Chairman Sarbanes and Members of the Committee: I am very pleased to be here today to discuss the problem of yield spread premiums and the Department of Housing and Urban Development's recent Statement of Policy 2001-1, 66 Fed. Reg. 53,052 (Oct. 18, 2001) ("Policy Statement"). Yield spread premiums and related industry practices have become a major problem for American homeowners. Payments of this sort are inherently confusing and serve primarily to raise the cost of home ownership for many Americans, particularly the less educated and the financially unsophisticated, by billions of dollars a year. In my opinion, yield spread premiums represent the sort of sharp practices that Congress sought to prohibit when it enacted the Real Estate Settlement Procedures Act of 1974 (RESPA) more than twenty five years ago. I urge both Congress and the Department of Housing and Urban Development to redouble their efforts to eliminate the substantial and widespread consumer abuses that yield spread premiums have visited upon American homeowners in recent years.
Over the past year, I have been investigating the economic impact of yield spread premiums.(1) A major component of my investigation has been an empirical analysis of a nationwide sample of approximately 3,000 mortgages originated by one group of affiliated lending institutions in the late 1990s. This study constitutes the most extensive empirical investigation of yield spread premiums to-date. In my testimony before the Committee this morning, I would like first to discuss the implications of my study for the Department's Policy Statement and then to propose a number of specific actions I believe the Department should take to prevent abusive uses of yield spread premiums in the future.
The Policy Statement
Let me begin by commending the Department for its willingness to take on an issue as complex as the payment of yield spread premiums. While my analysis of these practices differs from the Department's views in many important respects, I wholeheartedly agree with the Department's initial premise and the premise of the RESPA itself: that real estate settlement practices are an area in which governmental intervention is necessary both to protect consumers and to ensure the efficient operation of market forces.
My comments about the Policy Statement are divided into two parts. First, I will discuss the statement's factual assumptions about the role of yield spread premiums in today's mortgage market. Second, I will comment on several aspects of the Department's legal analysis of how section 8 of RESPA, which prohibits certain kickbacks and unearned referral fees, should be applied to the payment of yield spread premiums.
A. Factual Assumptions about the Role of Yield Spread Premiums
As explained in the Policy Statement, the Department conceives of yield spread premiums as a valuable "option" that "permits homebuyers to pay some or all of the up front settlement costs over the life of the mortgage through a higher interest rate."(2) This method of financing up front settlement costs, according to the Department, is particularly suited to borrowers who are low on cash and "whose loan to value ratio has already reached the maximum permitted by the lender."(3) Based on these factual assumptions, the Department concludes that the yield spread premium is a "legitimate tool to assist the borrower" and a financing option that "fosters home ownership."(4)
As a purely theoretical matter, the Department's assumptions about the role of yield spread premiums are plausible. Homeowners who are short on cash could, theoretically, use yield spread premiums to finance settlement costs. My study, however, offers compelling evidence that yield spread premiums are not being used in this way.(5) Rather, the manner in which yield spread premiums are levied combined with the complex structure of real estate settlement procedures serves principally to allow mortgage brokers to impose higher prices on borrowers who bear the cost of these charges - particularly on individuals who are less educated and less sophisticated about financial matters. This abusive form of price discrimination substantially increases the overall costs to borrowers, thereby imposing a hidden tax on home ownership for many Americans.
1. Yield Spread Premiums Are Not Currently Presented to Consumers as an Optional Way to Finance Settlement Costs. An initial problem with the Department's understanding of yield spread premiums is its notion that these payments represent an option that consumers voluntarily choose. Consumers are given no such choice. Mortgage brokers, in my experience, never describe yield spread premiums as an optional method for financing settlement costs, nor do the Department's own consumer publications or the most popular consumer guides for buying a home. What is more, consumers are never given the sort of advice they would need to make a meaningful comparison between the cost of higher interest rates over the life of a loan and direct cash payments for closing costs.(6) Rather, borrowers are simply told that their loans will have a certain interest rate, and they never understand that the interest rate is higher than it needs to be or that the higher interest rate is used to finance a payment to the mortgage broker.
