Commentary Article:
One of the definitions of the word “inherent,” according to the Merriam-Webster Dictionary is “belonging by nature or habit.” “Conflict of interest” is defined as “a conflict between the private interests and the official responsibilities of a person in a position of trust.” In plain language, an inherent conflict of interest would be present when someone has to choose between what is in his best interests versus the best interests of a client. Conflict of interest is a consistent, ongoing problem in the mortgage industry.
People familiar with the mortgage business know of the current mortgage crisis, but they may not understand the real cause. The Real Estate Settlement Procedures Act of 1974 (RESPA) attempted to regulate the real estate and mortgage industries, especially in terms of costs to homebuyers and borrowers. For example, Section 32 of RESPA states that the total closing costs to borrowers may not exceed 8% of the loan amount of the mortgage. That figure makes perfect sense for a home that costs about $60,000; however, anything over that selling price opens the door to all sorts of things. Anything below that amount, and a mortgage company doesn’t want to handle the loan because it won’t get paid. All in all, it is my belief that RESPA has been a dismal failure and is partially responsible for creating the crisis we see today. The State of Texas did attempt to make improvements with what are known as the A6 regulations. These regulations have an impact on refinance loans, particularly cash-out refinance loans. A borrower may not borrow against more than 80% of the value of the home, and the closing costs for the loan may not exceed 3% of the loan amount.
To begin, perhaps it would be a good idea to explain the various entities involved in the mortgage process. The company that takes applications and assembles a loan file is not usually the lender. Lenders are the major banks around the country. Some have their own in-house mortgage departments. They also have what are called “wholesale divisions” that allow mortgage companies or mortgage brokers to place mortgages with them. As an example, Countrywide Home Loans is a lender that has its own branches and loan officers, but it also has a wholesale division that is used by mortgage companies and brokers. Most of the mortgage companies out there are not, themselves, lenders. Unfortunately, the mortgage is not being purchased on a wholesale level and sold on a retail level. Rather, it is merely a commission situation.
Can borrowers get lower rates from mortgage companies or from banks? Both and neither. Borrowers can potentially get a better rate from a mortgage company or broker because brokers have a great deal of leeway in terms of pricing. Bank pricing structure, however, tends to be more rigid. That flexibility with mortgage brokers, however, can go in both directions–in favor of the borrowers, and against the borrowers.
In nearly every other industry that involves sales–furniture, clothing, automobiles–there is a set commission structure for the salesperson, usually in the 10% range. When you go out to buy a car and the car costs $22,000, you might negotiate the price down to $20,000. The salesman gets paid $2,000 on that sale. Pretty simple, really. In the mortgage industry, on the other hand, words like “salesman” and “commission” have been transformed into other words, although the function is the same. Borrowers deal with a loan officer (licensed in one way or another) who will be compensated based on a yield spread premium and overage. The loan officer is a salesman, the yield spread premium and overage is the commission. The changing of the words does not alter the function of the people or the system; rather it muddies reality. Added to that confusion is thirty-plus pages of documentation called “disclosures” that borrowers must sign which, theoretically, explains their rights and the obligations of the loan officer. How many borrowers actually read or understand what they have signed? Almost none. In fact, in Texas, there is an additional three-page disclosure which merely restates (and very poorly, in my opinion) the two similar disclosures required by federal law, although at least the Texas disclosures include the word “commission.” A bit more honesty.
In nearly every instance where one of my borrowers is signing disclosures–a thirty-minute tedious process–I will say, “What is Yield Spread Premium? It is a fancy word for ‘commission.’ After all, in banking we can’t use words like ‘commission,’ can we?” No, we can’t, but we should, because it would be more honest.
What, then, is yield spread premium and overage? In the mortgage industry, those terms are translated into (inside the industry itself) “back end” and “front end.” Are you getting confused yet? Let’s see if I can explain it so it becomes understandable. If you have ever bought a home and taken out a mortgage loan, you saw the “front end” part at the very beginning. You were given a document called a Good Faith Estimate. That showed a rate, which is merely a guess until the loan application has been submitted. It also showed some other things: Origination Fee and Mortgage Broker Fee. Those two things are identical; there is no difference in them, so if a mortgage broker or banker is charging a 1% origination fee and a 1% mortgage broker fee, the company is making 2% on the front end of the loan. It goes right into the mortgage company’s pocket. In addition, there may be some other interesting fees like an Application Fee, Loan Administration Fee, File Review Fee, Processing Fees, and other things. These also go into the mortgage company’s pocket, although the processing fee is usually paid directly to the processor. That’s the person who takes all the documentation, assembles it into a file in the order requested by the lender, and sends the file where it needs to go.
