Yesterday I started the first of a three part series about the top three reasons that the new Fed Rule on loan originator compensation, being implemented for all applications received by lenders after April 1, 2011, will ultimately kill the independent mortgage brokers. I talked about the first reason--the anti-competitive nature of the rule which favors banks heavily against small origination companies.
Today I want to talk about the second reason that that rule will kill brokers. Reason # 2 that the mortgage broker will not survive the rule is that the rule is incomprehensible. Although there have been multiple requests for clarification about the Federal Reserve's new rule, those requests have been largely ignored. So as a result, in about five weeks the mortgage industry will be attempting to implement a sweeping new rule that it does not fully understand.
The areas of confusion were very apparent yesterday in a conference call hosted by one of my investors. For example, nearly everyone seems to agree that consumer-paid compensation offers the most flexibility for the originator and the most options for creating flexible pricing. In a sale, the seller can contribute to the buyer's closing costs--sometimes up to 6% of the costs, which can include paying the originator's fee in a consumer-paid transaction. However, in the case of lender-paid compensation, the seller cannot pay the originator's fee, because it is being paid by the lender. But, since the Federal Reserve announced last week that brokers must salary their loan officers--or as some companies interpret the rule be a sole proprietor--consumer-paid compensation will not be an option for many small broker shops.
A second area of confusion is going to occur in how to quote interest rates. The originator can still quote above par pricing for the interest rate, but in the case of consumer-based compensation he cannot be paid on it. In the case of lender-paid compensation, the originator can be paid only the percentage that has been agreed upon between the mortgage company and the lender. So in a real life pricing scenario, if the lender and the broker have agreed that the broker will be paid 2% on each transaction, the above par pricing is 2.5% after all adjustments, the extra .5% goes to pay for the borrower's closing costs. Right now, all of the premium is credited toward the closing costs, but the origination fee can vary based on the terms of the loan. In the new world of compliance with the Fed Rule the loan officer's compensation cannot vary from transaction to transaction. So what happens to the extra money? Normally it would go to the consumer, but what if the seller is paying all third party closing costs? (In a case like this the seller contribution would have to be reduced so that the premium could cover the balance of the closing costs.)
Additionally, the lender-paid compensation packages will include dollar amount caps with lenders. So even though the originator has an agreement with the lender to receive 2% on each transaction, if his contract has a $6000.00 cap, on a $417,000 loan he would receive only $6000.00. The difference between the 2% and the $6000.00 will be credited to the borrower or else the originator will need to select a lower interest rate.
With interest rates on the rise and fees that affect the interest rate also rising, I do not see pricing the loans with additional premium pricing to be credited toward the borrower becoming a big issue. As I discussed yesterday, I believe that the likelier outcome is that broker interest rates are going to be higher than bank interest rates on the same transaction. This will create a very different dynamic in the lending world, since traditionally brokers offer lower interest rates than banks which has historically made them a more attractive option for the consumer.
One major change in the new truth in lending rule is that all compensation will become part of the APR, so the lender's compensation to the broker will be included in APR charges. As a broker community, we have argued consistently that the spread on the interest which paid to us by the lender is calculated as part of the interest rate so it is included in the APR now. However, up until last year, the compensation that we received from the lender did not show up on the good faith estimate. Beginning in 2010, RESPA required that we show the total amount of the compensation we plan to receive on the transaction on the good faith estimate and then we credit the amount paid by the lender back to the borrower. So the bank's estimate with one percent origination fee is going to offer a lower APR than the lender paid transaction with a 1.5% or 2% fee paid by the lender. Both the interest rate and the APR will be higher on the brokered deal.
Under the Federal Reserve's new rule, however, the originator cannot be paid by both the borrower and the lender, but even if he is being paid solely by the lender, he must show the amount of the compensation on the good faith estimate. The dollar amount of the compensation is not shown as an origination fee or a processing fee, because in a lender-paid compensation environment, the broker cannot receive origination or processing fees. But the fee is shown on page 2 of the good faith estimate. This is going to cause a lot of confusion for the borrower.
Last year, when HUD changed the good faith estimate from a one page form which included the borrower's funds to close and total estimated monthly payment to a three page form which does not show total funds to close or the total monthly payment, borrowers became very confused. I used to be able to prepare a good faith estimate in 15 minutes while my borrower waited at application. Now, I email them an estimate after loan application to give myself time to double check all numbers. But even with my notes clarifying their monthly payment and funds to close and explaining that the owner's title policy is going to be paid by the seller as spelled out in their contract, borrowers are still confused.
Imagine the level of confusion two months from now when the interest rate is a lot higher than the rate would normally be, and the percentage of compensation that we are receiving from the lender is on the good faith estimate, but the fee is not negotiable. Isn't the purpose of showing the borrower how much the originator is getting paid on the transaction so that the borrower can negotiate for better terms? But in the case of the broker who is receiving lender-paid compensation, the borrower on a $250,000 loan whose originator is receiving 2% in lender-paid compensation will come to understand that the originator is making $5000.00 on a transaction and cannot even pay the lock extension fees--even if the delays are the perceived fault of the originator. Talk about an exercise in frustration!
Some lenders are offering to allow brokers the flexibility to select consumer-paid or lender-paid compensation at the time that the transaction is registered. I do not believe that this practice will stand up to scrutiny since my own understanding of the new rule is that originators are supposed to have written agreements regarding their particular manner of compensation which stay in place for a period of time--probably quarterly. But suppose the lenders do continue to allow originators to choose between borrower- paid and lender-paid compensation at the time of the loan registration. A broker will have to present choices to the borrower for consumer- or lender-paid compensation at the time of loan application as part of presenting loan options. (I will discuss the hazards of this for the broker tomorrow.) Then the broker issues a good faith estimate to the borrower which is a binding contract on the broker's part. Remember that under the current RESPA reform rules, a new good faith estimate can be issued only in the case of a valid changed circumstance, and changing lenders does not qualify as a changed circumstance. Further, the loan originator's compensation cannot increase from the original amount quoted, unless the loan amount increases. So if the originator sells the borrower on lender-paid compensation, but then that investor turns down the loan, what is the originator to do? He cannot go back and redisclose a new good faith estimate with a different compensation plan, so all he can do is deny the application, unless he has a second lender with an identical or lower compensation plan that he can send the loan to. Later this year, the good faith estimate and the truth in lending are supposed to be combined into one new form as part of the Dodd Frank bill, so when this new form emerges some of these problems may be corrected in the rule making, but as the rules stand today, I do not see many avenues for resubmitting problem loans.
The Federal Reserve Rule is being implemented subject to interpretation by a lot of different parties, and this is going to lead to regulatory problems and enforcement issues. Broker shops tend to be small and to have limited budgets to pay attorneys for help and guidance. In the past, we in the broker community have relied largely on guidance from our lenders about how to implement new rules. But now that the SAFE Act is in place, we have a national loan originator registry, and we will be subject to the Consumer Financial Protection Bureau, we can be held responsible for compliance individually. Our conference call yesterday started with a disclaimer that the lender was not giving us legal advice and that we should consult with an attorney to make sure that we are individually in compliance. But most brokers are not going to do that, nor can they afford to. So brokers with multiple relationships with multiple lenders who are allowing various types of compensation agreements may be held individually responsible for being out of compliance with the Federal Reserve's rule regardless of whether they met the guidelines of their individual lenders. That's the problem with a vague, incomprehensible new rule--now matter how well intentioned the broker-owner is, it almost impossible to know whether he is really complying with it until it is too late.
Tomorrow, I will examine the third reason that the Fed Rule will kill the mortgage brokers.
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