2. Incidence and Magnitude of Yield Spread Premiums Are Extremely High. Another erroneous factual assumption implicit in the Policy Statement is the notion that yield spread premiums are paid by a relatively small number of borrowers who lack adequate resources to pay closing costs directly. To the contrary, my study indicates that the vast majority of borrowers pay yield spread premiums - on the order of 85 to 90 percent of all transactions.(7) Moreover, the average amount of yield spread premiums is quite substantial, on the order of $1,850 per transaction, making these payments the most important single source of revenue for mortgage brokers.(8) In other words, contrary to the Department's assumptions, yield spread premiums are not an "optional" form of financing made available to a limited number of borrowers with special needs. Rather these payments constitute by far the largest source of compensation for mortgage brokers and are imposed on almost all borrowers who obtain mortgages or refinancings through this segment of the industry.
3. Most Borrowers with Yield Spread Do Not Need Extra Financing. Another fallacy in the Department's factual assumption is its suggestion that borrowers who pay yield spread premiums have no other means of paying closing costs. This assumption is clearly wrong. According to my analysis, more than three-quarters of the borrowers who were charged yield spread premiums had loans that were less than the defendant lending institutions' maximum loan-to-value ratios and therefore could easily have financed closing costs by increasing the amount of their loans.(9) In other words, most borrowers who are charged yield spread premiums do not need an extra (and exorbitantly costly) form of financing for their closing costs.
4. Mortgage Brokers Earn on Average $1046 more on Loans with Yield Spread Premiums. Another erroneous premise of the Policy Statement is that industry offers yield spread premiums as a service to their customers and is indifferent to whether consumers pay closing costs directly or through the imposition of yield spread premiums. Mortgage brokers clearly much prefer making loans with yield spread premiums. According to my study, mortgage brokers made an average of $1,046 more on loans with yield spread premiums than they did on comparable loans unaffected by these practices.(10) Thus, on average, borrowers who get loans with yield spread premiums pay their mortgage brokers over a thousand dollars more than other borrowers. This substantial difference, in my view, goes a long way to explain why the industry has so zealously resisted efforts to police the payment of yield spread premiums, and it clearly refutes the Department's premise that yield spread premiums are just another form of payment.(11)
5. On Average, Seventy-Five Percent of Yield Spread Premiums Goes to Mortgage Brokers. The most critical error in the Policy Statement is its assumption that mortgage brokers use yield spread premiums to "recoup the upfront costs incurred on the borrower's behalf."(12) In my study, I employed a variety of statistical techniques to explore the relationship between yield spread premiums and direct cash payments to mortgage brokers. With the highest degree of statistical confidence, my studies refute the proposition that borrowers receive a dollar for dollar offset for yield spread premiums.(13) My best estimate is that borrowers, on average, enjoy 25 cents of benefit for each dollar paid in yield spread premiums.(14) In other words, the vast majority of yield spread premiums - on the order of seventy-five percent - serve only to increase the compensation of mortgage brokers. Contrary to the Department's assumptions, consumers do not, by a long stretch, recoup the costs of yield spread premiums.
6. Characterized as a From of Financing, Yield Spread Premiums Are Usurious. As explained above, I do not believe that yield spread premiums are actually being offered to borrowers as a form of financing upfront costs.(15) However, if one were to accept this characterization and then attempt to estimate the cost of this sort of financing, the implicit interest rates are absolutely outrageous. For an average borrower in my study, the implicit interest rate on a "yield spread premium loan" to finance closing costs would be in excess of 114 percent per year - on the order of ten times higher than a typical credit card interest rate.(16) Had the Department been aware of the true costs of this sort of financing when it prepared its Policy Statement, I expect it would have approached the problem in a very different manner.
7. African Americans and Hispanics Pay Much More for Mortgage Broker Services. While my study suggests that yield spread premiums are a very bad deal for average consumers, I believe these practices are particularly injurious to the least sophisticated members of society - groups of which the Department has historically been most protective. To test this hypothesis, I also examined the relationship between mortgage broker compensation and the racial identity of borrowers. The results indicated that mortgage brokers charged two racial groups - African-Americans and Hispanics - substantially more for settlement services than they did other borrowers. For African-Americans, the average additional charge was $474 per loan, and for Hispanics, the average additional charge was $580 per loan.(17) While I expect to do more work on this aspect of my analysis, these preliminary results are consistent with my hypothesis that current industry practices allow mortgage brokers to exploit less sophisticated borrowers by imposing higher charges.
