Current Political Climate Prompts Regulatory Reform in the Mortgage Industry

On February 3, 1960, British Prime Minister Harold Macmillan addressed the South African Parliament in Cape Town. Prior to the address, he had spent a month in the British-controlled territories in Africa to assess the struggle for black nationalism in Africa and the independence movement across the continent. In his address he indicated that there was a shift in the current political climate and implied that Great Britain intended to grant independence to most of its African territories. He stated:

“The wind of change is blowing through this continent. Whether we like it or not, this growth of national consciousness is a political fact”.

Since that time, the phrase “wind of change” has been used to indicate a shift in a political climate. In an earlier blog post today, I used this phrase in reference to the current political atmosphere enveloping the mortgage industry. Many still hope there is a possibility to assert self-regulation and, in doing so, stave off a heavier wave of government regulation. I personally feel that this would be ideal, but I don’t believe that it will be possible.

I make that statement considering the fact that there is a widespread belief that the current financial crisis stemmed from a failure to regulate the financial services industry — especially the mortgage industry. As such, strong reforms to financial services regulation are an appealing proposition to many policymakers. Regulatory reforms born in this political climate, such as the proposed Consumer Financial Protection Agency, have in turn caused the Fed to feel pressure to defend its position as a strong regulator.  Congress is currently pressuring the Federal Reserve to address abuses in mortgage lending. The Fed believes that the average consumer is unprepared to negotiate with a mortgage loan originator. Because of the complexity of how mortgage loan originators are compensated, the Fed believes that disclosures alone will not adequately protect consumers.

Consumer advocates and regulators believe that the historical lack of regulation regarding loan originator compensation have created opportunities for unscrupulous loan officers and loan brokers to take unfair advantage of consumers. Market conditions, including marketing methods for mortgage loans, lack of transparency in loan pricing and the complexity of the mortgage origination process create an environment where abuses can occur. As such many feel that the loan originators’ responsibility to the customer has been compromised by these conditions.

Perceived Abuses That Stem From Loan Originator Compensation Practices:

Overages:

• A lender offers its originators the option to quote an interest rate that at an above-par price for a loan wherein the originator may collect a larger commission as a result of closing the loan at the higher interest rate but with no financial benefit to the consumer.
• Consumer advocates have been very critical of overages. The perception is that overages are simply an invitation for a loan officer, trusted by the borrower to provide all loan options available, to simply take advantage of the borrower. The borrower does not know that the loan officer is not offering the best rate his employer has to offer. The loan officer is simply saddling the consumer with a higher-rate loan in exchange for a larger commission.

Yield Spread Premiums (YSP):

• YSP is the amount wholesale lenders pay mortgage brokers upon closing a loan with an interest rate above the par pricing. Critics of the mortgage industry believe that brokers must use YSP effectively to benefit consumers, offering the broker more flexibility in reducing out of pocket settlement costs. Otherwise, the originator can benefit at the expense of the consumer.
• Consumer advocates and regulators perceive YSP as a method for the broker to disguise additional compensation paid by the borrower. They believe the average borrower is not sufficiently experienced or informed to understand how the broker is compensated.

Tomorrow, the Federal Reserve Board is closing its commenting period on Closed-end Mortgages [R-1366], a proposed amendment that designed to revise Closed-end mortgage disclosures to, among other things, prevent mortgage loan originators from “steering” consumers to more expensive loans that are “not in their interest in order to increase the mortgage broker’s or loan officer’s compensation”. It would prohibit payments to a mortgage broker or a loan officer that are based on the loan’s interest rate or other terms.

As a result, a loan originator would be able to receive compensation from either the creditor or the borrower — but not both. In other words, a broker would have to choose between accepting compensation from the lender or the borrower. This could have dramatic impact on how lenders are forced to establish compensation for brokers.

The Federal Reserve board will announce within the next 90 days if the amendment will be enacted. This proposed amendment could have a greater impact than any other regulation in the mortgage industry in the past number of years. The proposed changes could have various unintended negative consequences such as follows:

• Loan originators serving high balance markets, e.g., Paradise Valley, AZ, will suffer significant compensation losses. As a result, many honest loan officers will be forced to exit the business.
• Flat-fee commissions may tend to favor large lenders with strong branding in competing for loan officers.
• Loan officers may be less quality conscious and try to push loans through the system resulting in an increased burden on and cost of underwriting and quality control.
• Borrowers whose loans require more up-front loan originator time – such as lower income first-time homebuyers may have a harder time finding a loan officer willing to work with them.
• Lenders will be exposed to greater financial adversity during down markets.
• Lower income, low loan balance borrowers could suffer a significant negative impact regarding loan pricing and the service they get from loan originators.

Hopefully, the Federal Reserve will consider the deep potential negative impact of their proposed changes and will make prudent decisions that will not cause more harm than the problems that they were originally trying to fix.