The Top Three Reasons the Fed Rule Will Kill Brokers-- Part II

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.

For related posts, go to http://www.frontier2000.net/.

The Top Three Reasons the Fed Rule Will Kill Brokers Part I

If the new Federal Reserve Compensation Rule were ever the subject of a Hollywood movie--which it won't be--the most appropriate title I can think of would be "10 Things I Hate About You."  Now that our industry is only about 5 weeks away from implementation of the new rule, we are starting to receive some training on how loans will be done in the new world of lending as defined by the Federal Reserve. I sat through my first conference call this morning on the how to comply with the new rules, and I now have more questions than I did before I started.

When the Federal Reserve Compensation Rule was finalized last August, many of us predicted that the rule spelled the end of the mortgage broker industry.  Since that time, a number of industry participants have assured us that such predictions are alarmist--mortgage brokers will continue to be a vital part of loan origination and we can emerge from the wreckage of the last three years stronger than ever.  The reassurances of these "experts" are so comforting that they are easy to believe. But having completed this preliminary training, I can give you three reasons that the Fed Rule will be the end of the mortgage broker industry.

1.  The Rule is tilted completely in favor of banks and larger correspondent lenders, so much so that it destroys any concept of competition.  Remember that the rule states that no loan originator can be compensated by both the lender and the the borrower.  That original wording led brokers like me to believe that our compensation would be coming from the consumer.  However, last week the Federal Reserve issued a clarification on this point.  Under the new clarified version of the rule, the borrower can compensate the loan originator only if he is salaried (or as some companies interpret the rule if he is a sole proprietor with no loan officers working for him.)  Small broker shops cannot afford to salary their loan officers.  In fact, the mortgage broker industry has been successful because it revolved around commissioned sales people.  But in this new world, the loan officers must be salaried in order for the consumer to pay the fees. 

It turns out that there are several benefits to the consumer being able to pay the fees.  For one thing, if the borrower is charged an origination fee, the originator can reduce the fee in order to correct problems with the good faith estimate, or to pay fees that were not quoted properly.  None of that is possible if the lender pays the loan originator. 

According to the Fed Rule, the loan originator cannot be paid on the terms of the loan.  However, if the bank or lender is selling a closed loan, the bank or origination company can be paid on the service release premium (which is the same as the yield spread premium).  They can keep that money--they just can't pay it to the loan originator.  The loan originator has to receive a set amount of compensation from each borrower; if the borrower is paying the loan origination fee, the percentage of fee must be exactly the same for all borrowers.  So a salaried originator working for a bank can charge a 1% origination fee to the consumer and the bank can keep the spread on the sale of the money.  Isn't that basically the way it works now?

But for the independent mortgage broker the change is huge.  A mortgage broker who cannot salary his loan officers or who is not set up as a sole proprietor cannot receive any compensation from the consumer.  He must set up a payment agreement with each of his lenders.  That agreement cannot be renegotiated for a set period of time, such as quarterly. And since all compensation must come from the lender, it must be charged to the consumer in the form of a higher interest rate, but since the percentage of compensation is the same on all loans, the interest rate is increased proportionately the same for all loans. 

Lender-paid compensation cannot be reduced for any reason.  The originator cannot use it to lower the consumer's costs or to correct any discrepancies on the good faith estimate.  The good faith estimate allows only a 10% tolerance for third party fees.  For example, I recently did a good faith estimate for a long-time borrower of mine who recently moved to Dallas, Texas.  The contract says that she has to pay for her survey.  Since I do the majority of my work in El Paso, Texas, where surveys cost $216.50,  I looked on line for a surveyor in Dallas.  I found a company that looked professional and appeared to service the Arlington area where she is moving, and I used that company for my written provider list.  Since the costs for home inspections were quite a lot more than they are in El Paso, I surmised that a survey might also be more,  and since I know that the house she is buying has a comparatively large lot, I estimated her survey fee at $400.00.  After I sent the estimate to the borrower, I asked her about ordering the survey, and she said that her agent had recommended that the title company order it.  Interestingly, when the survey arrived from the title company a few days later, the company was the same one that I had quoted on my provider list and the actual survey cost was $390.00.

But what if I had quoted the El Paso fee of $216.50?  In that case I would have been responsible for paying any amount over a 10% increase against what I quoted.  In a world of lender-paid compensation, which is the only type of compensation that I can legally receive under the new guidelines, I am not allowed to pay for these kinds of corrections.  And legally, my borrower is not allowed to pay for them either.  So the lender has to pay for the corrections, and to do that they have to set up a special fund to pay for items such as lock extensions, missed tolerances, etc.  Whether or not they use that fund to pay for one of my specific missed tolerances will be determined by my overall performance with them, including number of closed loans, quality of loans, etc.

Most of the time corrections to the good faith estimate can be avoided simply by double checking all of the fees carefully ahead of time, but what about lock extensions?  Missed closing dates can be unavoidable even when the originator does all of the components of his job properly.  Take my borrower in Arlington again.  At the end of January, she requested that I do her loan for her in Arlington.   I sent her a loan package to sign, which she sent back around February 3rd.  Since her husband is salaried and they have excellent credit, I was able to complete all of my due diligence and get her underwriting approval back before February 11--she told me when she asked me to do the loan that she wanted to close February 24.  However, her closing on her home in Arlington is conditional upon her selling her home in El Paso, and her buyer has not closed yet.  Originally, her buyer was supposed on February 14; that closing has now been delayed until February 25.  I can extend her lock, which expires March 3, for three days free but then the lender starts charging. Under normal circumstances, a broker will lower his fees to cover a lock extension for a long time customer so that everyone walks away happy.  But what if we were in the new world of lender-paid compensation and she refused to pay for the lock extension since the circumstances that will cause it are beyond her control?  I would not have the option of paying for it, and if the lender determined that they were not going to pay for it, the deal would be dead.  The only way to prevent this type of situation is to require longer lock periods to start with.  And that is what we will have to see--lock periods that are 45 days or longer will probably become standard for brokered deals.

Now the problem with that is that in a competitive situation, the brokered loan now has a much higher interest rate.  Remember that the salaried originator working for a bank can charge a 1% origination fee and he can still pay for items like lock extensions.  Since he can charge the borrower directly, all of his fee is not priced into the interest rate, so he can afford to offer a shorter lock at a lower interest rate which is going to help him capture that deal in the first place.  The independent broker has to figure out how set his initial compensation that he is getting from the lender at a percentage that will allow him to keep the doors open while still allowing him to compete.  And since the compensation cannot be changed for a set period of time--we all assume that the period will be quarterly--he has to try to predict the future interest rates to figure out where to price himself.    Then, when we add in factors such as longer lock periods in a rising interest rate environment where we are today combined with rising fees imposed by Fannie and Freddie, the broker has probably priced himself out of the market.

Tomorrow, I will examine the second reason that the Fed Rule will kill the mortgage brokers.

For related posts go to http://www.frontier2000.net/