Friday, January 7, 2011

New Year; New Interest Rates

In better days, my family and I used to go to a local steakhouse after work on Friday nights.  The steakhouse had been recently purchased by a long-time client of mine who had spent considerable money renovating it to make the decor more modern and to add a state of the art computer system complete with monitors that allowed the servers to adjust customer tickets using touch screens on the walls.  If I happened to be seated a table very close to the wall, I could see that the screens flashed reminders to the wait staff, "Upsell the beverages; Upsell the desserts."

I always laughed when I saw the flashing signs because it was a reminder that in all businesses, the little things count.  If every customer purchased one dessert, bottom line profits probably improved a lot.

In our business, we negotiated interest rates and closing costs with borrowers so that they could finance their home.  For many borrowers, that meant "upselling" a slightly higher rate in favor of less cash up front to close.  More often than not this practice helped the borrower because he spent less money out of pocket and was financing his costs over time.   After all, a small increase to the interest rate spread over a 30 year period caused a very small increase to the monthly payment.  For us as brokers, it meant that we could look forward to a payday from even those borrowers who were not bringing much money to the table.  And for the lender who made the loan, that extra .125% of .25% of a point meant a lot of extra revenue over the life of the loan.

This upselling process was completely voluntary, however.  More affluent, cash-rich borrowers might choose to get the lowest interest rate they could receive and to pay more closing costs upfront.  Since they had the cash, they knew that they could pay upfront to save money over a long period of time.

Much has been made of the new Federal Reserve Rule which goes into effect April 1, which makes it illegal to tie compensation to the terms of the loan--particularly interest rates.  The argument in favor of the new rule is that loan originators will make better loans which are less costly for the consumer since they have no incentive to upsell higher rates.  But on the flip side of that coin, the lender now has no one to upsell their product.

If you really think about what this means in business terms, it is counterproductive to basic business principles. In the steakhouse, the servers had an incentive to comply with the owner's request to upsell the desserts and beverages since a larger tab presumably meant a larger tip.  For the server who persuaded dinner patrons to buy a nice bottle of wine or to indulge in a slice of the triple chocolate layer cake with vanilla ice cream, that sale could pay off in dollars in their pocket.  But what if the owner had programmed the computer screens to read, "Upsell the beverages, upsell the desserts.  But understand that in order to keep you from unnecessarily influencing patrons of this establishment to drink and eat sweets, any gratuity in this establishment shall be computed solely on the price of the entree."   The owner would have had mountains of moldy cake to throw away at the end of each month.

And so it now is with lenders, and ultimately with Fannie Mae and Freddie Mac, those two all-powerful government-sponsored, government-owned entities who set the price of loans.  Since the government took Fannie Mae and Freddie Mac into conservatorship in 2008, both entities have added a number of previously non-existent add ons to interest rates.  And now, in the first week of 2011, Fannie and Freddie are giving us all a little New Year's present by raising the cost of money again.

We all know that interest rates are rising in response to market conditions and have been moving steadily towards 5% for a 30 year fixed rate loan for the past six weeks.  However, the adjustment that Fannie and Freddie did this week, which for most lenders will go into effect Monday January 7, 2011, is not connected to these natural market adjustments.  Fannie and Freddie are basically raising interest rates for all borrowers including those with scores of 740 or higher who had previously been a protected class.  Borrowers with scores of over 740 will see an interest rate adjustment of  .25%  for downpayments of 25% or less.  Those with lower credit scores and smaller down payments will also see interest rate adjustments.  The adjustments are in the form of fees that the lenders have pay when they deliver the loans to Fannie or Freddie, but they are paid for through higher interest rates in the products delivered to the consumer.

This move on the part of Fannie and Freddie is really unprecedented, since the 740 and higher credit score borrower is usually rewarded for the way that they have handled their financial affairs.  By raising the interest rate for borrower making less than a 25% down payment, the agencies are saying that:  1. They no longer particularly value the more affluent borrower; they are prepared to raise money from anyone they can; 2. They recognize that these high quality borrowers don't have any choice about paying the higher rate unless they want to put 30% down.

The supreme irony is that this rate hike is coming courtesy of the same bureaucracy that gave us RESPA reform which was supposed to cut costs to the borrower; the SAFE act which was supposed to eliminate "bad players" from our industry, and the various failed loan modification programs which have been circulating for months.  With all of this focus on cutting costs for the consumer, why do Fannie and Freddie continue to raise their fees?  Very simply, because with the new rules going into effect April 1, interest rate negotiations are going to become a thing of the past.  When compensation and rate cannot be tied together, there is no reason to negotiate rate.  And if there is no possibility of negotiation, there is no incentive on the part of the loan officer to upsell, but there is also no incentive on the part of the lenders to offer lower rates or Fannie or Freddie to offer lower fees.  Competition and negotiation are gone. 

For the consumer who is stuck paying these bills, this is really a raw deal.  At least in the past, the consumer had choices and if he did not like the deal presented to him, he could go elsewhere.  But coupling the Federal Reserve rule with these new rate adjustments from Fannie Mae and Freddie Mac is like charging the dessert and the bottle of wine to the teetotaler who does not eat sweets and then telling him, "Hey, that's just the price of having a steak in this restaurant."  With rates on a steady upward rise, the new fees from Fannie and Freddie are likely to leave a bad taste in nearly everyone's mouth.


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