Tuesday, August 17, 2010

The Broker

I have not read John Grisham's novel, The Broker, which tells the story of a Washington power broker who, in fear of his life, has to flee the government and go to Italy. My mother has--she tells me that it is a good read. Of course, if Grisham had been writing about a mortgage broker his novel would have been the sad story of a tired, overworked individual who, in fear of his livelihood, has to flee excessive government regulation and find a new career path. That probably would not be such a good read, and for those of us in the lending industry it might hit too close to home to be enjoyable at all.

Since news of the Federal Reserve's final rule was announced yesterday, internet sites are buzzing with comments about how the final rule which ends yield spread premiums will affect the mortgage industry. I read the article posted today on Mortgage News Daily regarding the final rule. The article states that the Fed received 6000 comments about the proposed rule to end the practice of yield spread premiums--which allows mortgage originators to be paid on the spread of the interest rate--even though the rule was first announced in August of 2009. That is really amazing, because I am sure that there were more than 6000 comments posted in response to the Mortgage News Daily article today. Seriously, 6000 comments from an entire industry is pathetically few for an issue this important. I am not implying that more comments would have made a difference in the final rule, but I do believe that over the past two years, industry participants have largely given up on attempting to lend a voice to the regulation that is being passed. That is true partially because active originators have faced so many challenges with market crashes, wholesalers going bankrupt with no advance warnings, sudden guideline changes, and an overall decline in business that many people just do not have the energy for activism. But I believe that it is also true that many of us who used to work actively in grassroots lobby efforts, commenting on federal rules, and writing to our representatives have also given up and taken on a "What's the use anyway?" stance. In saying that, I am not assigning any blame whatsoever--it's really hard to keep going when the entire tide of public opinion is against you.

One area where I strongly disagree with the Mortgage News Daily Wire is in part of Adam Quinones' commentary. Starting April 1, when the new rule goes into effect, originators cannot be compensated on the spread on the interest rate. The new rule does mirror one aspect of the Dodd Frank Bill which says that the originator cannot receive compensation from the lender and the consumer on the same transaction. But then Quinones states, "To me that says a loan originator can earn rebate (yield spread) as long as they aren't being paid and {sic} origination fee. Plain and Simple: Am I missing something or is this pretty much the same way business is done right now."

Actually, that is not what the rule says. The rule, as I read the summary last night on the Federal Reserve website, says that the originator cannot be compensated on the terms of the loan, which includes the interest rate. Since January 1, mortgage brokers have been required to disclose all of the yield spread on any mortgage loan on the good faith estimate as a credit to the borrower to offset closing costs. Only mortgage brokers and loan officers are required to do this. No originator working for a depository bank is required to disclose this information. The new rule does at least apply to all individual originators whether they work for small independent companies or banks--no originator can be paid on the terms of the loan. However, the banks themselves can still receive the service release premium, which is the interest rate spread on the sale of the money. They just are not allowed to pay it to an employee. Talk about a quick way to improve the bottom line!

The new rule will have a huge impact on all mortgage originations. Remember that the Dodd Frank Bill contains a provision that total origination fees cannot exceed 3% of the loan amount and that an originator receiving compensation from a lender cannot also receive compensation from a consumer. Since this applies to all originators, let's look at how this would work in real life. Originator A works for Bank X which is a billion dollar corporation. The law says that he cannot receive compensation from the lender and also from the consumer. The law also says that he cannot be compensated on the terms of the loan except as a percentage, but he can be paid based on factors such as quality of loans produced, volume of work, etc. Bank X gives Originator A a base salary. Therefore, he cannot be compensated by the consumer. However, if he works hard and produces good quality loans, he could be eligible for a quarterly bonus.

The new rule specifices a "safe harbor" for loans with the lowest interest rate, "no risky features," and the lowest total dollar amount of points and fees. What does that mean exactly? After all, the lowest dollar amount of points and fees would be zero. To be in compliance and to be eligible for the safe harbor provisions, Bank X needs to publish one rate per day for each credit score tier. Persons with a 620-640 receive rate such and such, persons with a 640-660 receive rate such and such and so forth. Bank X also needs to publish one set of closing costs for each borrower--sort of back to the old idea of a one fee loan. That way, they can demonstrate that they have provided the consumer with the best available loan that day.

Now, Originator B works for himself. He has been an independent mortgage broker for 15 years. Each day he receives multiple rates from multiple lenders. He does not consolidate these into one sheet. He knows that Lender X will close certain borrowers more easily than Lender Y. Lender Y is offering him a pricing special of additional yield spread premium to earn his business, and even though he now has to credit that to the consumer, he can use that pricing incentive to offer a lower interest rate to consumers who qualify which helps him to woo business when he competes against Bank X.

Originator B does not get a salary from anyone. He has to pay for his office space, his computers, his phone lines, his Fed Ex bill. Unlike Originator A, he does not have potential borrowers coming in and out all day long, so he has to pay for whatever advertising he does to bring business in. He has to pay for memberships to organizations that might allow him to network and make contacts. He has to pay any employees who work for him. And unlike Originator A, he has to pay self-employment taxes.