B. Legal Analysis Proposed in the Policy Statement
The Department's misapprehension of the true economic impact of yield spread premiums has substantial implications for the Policy Statement's legal analysis. Had the Department understood how disadvantageous yield spread premiums are for most consumers, the agency would, I believe, have proposed that the payments be treated very differently under the two-step test used to determine whether particular payments are prohibited under section 8 of RESPA.(18)
1. Payment of Yield Spread Premiums Could Run Afoul of the First Step of HUD's Test. In its Policy Statement, the Department summarily concludes that yield spread premiums are paid for "good or services" and thus reasons that the payments passed the first step of the Department's test. If one accepts the Department's factual assumptions - that yield spread premiums are a bona fide option for financing closing costs and that the payments are in fact recouped through offsetting reductions in closing costs - this conclusion would be understandable. However, if instead one credits the findings of my study - that the yield spread premiums serve primarily to increase payments to mortgage brokers and not to lower the up front costs of borrowers - the legality of the payments under step one of the HUD test is far from clear. As explained above, my study suggests that only a fraction of each dollar of yield spread premiums goes to financing goods and services. Under these circumstances, I believe that it is more accurate to characterize the payment of yield spread premiums as not being a bona fide payment for goods and services. Under this view, the practice runs afoul the first step of the Department's test for legality.
2. Allowing Payments of this Sort to Escape Liability Under Step One Does Not Square with the Congressional Policies Underlying Section 8 of RESPA. The alternative approach - that is, allowing settlement service providers to escape liability under step one as long as the providers could show they contributed some value to the transaction - flies in the face of the legislative history that preceded the passage of RESPA. In the early 1970s, real estate settlements were plagued by kickbacks and referral fees. Typically, a firm with substantial influence over the settlement - for example an attorney or a real estate agent - would demand sidepayments from other service providers, such as title insurance companies, as a quid pro quo for recommending the service provider to preform the transaction. It was these referral fees that Congress sought to outlaw with section 8 of the RESPA, principally because Congress believed these transactions increased the overall cost of home ownership.(19) Were the Department to adopt the position that recipients of kick-backs have a defense from section 8 liability if they can demonstrate that they provided some other good or service for the transaction, it would seem to have created a major loophole for just the kinds of sharp practices that the provision was designed to eliminate. After all, almost all of the recipients of kickbacks that motivated the passage of the act also performed some level of service for the settlement transactions in questions. Certainly, where statistical evidence demonstrates that the payments in question (here yield spread premiums) serve substantially - indeed primarily - to increase the cost of home ownership, the activity should be proscribed under section 8.
3. Inappropriateness of Individualized Adjudication of Reasonableness. A further difficulty with the Department's legal analysis is its apparent willingness to have the courts determine the reasonableness of yield spread premiums on a case-by-case basis. As this aspect of the Policy Statement concerns a matter of judicial management, it is a matter that the courts themselves will have to resolve. But, on multiple dimensions, individualized determinations of reasonableness of the sort the Department appears to favor would be problematic. To begin with, in order to measure the impact of yield spread premiums for a particular borrower, a court must consider the impact of the payments in a large number of cases, as I did in my study. As is well-developed in other areas of the law - ranging from disparate impact cases to securities litigation - it is impossible to assess the reasonableness of one borrower's payments in a vacuum. For both litigants and courts, it would be an inefficient use of resources to repeat this analysis on a transaction by transaction basis. In addition, the Department's approach invites the sort of judicial rate regulation that Congress expressly rejected when it enacted RESPA more than twenty-five years ago. In the early 1970s, many recommended rate-making procedures for real estate settlement services, but Congress chose instead to police the industry through a combination of disclosure rules and the liability provisions of section 8. The Policy Statement threatens to resurrect judicial rate regulation as the principal mechanism for controlling kickbacks in the real estate settlement field. Arguably, under the Department's approach, a section 8 plaintiff would be forced to sustain the costs of a hearing on reasonableness whenever a defendant demonstrates that it provided any goods or services in connection with a settlement. In my view, this approach subverts the intentions of Congress and leaves consumers inadequately protected from predatory practices, such as the payment of yield spread premiums. Moreover, the approach seems to relieve from liability many of the abusive practices that Congress intended to outlaw with the enactment of section 8.
Proposals for Prospective Relief
One of the most heartening aspects of the Policy Statement is the Department's willingness to propose changes in the disclosure rules regarding yield spread premiums and related practices. In my view, reforms in this vein could go a long way toward protecting consumers and improving the efficiency of the market in this area. In particular, I would recommend the following specific changes.
