Last week I looked at various aspects of the new Federal Reserve Rule regulating loan officer compensation and I wrote about two of reasons that I believe that the independent mortgage broker will not survive the rule, which is being implemented April 1, 2011. Today, I am concluding my three part series on this issue with the final reason that I believe that the new Federal Reserve Rule on loan originator compensation will be the death of the independent loan originator.
Reason # 3--the new Federal Reserve rule governing loan origination is unrealistic and does not consider real world market realities. For instance, to be in compliance with the Safe Harbor provisions of the rule, a loan originator must provide a consumer with loan options from which to choose--these options should include the loan with the lowest interest rate and the loan with the lowest costs and fees. A loan originator working for a depository bank might meet this requirement by showing the consumer the comparative costs of a 15 year loan, and a 30 year loan, as well as a loan with or without discount points. Since the originator works for the institution making the loan, his administrative costs are always the same. Only an originator who is salaried by his employer can receive any compensation from the consumer, so his estimate might show a 1% origination fee, and $700 in administrative and underwriting costs. He could also show an estimate with a 1% discount which raises the upfront fees but lowers the interest rate. And he could show the consumer what the payment will be on a 15 year loan which would bear a lower interest rate
The independent originator (mortgage broker) must also meet the safe harbor provisions by allowing the consumer to "shop" for the lowest interest rates and fees, but because he offers more than one lender he must allow the consumer choices from among the lenders he represents. And under the Federal Reserve's recently clarified rules, the consumer cannot pay any part of the originator's fees unless the originator is salaried or is a sole proprietorship. Since all of the originator's fee is paid by the lender and the fee is not negotiable from transaction to transaction, the lender will price the originator's compensation directly into the interest rate. But, of course, interest rates will continue to vary a little among lenders daily, so Lender A may offer an interest rate that is slightly less than the rate offered by Lender B, but Lender B might have lower administrative fees. The originator will also want to quote a rate with and without discount points.
Once the consumer chooses the particular combination of interest rate and fees that he wants, the originator and the consumer both sign a statement affirming that the consumer has received the loan product that he wants, and then the loan is sent to underwriting.
While this type of a system might sound good to somebody who has never originated a loan, in real life it is ridiculous. What if the consumer chooses the costs and fees from Lender B because they are the cheapest and the originator sends the file in? The originator has underwritten the income (which includes recurring income such as interest and capital gains) and is certain that her figures are accurate. However, the Lender B underwriter disagrees. The underwriter will not allow the capital gains to be used as income because although there is a two year history of receiving them, the amounts vary widely from year to year so even when taking the most conservative figure, the underwriter does not believe that they should be counted as income, so she denies the loan. (This actually happened to me last summer.)
Like any good originator, our loan officer knows that one man's junk is another man's treasure and although the underwriter at Lender B will not do this loan, the underwriter at Lender A is more open-minded. The problem is that she sold the borrower on the lower costs and fees of Lender B, and the borrower signed a statement that this was the loan they wanted. Since the 2010 Good Faith Estimate does not allow redisclosure for changing lenders, and since origination fees can never increase once the original estimate is issued, the loan officer cannot resubmit the loan. She has to decline the loan and the consumer has to go elsewhere in search of financing.
And this is the basic problem with the new rule: In real life borrowers usually don't get the financing they really want; they get the financing they can qualify for. If we all got the mortgage loans we want, we would all have low interest rate, low fee loans and many of us would be in 15 year mortgages, but we know from experience that real life usually does not present us with an ideal situation. Very few of us actually have our dream job, or our dream house, or our dream car, or even our dream mortgage.
Mortgage brokers had a competitive advantage in the market place because when a loan was denied with one lender they could change directions and send the loan out elsewhere to a lender who would actually close it. Even with the new GFE last year, as long as we quoted our estimates so that we always reflected the fees of the most expensive lender we used, we could shop our loans around within the perimeters we had set. The new compensation rule is going make it impossible to make any corrections, and that is going to cause a lot of loan fallout.
Of course, the originator at the bank will also have fallout, but the bank originator has a steady stream of new applications coming in, while the small independent broker does not. That is another reason that a high close ratio is so important, both reputationally and financially to the independent broker. Independent originators do not have big budgets for marketing--their primary source of business is word of mouth referrrals from satisfied customers. And though they may not see a lot of traffic through their doors, as long as they close a high percentage of the business that they do write up, they can have a steady stream of income.
I want to finish this segment up with an illustration that I used last year when the Fed Rule was first published. I have updated it to reflect the information we have today.
Originator A works for Mega Bank. Mega Bank gives him a salary, a desk, a telephone, a receptionist, office equipment and coffee. Mega Bank does millions of dollars of advertising every year, so Originator A's job is to write the loan applications driven in by the advertising. Mega Bank provides Originator A with a rate sheet every morning showing the interest rates and the factors that cause those rates to adjust including credit score and credit worthiness. Mega Bank has one set of fees totalling $850.00 and their computers are preprogrammed to show this combination of fees on their good faith estimates. Under the Fed Rule clarification, because Originator A receives a salary, he can charge an origination fee on his good faith estimate.
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 Mega Bank.
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 cannot receive compensation from the lender if he receives it from the borrower also. Since Originator B is a sole proprietor, he can choose to have the borrower pay him or he can be paid according to his contract with the lender. But he cannot negotiate his compensation contract with the lender on a per transaction basis, so if he chooses to offer the lower upfront costs which are result of being paid by the lender, he may lose the deal to Mega Bank because his interest rate is now too high to be competitive. If he chooses to be paid by the consumer, he is basically going to be limited to a 1% origination fee, since that is probably the most his borrower is going to be willing to pay.
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 Mega Bank 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 whenever he chooses to be paid by the consumer. 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. So Originator B is out of the game. If his lenders turns down the loan, he cannot turn around and send it to a lender who will pay him directly because he cannot change his good faith estimate. If he is being paid by the lender directly, he cannot contribute any funds to correct any fee mistakes at closing. He cannot pay for a lock extension, or cover the cost of a survey. A correction that might have cost him $50.00 or $100.00 in fee reductions previously will now cost him his entire commission because his loans will not close. The loans that he cannot save will come to represent missed payments on the rent and utilities and maybe even his own home and car until he has finally drowned in an ocean of regulation so vast that he simply cannot comply with all of it.
Who is the real loser in all of this? All of us. We hear new statistics daily that we are in the middle of a "jobless recovery" and that housing remains "flat." But no one seems to consider that the recovery remains jobless because small entrepreneurs can no longer make a living in industries where they have spent their professional lives--much less employ others. And real estate remains "flat" because borrowers cannot qualify for loans.
The ultimate extinction of the mortgage broker does not come without a cost. The reason that 65% of mortgage loans were done by brokers in 2006 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. "Leveling the playing field" by making it impossible for all originators to shop loans from lender to lender is not the solution to the deadness of the housing market.
People may not think so today, but they're going to miss us when we're gone.
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