You know about the front end fees in the beginning. Ah, an aside. There is also a line on the Good Faith Estimate labeled “Discount Points.” Theoretically, if you wish to buy down your interest rate, this is where you would see that entry, right? Wrong. An entry under Discount Points goes to the lender, not the mortgage company or broker, so mortgage companies are not going to put anything there, even if you buy down your rate. They will plug it into the origination fee or mortgage broker fee. Why? Because they are crediting that toward their back-end fees.
What are back end fees, exactly? You will not see those, and in nearly every case not even hear about them, until the loan closes. They will appear on the HUD-1 Settlement Statement under Compensation to Mortgage Broker. This is the yield spread premium. How the yield spread premium is calculated is what creates the conflict of interest. This is the commission paid by the lender (the bank to which you will make your payments) to the mortgage company that originated your loan. Originated, in this case, means took the application, looked at the credit report, assembled all the documentation, and submitted the loan to a lender.
In all likelihood, the things I’m about to explain are going to make people angry. It will certainly make mortgage brokers angry, because I am opening a Pandora’s Box and divulging deep, dark secrets. Sadly, it will also make borrowers angry. Sadder yet, there is more to come.
In nearly every wholesale loan, things begin with a par rate. The par rate earns the mortgage company nothing. When I began working in the mortgage industry in Florida, my first job was with a company that advertised par rates. It never intended to actually give a borrower the advertised rate. It was a bait-and-switch tactic. I didn’t last very long with that company. The managers weren’t very happy with me when I said, “But you’re lying.” Any person with common sense would say, “Well wait, I would just change mortgage companies if you didn’t get me the rate you promised.” Think so? What if you paid a $350 application fee to start the process? Would you walk away? No, because you wouldn’t want to lose that $350. That’s how the company hooked its victims.
As an example, let’s say the par rate for a mortgage loan is 6.50%. At a rate of 6.75%, the mortgage company earns a 1.00% yield spread premium (commission). This example is not necessarily an everyday actuality. At 7.00%, the company earns 2.00%. At 7.25%, 3.00%. Here is the conflict of interest. Who is the mortgage company working for, its clients or itself? Who is the loan officer working for, his clients or himself? Who is paying the yield spread premium, and for how long? The borrower, in most cases over the course of, thirty years. In hard dollars and cents, it looks like this: $100,000 loan amount, 7.00% interest rate, 2% yield spread, thirty-year mortgage. The principal and interest (PI) payment is $665.30. If the par rate is 6.50%, the PI payment would be $632.07, a difference of $33.23 per month. The yield spread amount is $2,000. The total difference paid over thirty years is $11,962.80. How long does it take to pay for that $2,000 yield spread premium? Five years. Except the borrower keeps paying after that. As long as a loan officer doesn’t have a conscience and money is the sole object, it’s not a problem; however, for those with a conscience, this setup can create an internal struggle that is difficult to resolve.
One company was extreme. It has (or had, it may be out of business by now) a rule of two on the front, three on the back. $100,000 loan. Two points on the front - $2,000; 3% on the back - $3,000. The total was $5,000 earnings on each and every loan. This amount is the maximum allowed by RESPA law. What did this math mean to its borrowers? Higher than necessary interest rates and payments plus high closing costs. It offered no-down-payment programs and worked with real estate agents so that the closing costs were paid by the seller, the 6% seller’s concessions allowed by law. Most of the company’s clients were ignorant of the process and the company kept clients deliberately kept in the dark. In other words, the company literally preyed on its clients. The saddest part of all? Nearly 80% of the company’s loans have gone into foreclosure, meaning those people who didn’t understand the process, but who could have been educated, have lost their homes.