1. Requiring Disclosure of Par Rate Loan Option. One of the principal sources of confusion underlying yield spread premiums is that most consumers are not aware that when they are offered an above par loan (on which a yield spread premium is paid), they almost always have the option of receiving a par rate loan with a lower interest rate and lower monthly payments. Whenever a mortgage broker proposes an above par loan, the Department should therefore require the broker to offer the borrower a comparable loan with a par interest rate. By offering consumers both types of loans, mortgage brokers would make clear that above par loans (and yield spread premiums) are simply one option for home financing.(20) Requiring such offerings would also encourage both the Department and independent consumer groups to educate consumers about the pros and cons of the two options.
2. Direct Payment of Yield Spread Premiums to Consumers (on line 200). Whenever a mortgage broker presents a good faith estimate or a HUD-1 form for an above par loan, the full amount of the yield spread premium should be paid directly to the borrower in the form of a credit on line 200. If yield spread premiums are to become a legitimate form of financing, the proceeds of the financing must always be given to the borrower. Then, the borrower can decide how to use those funds - whether to pay for closing costs or some other purpose. A further advantage of this reform is that it will force mortgage brokers to provide borrowers with a full accounting of their costs elsewhere on the form. Under the current rules, brokers use yield spread premiums to disguise their true levels of compensation. Not only is the current practice inherently deceptive; it also makes it all but impossible for consumers to compare the true costs of loans from different brokers and other lenders.
3. Prohibition on Discount Points Paid to Brokers. A further practice that should be eliminated is the payment of discount points to mortgage brokers. Traditionally, consumers pay discounts points to lenders in order to obtain a below par loan - that is, a loan with an interest rate below the rate on a comparable par loan. Under current HUD regulations, however, mortgage brokers are also permitted to charge discount points "to lower" the interest rate of a loan. In my study, I discovered that mortgage brokers were routinely charging discount points, even on par and above par loans.(21) This practice is inherently deceptive. The only way a mortgage broker can "lower" the interest rate on such loans is to start by offering the borrower an above par rate. In this context, the payment of discount fees to mortgage brokers simply serves to convert a yield spread premium into a direct up-front cost for the borrower.(22) In my view, the term "discount fees" should be limited to payments made to the lending institution that are actually used to lower a par rate loan into a below par loan.
4. Comparable Reforms for Direct Lenders. A final area of regulatory reform concerns the development of comparable disclosure requirements for direct lenders. Representatives of mortgage brokers occasionally defend current disclosure practices on the grounds that reforms of the sort outlined above would put mortgage brokers at a disadvantage to direct lenders. The Department, I believe, should reject claims of this sort. To begin with, mortgage brokers have become the leading source of home mortgages in the United States. It is imperative that the Department correct disclosure practices for this dominant segment of the industry. To allow issues associated with other sectors of the industry to stand in the way of such reforms would be letting the tail wag the dog. Still, I agree with those who say that disclosure reforms for direct lenders are also appropriate. After all, when direct lenders charge above par rates and then resell their loans in the secondary market, they receive implicit yield spread premiums. The solution to this problem, I believe, is to require direct lenders to credit borrowers with an implicit yield spread premiums similar to the ones to be required for mortgage brokers. For direct lenders who actively participate in the wholesale purchase of loans, the appropriate par rates could be derived from the institution's contemporaneous rate sheets. For other direct lenders, the Department might maintain and keep current a national listing of averages of par rates for various categories of loans, derived from the contemporaneous rates sheets of leading wholesalers. The Department would have to work out the details of such a proposal, but the concept is well within the agency's expertise.
* * * * *
Let me conclude by again commending the Department for taking on this issue. I would be delighted to work with the Department as it moves forward in this area, and would welcome any questions that members of the Committee have.
1. I initially undertook this project as an expert for the plaintiff class in Glover v. Standard Federal Bank, Civil No. 97-2068 (DWF/SRN) (U.S. District Court, District Court of Minnesota) (pending) and am currently expanding the study into an academic article, the current draft of which is attached to this testimony: Howell E. Jackson & Jeremy Berry, Kickbacks or Compensation: The Case of Yield Spread Premiums (Jan. 8, 2002) (hereinafter "Jackson & Berry") [a abridged draft of this paper is available at http://www.law.harvard.edu/faculty/hjackson/jacksonberry0108.pdf.
