay a rate-lock extension fee out of his own pocket. Similarly, if credit reports or appraisals needed to be updated at an additional cost, mortgage brokers would often pay them or reimburse the borrower. These accommodations are now absolutely prohibited. Such unexpected additional costs must now be paid by the borrower.
Readers may be incredulous to learn that until April 1, it was legal for a mortgage broker to steer a borrower to a loan that benefited the mortgage broker to the detriment of the borrower. Now the loan originator must present the borrower a loan with the lowest available interest rate, and that does not contain any risky features such as prepayment penalties, negative amortization or balloon payments. The loan is supposed to provide the borrower the lowest total cost, taking into account origination points, fees and discount points.
But these new rules only apply to mortgages made by brokers. They do not apply to mortgage bankers, nor to home equity lines of credit, vacant property or timeshares.
The most controversial aspect of these rules relates to the fact that the Federal Reserve, in its infinite wisdom, exempted mortgage bankers from these rules but not mortgage brokers.
The Federal Reserve received about 6,000 comments on these rules before finalizing them. It is not surprising that the vast majority of these letters came from outraged mortgage brokers complaining about the disparate treatment their industry was facing compared to that of mortgage bankers. While mortgage bankers do not pay or receive yield-spread premiums, they do obtain “hidden” back-end fees, called servicing release premiums, when they sell high interest-rate mortgages to investors on the secondary mortgage market. The higher the interest rate, the higher the servicing-release premium. Mortgage lenders are not required to disclose the possibility of these fees to the borrower.
A lawsuit pending before the U.S. District Court for the District of Columbia, brought by the National Association of Mortgage Brokers and the National Association of Independent Housing Professionals, seeks to invalidate the Fed’s action on the grounds that the rules exceed its authority, that the Fed relied on flawed consumer testing and that it failed to adequately analyze the impact of these rules on small business or to consider less-harmful alternatives.
Until these new rules have been in place for some time, it is difficult to predict whether they will be a net positive or negative for the consumer. One thing is certain: The complexity of the rules and the radical changes to the standard operating procedures will only cause further confusion in an already befuddled industry.
Harvey S. Jacobs is a real estate lawyer in the Rockville office of Joseph, Greenwald & Laake. He is an active real estate investor, developer, landlord, settlement attorney and lender. This column is not legal advice and should not be acted upon without obtaining your own legal counsel.