This type of situation leads to a term that has appeared a great deal in the news lately. President Bush talked about it. Congress is talking about it. The term is “predatory lending,” and I offer two examples. The first is with lazy loan officers. It has always been easier to originate a no-document, stated-income loan than a full document A-paper (or good credit) loan. Full document means supplying W2s, tax returns, pay stubs, bank statements, and all the rest. A stated-income, stated-asset loan is a whole bunch less paperwork, fewer hassles, and fewer problems–especially if the borrower has good credit–but at a higher interest rate. Send in the application and credit report. Don’t worry about the borrower. Just get it done. The rate? In today’s world, 8.00% to as high as 13.00%. With some work on the loan officer’s part, the rate could have been much lower. This example is not a common; it doesn’t happen all the time, but it does happen.
The second example is no less serious and has happened far more often. Interest rates are cyclical in nature, like a wave, up and down. The wave peaked in the mid-1980s with interest rates in the high teens. It bottomed out in 2002 and 2003–high 4% to a low 5%. It is now on its way back up. Will it get to the high teens again? It might; there is no way to predict. Now consider the two major categories of mortgages: fixed-rate mortgages and adjustable (or variable)-rate mortgages. When the rates were going down (1980s to 2002), an adjustable-rate mortgage makes sense because the rate would adjust downward. Perhaps someone started with a 14% interest rate, and then five years later, it went down to 11%. If, however, someone started an adjustable rate mortgage in 2005 at 6.00% and now, two years later, the rate is about to adjust, it will be 8.00% or higher. To put someone into an adjustable-rate mortgage knowing full well that rates are on an upward swing is predatory lending–from two different perspectives. First, the loan officer is knowingly putting a borrower into a mortgage program that will cause the borrower harm–increasing rates. Second, the loan officer has built a second loan into the process hoping the borrowers will come back and refinance the loan two or three years later. It is not the companies and brokers who are the only guilty parties here. The lenders have created adjustable-rate programs with rates that were slightly lower than the fixed rates counterparts.
Do I ever discuss refinancing with a client? Of course I do. When? When a borrower can qualify only for a subprime, high-interest loan. My attitude is this: This is all you qualify for. There is nothing else that can be done; however, one year from now, with twelve consecutive on-time mortgage payments, you will probably qualify for a much better, good credit rate. In such a case, it makes sense to refinance. Live with the bad loan for one year, and then get the good loan. However, neither of those is adjustable. In other words, there is no way the borrower could end up in a worse position.
The mortgage business is, in my opinion, unnecessarily complicated. There are many programs available through Fannie Mae and Freddie Mac that offer incentives to first-time homebuyers and even second-time homebuyers. There are bond programs available. There are special programs from one or two lenders that can help people who might not otherwise qualify for a mortgage. The average loan officer understands only a few of these programs, what is called in the industry chocolate and vanilla. Being typical human beings, they sell what they know and nothing else. If there is a problem with the mortgage industry, it is mostly that loan officers are in a position where greed can so easily become a factor. As one of my mentors in business development once taught me, “Money does strange things to people.” It certainly can. It certainly does.
Are there solutions? Yes. The first is being an educated consumer. You, as a borrower, have every right to ask a loan officer how much he or she intends to earn on your loan. If the answer is, “That’s confidential” (a nice way of saying “It’s none of your business”) go elsewhere.
Second, there are a handful of former loan officers who are true mortgage consultants. They are hired by borrowers and paid a set or hourly fee. Their job? To find the very best mortgage program available. They have established relationships with a number of mortgage companies or brokers and negotiate the best possible program available for their clients. These mortgage professionals query the mortgage companies, collect all the documentation, and work with the borrower, allowing the broker to focus on submitting the loan and getting it approved. In advance, they establish how much the mortgage company intends to earn and require verification when the loan rate is locked to “prove up” exactly what the mortgage company or broker is earning. There is no conflict of interest because the consultants are not being paid from the proceeds of the loan.
The third solution is reform in mortgage-lending law. This action is sorely needed. How it will come about is hard to say. I fear that it will be much like other bureaucratic fixes. The focus will be on the immediate crisis, with little or no consideration for long-term impact.
As a borrower, the one thing to remember is this: It’s your money. Whether it is your money in the beginning with overage or over the course of the loan with yield spread premium, it’s still your money. You are the one who is paying, and that gives you the right to know the exact costs involved in obtaining your mortgage.
Patrick Spithill is a business consultant, speaker, and author who educates consumers about mortgage lending. As a writer, he has been published in Water Technology, Reseller Management, and other industry-centric publications, with his five-year career as a mortgage loan officer as background. Mr. Spithill can be reached at patrick@bpbusinessconsulting.com or 432-847-7728.