Monday, April 18, 2011

Fed Aims at Mortgage Fraud, Shoots Housing Market in the Gut

The problem with mortgage fraud wasn't broker compensation: it was the ease of the fraud and the incentives throughout the food chain for collusion. New Fed rules simply wipe out competitors to the "too big to fail" mortgage banks.



Why are we not surprised that the Fed took aim at mortgage fraud and ended up shooting the housing market in the gut. Here's a simple guide to what's good and bad for housing:


Things which makes it easier and cheaper to borrow money: good.


Things which make it harder and more expensive to borrow money: bad.


And that's the fundamental problem with the Federal Reserve's new regulations crimping mortgage broker compensation. Unless we expect mortgage brokers to take vows of poverty, then the system has to allow legitimate brokers to get paid in accordance with the amount of work the loan requires to get funded.


By severely limiting compensation, the Fed has basically wiped out small brokerages and lenders, reducing the availability of mortgages to a handful of--you guessed it--too big to fail banks, who already control the majority of mortgage origination.


The Fed's ill-advised "reforms" simply act to further consolidate an already concentrated market, creating what amounts to a mortgage cartel by snuffing out smaller competitors in the mortgage market.


The goal of limiting mortgage fraud is necessary and laudable--the point here is that limiting compensation is like chopping off a toe to fix a tooth ache: the problem was lax underwriting rules, inadequate/zero oversight, fraudulent appraisals and ratings of mortgage-backed securities, etc. etc.


The Federal Reserve Board says that its regulatory goal is to “protect mortgage borrowers from unfair, abusive, or deceptive lending practices that can arise from loan originator compensation practices.” The basic idea is to prevent loan officers from steering borrowers into riskier types of loans or a higher than average interest rate to make a higher commission.


Officially titled “Loan Originator Compensation amendment to Regulation Z,” The new rules apply to mortgage brokers and the companies that employ them, as well as mortgage loan officers employed by banks and other lenders.


Since most of us only deal with mortgage loan origination fees when we buy a home or refinance a mortgage, the average citizen will have a tough time sorting out the often-arcane issues at stake. But the bottom line is straightforward: the already-limited mortgage market is about to become more limited, as small mortgage brokers are being shoved out of business. Call it “unintended consequences” or a cloaked plan to channel more of the mortgage business to the “too big to fail” big banks, but regardless of the motivations, the rules end up limiting consumer choice and making it harder for home buyers to get a loan.


That's bad for housing in two ways: limited competition drives costs up, and marginal buyers will find nobody wants their business because it's simply not worth the compensation allowed by the Fed's new rules.


One size does not fit all--except in a Centrally Managed Economy (TM, Federal Reserve).


This is yet another case of closing the barn door after the horses have already left: the riskiest subprime-type mortgages that were the root cause of the problem have largely vanished from the mortgage market.


Since the rules largely apply to small lenders and brokers who must sell the mortgages they originate to larger banks--most banks and other direct lenders, including big mortgage companies that function like banks, are exempt from the new regs—then the limits will weigh entirely on smaller independent players.


Critics, including U.S. senators David Vitter and John Tester, observe that this will further concentrate a market which is already dominated by mega-large banks. According to the senators, two banks already originate 43% of the nation’s mortgages. (Can you spell "cartel"?)


What the regulations do is set some ground rules--consumers must be offered the lowest possible interest rate and fees for which they qualify, for example--and limit loan officer and broker compensation in several key ways.


“The loan originator may not receive compensation that is based on the interest rate or other loan terms.” In other words, a lender can no longer pay a loan broker a yield-spread premium, which is tied to the rate or terms of the mortgage. Currently, the brokerage firm and the loan officer typically split this rebate, which is typically stated in “points,” where each point equals 1% of the loan amount. Thus a loan origination might earn an $8,000 fee, $4,000 of which goes to the loan officer and $4,000 to the mortgage broker.


Under the new rules, the mortgage broker cannot pass on a part of the commission to the loan officer, who must now be paid an hourly wage or salary. The idea is to remove the incentive of the loan officer to push the consumer into a more lucrative loan, but the result is to remove the incentive to remain in the independent mortgage business.


Mark Helling, a licensed loan officer based in Ohio, summed up the view from inside the industry: “After April 1st, a Loan Officer will have to be paid the same rate whether it is an easy loan that takes two weeks to close or a foreclosed property in need of rehabbing for marginal borrowers that takes three months of work to close. Just when the country needs the most experienced and knowledgeable mortgage professionals to help liquidate the flood of foreclosed homes, the Fed is making it unprofitable for loan officers to accept these deals."


From the point of view of those in the mortgage industry trenches, what the rules do is increase the regulatory expenses of being in sales but eliminates the commissions that are the lifeblood of any sales enterprise.


“Prohibits a loan originator that receives compensation directly from the consumer from also receiving compensation from the lender or another party.” In other words a loan originator cannot collect payments from both the consumer and the lender in a single transaction. If a broker is paid a commission by the lender based on the loan amount, then the broker is barred from charge the borrower “points” or fees for the loan processing.


This prohibits loan officers from paying borrowers’ fees or issuing them a credit from their own commission. This has been a common practice within the industry, and from the inside perspective, it that has offered a flexible way to lower borrower’s costs.


These major regulatory changes are being made in the service of fair lending practices, but to those seeing their livelihoods threatened, it looks like a sledgehammer is being used where a flyswatter would have sufficed.


“As far as trying to protect consumers from those seeking to charge a higher interest rate, with all of the competition out there for mortgage loans,” Helling observes, “all a consumer has to do is check one or two other banks and they can quickly find out if they are getting a fair deal or not.”


The rules will also interact in potentially harmful ways with the massive Dodd–Frank Wall Street Reform and Consumer Protection Act, the most sweeping financial regulation since the Great Depression.


At issue is section 1413 of the Dodd-Frank Act, which states that any violation of the loan originator compensation rules will offer the borrower a “defense to foreclosure” for the life of the loan.


In other words, if a delinquent borrower can go back and find some violation of the compensation rules in his/her mortgage origination, the lender is effectively barred from foreclosing on the borrower’s loan.


Given the risks this presents to banks, many observers, including the two senators, expect the large banks which typically buy mortgages from independent brokers and small lenders will shun these mortgages. Why buy a mortgage which could go sour via default that could preclude foreclosure as a remedy? Talk about putting a bullet in the housing market when it's already down: the new rules create huge disincentives for banks, too big to fail or otherwise, to buy independently originated mortgages.


These rules will poison the housing market in several ways. If mortgage brokers can no longer make enough in commissions to stay in business, then the mortgage options for home buyers will shrink. The most productive loan officers will find reduced incentives to risk remaining independent, and so there will be less competition offered to the big banks which already dominate the industry.


What happens as mortgage sources and competition dry up? Mortgage costs rise, and marginal buyers will be shunted aside as unprofitable customers.


The need for carefully thought out regulation has been made painfully apparent by the excesses of the credit and housing bubbles, but squashing legitimate independent loan originators and further concentrating the mortgage industry into the hands of the “too big to fail” banks does nothing but hurt the housing market and eliminate the healthy competition to big banks offered by smaller lenders and legitimate mortgage brokers.


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