Under the new rule, Originator B also cannot receive compensation from the lender if he receives it from the borrower also. But he cannot be paid on the terms of the loan, except just a percentage of the loan amount--the loan origination fee. The Dodd Frank amendment says that a borrower can be charged up to 3% in origination fees, but what borrower is going to pay 3% in loan fees? On a $200,000 loan that would be $6000.00. Most borrowers don't have that kind of money, and the ones who do can go over to Bank X and get a loan which will probably have no origination fee at all since Originator A is on a salary. Originator B used to be able to compete effectively because the lenders he sold to did not have to pay the cost of office space, or phone lines, or Fed Ex bills, for the areas where they had mortgage brokers, so they could offer him a better rate than Bank X and he could pass that rate on to his customers. And, he made a nice living off of the spread on the money, which the consumer did not have to write a check for at closing. The consumer got a low rate, and Originator B got a good payday. But now, with the new rules in place, Originator B will have to be able to prove that for every customer who walked in the door, he offered the best rate and the lowest cost loan based on all of the lenders he works with at any given time. That is virtually impossible to do, because it involves checking every lender for rates and costs without regard to other factors such as timeliness in underwriting or ability to underwrite a particular loan product.

But even if Originator B could pass this litmus test, which he cannot, he is going to realistically be getting paid 1% of the loan amount. And from that sum, he is going to have to pay the office rent bill, the phone bill, the utilities, the Fed Ex, the employee and the taxes. With whatever is left he might be able to buy some food and pay his own mortgage--maybe. Maybe some of his lenders could offer some type of a bonus system for quality and volume, but meeting the numbers to qualify for any such bonus would be nearly impossible for a broker who works for more than one investor. So Originator B is out of the game. No, Adam, it's not going to be at all the same as it is now.

As I read commentary on the Mortgage News Daily website and on numerous other websites on these issues, one point that bothers me is that there are always a lot of posted comments that these restrictions are the fault of the corrupt mortgage community--that we brought this on ourselves. I do not believe this either. No one would argue that the banking giants who are going to be taking over the origination industry are doing so because they are particulary virtuous, and I think it is equally false to say that our industry is ending because it is especially corrupt. Rather, our industry was remarkably successful. In 2006, more than 65% of residential mortgage loans were done by a mortgage broker. The last statistic that I heard this year stated that mortgage brokers now have only 12% of the market. We went from being an integral part of the mortgage delivery system to largely unnecessary--particulary as banks have consolidated and now have more branches in more locations. (Since they are paying for the brick and mortar anyway, why pay a broker too.)

I believe, rather, as I wrote last Friday, that what we are seeing now is part of a move to eliminate the independent business person completely and to force originators to work for other institutions. Michael S. Barr discusses the role of the mortgage broker in some depth in his paper, Behaviorally Informed Financial Services Regulation. In this paper, Barr writes, "An alternative approach to addressing the problem of market incentives to exploit behavioral biases would be to focus directly on restructuring brokers' duties to borrowers and reforming compensation schemes that provide incentives to brokers to mislead borrowers." Although he acknowledges that most states require that brokers disclose in writing that they are independent business people and not agents of the borrower, Barr says that this is not sufficient. "Brokers cannot be monitored sufficiently by the borrowers...and it is dubious that additional disclosures would help borrowers be better monitors...in part because brokers' disclosures of potential conflicts of interest may paradoxically increase consumer trust...Thus, if the broker is required to tell the borrower that the broker works for himself, not in the interest of the borrower, the borrower's trust in the broker may increase: after all, the broker is being honest!" Barr mentions the national licensing laws (the SAFE Act had been signed into law months before he co-authored this paper) but he says that even this is not enough. His ultimate solution--"we need to shift from a lender-compensation system to a borrower compensation system, and we would need a regulatory system and resources to police the fiduciary duty. An interim step with much lower costs and potentially significant benefits would be to ban yield spread premiums." As you may recall from yesterday's post, Barr was a University of Michigan Law Professor when he wrote this paper; today he is Assistant Secretary of the Treasury for Financial Institutions and a huge proponent of financial reform.

As in Grisham's novel, where the government has put the broker in a position to be eliminated, so here the government is eliminating the last few independent brokers who have survived--survived market meltdowns, loss of income, testing requirements, tough underwriting standards, increased costs of doing business. The only way to finally get rid of us is to make it financially impossible to stay open.

But the ultimate extinction of the broker does not come without a cost. The reason that 65% of mortgage loans were done by brokers in 2006 was not that we were such clever crafty people who hypnotized our borrowers. It was that we offered personal service and flexibility which are largely missing in an on line or institutional experience. The fact that the broker was a self-employed commissioned person who had bills to pay and got paid only if the loan closed gave him or her an incentive to really go the extra mile for the borrower. A salaried employee of a huge bank is not going to have that same incentive. Nor are they going to offer the option of moving a problem loan to a different lender while keeping it in house--something which can save a borrower hours of time and legwork.

People may not think so today, but they're going to miss us when we're gone.

1 comment:

  1. Best explanation I have read and I am on about number 200. It blows my mind that most brokers really think this changes nothing for them. I was a broker for 10 years and have been a BM for a banker for the last 3. It is a sad day, but will be worse once everyone truly understands that, this time, chicken little is not lying.