2. 66 Fed. Reg. at 53,054.
5. As indicated above, the sample upon which my empirical study is based was limited to loans originated by an affiliated group of lending institutions and thus does not include loans from all lending institutions in the industry. It is possible that the abusive practices uncovered in my study are peculiar to the lending institutions included in my sample. However, I doubt that this is the case. Industry experts have opined that the practices of the lenders in my study "are typical of other wholesale lenders." See Report of David Olson, Glover v. Standard Federal Bank, Civ. No. 97-2068 (DWR/SRN) (U.S. District Court, District Court of Minn.) (filed June 24, 2001) (expert for defendants). At a minimum, the evidence uncovered in my study should put the burden on the Department to demonstrate with comparable evidence that the factual assumptions underlying the Policy Statement are accurate for the industry generally.
6. What HUD regulations do require is "disclosure" of yield spread premiums. However, this disclosure is inadequate in many respects. Yield spread premiums are not reported in a consistent manner in HUD-1 forms; oftentimes they appear on back pages of the form and sometimes in a smaller font. Most important, these payments are almost always denominated "p.o.c. by lender," meaning that they are "paid outside of closing by the lender." It is inconceivable that more than a tiny fraction of consumers can correctly evaluate this information. For a more complete discussion of the problems consumers face in deciphering this information, see Jackson & Berry, supra note 1, at 2-5, 51-65.
One measure of inadequacy of current disclosure practices is the difficulty my assistants had even finding the amount of yield spread premiums on HUD-1 forms. Even after receiving explicit training on the subject, a team of paralegals and certified public accountants was only able to find yield spread premiums on about two-thirds of the forms on which the payments were supposedly disclosed. See Jackson & Berry, supra note 1,at 71-74 & n.112.
7. See Jackson & Berry, supra note 1, at 73 (Table 2)
8. Id. at 78-81.
9. Id. at 147 & n. 180. My study did not consider other sources of funding, such as cash reserves or credit cards or loans from family members. Were these and other alternative sources considered, even more borrowers would have had viable financing options other than paying yield spread premiums. As explained below, the true costs of yield spread premiums are so high that a borrower would be well advised to employ almost any other form of financing.
10. Id. at 91-97 (Figure 14).
11. Why mortgage brokers can earn more money on loans with yield spread premiums is an interesting and important academic question I explore this issue in considerable detail in my academic writings on the subject. In brief, I believe a number of factors are at work. In this context, consumers are primarily concerned with buying homes and being approved for financings; thus, they spend less time monitoring the comparatively smaller costs associated with real estate settlement. In addition, they trust their mortgage brokers to recommend appropriate financing terms and cannot easily police these recommendations. In addition, consumers have difficulty calculating costs of higher monthly payments as compared with direct cash payments and are not protected by market forces because these side payments allow brokers to discriminate among sophisticated an unsophisticated consumers and avoid creation of a single market price for settlement services. See id. at 51-65.
12. 66 Fed. Reg. at 53,054.
13. Jackson & Berry, supra note 1, at 102-16.
15. See supra text accompanying note 6.
16. Jackson & Berry, supra note 1, at 144-47.
17. Id. at 120-26. This analysis controls for a variety of factors, including principal loan characteristics, credit quality of borrower, loan-to-value ratios, and certain geographic variables.
18. In an earlier statement of policy, the Department proposed this two-step test. Under the first step, courts are to consider whether a particular payment is made for "goods and services actually furnished or services actually performed." If the answer to this question is no, then liability is attached; if the answer is no, then the court must proceed to the second step of the test, under which it must determine whether the amount of the payment was reasonably related to the goods and services provided. See HUD Statement of Policy 1999-1, 64 Fed. Reg. 10,080 (Mar. 1, 1999).
19. Id. at 9-23.
20. Brokers might also be required to disclose the rate sheet associated with the pricing of their loans. This would provide more information than most consumers would need but could be useful to consumer groups and the financial press.
21. The incidence of discount fees to mortgage brokers ranged from 10 percent to 47 percent, depending on the sample, and averaged between $744 and $1,335. See id. at 77 (Table 4).
22. Not only does this practice needlessly complicate the true compensation of mortgage
brokers; it also belies claims that above par loans are being used to lower up front costs for consumers.
How could a consumer rationally request an above par loan for this reason and then pay an up front
discount fee to turn the loan back into a par loan?
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