Mr. Chairman and Members of the Committee, the National Association of Consumer Advocates thanks you for inviting us to testify today regarding HUD’s recent policy "clarification" on yield spread premiums. We offer our testimony here today on behalf of our members, as well as the National Consumer Law Center.
At the outset, let me make it perfectly clear that while we believe that the use of yield spread premiums can be a source of benefit for American consumers, this practice as it is currently being used by the mortgage lending industry, is both abusive and deceptive. Furthermore, instead of carrying out its mandate to promote homeownership by encouraging a fair, open and honest marketplace, HUD has attempted to use its policymaking authority to legitimatize the otherwise illegal, anticompetitive nature of yield spread premium abuse. This testimony will discuss how yield spread premiums currently operate in the real world, explore previous efforts to regulate this practice, explain how HUD’s purported clarification in the 2001 Policy Statement ignores the law and perpetuates and encourages bad lending behavior and finally, offer proposals to make the use of yield spread premiums provide American homeowners with real benefit.
I. Yield spread premiums in the current marketplace.
Section 8(a) of RESPA prohibits any person from giving or receiving any fee, kickback or thing of value pursuant to any agreement incident to a real estate settlement involving a federally related mortgage. This rather simple provision was the product of much debate in Congress and was created in 1974 because of the widespread recognition that referral fees and kickbacks were making the market place anti-competitive (home buyers were not being directed to a service provider who would provide them with the best deal, but instead to the provider who would pay the largest sum of money to the referring agent). The rationale for this legislation was simple. Eliminate market-distorting incentives and homeowners would have real opportunity to obtain the most beneficial and cost efficient loan products available. While Section 8(a) of RESPA seems rational, fair and explicit, current participants in the home lending marketplace have gone to great effort to obfuscate the law and preserve their ability to receive and provide kickbacks at the great expense of American homeowners. This is where the practice of yield-spread premiums (ysps) enters our story.
In a nutshell, ysps are payments made by a lender to a mortgage broker in return for a referral of an "above par" loan. An above par loan is a loan with a ysp paid to the broker and a higher interest rate than the loan the borrower qualified for. A par loan is a loan with an interest rate that an individual homeowner would qualify for if s/he paid no discount points and was charged no ysp. For a "below par" loan, the homeowner would pay discount points in exchange for the lower interest rate.
In theory ysps could offer homeowners using a mortgage broker a valuable choice. Borrowers could choose the amount of points they would want to pay (or not pay) and thus choose an interest rate. For instance, a homeowner who didn’t want to pay an upfront broker fee, could choose an above par interest rate and have the lender pay the broker in the form of a ysp. While this could all be so very neat and clean (and legal), this scenario does not remotely reflect what is happening in today’s consumer marketplace.
Consumers who do business with mortgage brokers generally have the understanding that the brokers will provide them the loan at the lowest rate that the broker finds for them. Consumers have generally understood and agreed to a specific broker's fee to be paid directly by them – either in cash or by borrowing more – to the mortgage broker to compensate the broker for obtaining the loan. What consumers do not understand, and have not agreed to, is the mortgage broker receiving an additional fee from the lender.
As an attorney for the last five years running a foreclosure prevention project in Chicago, I have had the opportunity to review hundreds and hundreds of loan documents. I’ve probably interviewed thousands of homeowners, given countless seminars and trained and spoke with scores of attorneys representing consumers. In all that time, I have seen countless loans that contained both yield spread premiums and borrower paid broker fees, yet not once, have I spoken to a homeowner who knew that a ysp had been paid on their loan, or that because of the ysp, the interest rate they received was greater than they were otherwise qualified. To some, this evidence is anecdotal, but both industry commentary and objective study bear this observation out. This reality begs two questions. First, if ysps are not being paid for the benefit of consumers, why are they being paid? Second, if these are referral fees why aren’t these payments illegal?
The answer to the first question is very simple. Ysps are generally paid by the lender to the broker solely in compensation for the higher rate loan. In other words, because the broker brings to the lender a loan at a higher rate than the consumer would otherwise qualify, the broker is paid a fee, or kickback. These fees are solely an extra fee that the broker is able to extract from the deal. In practice, the borrower is not only paying an upfront broker fee, but is also paying a higher interest rate as a result of this kickback. As this practice clearly provides an incentive for brokers to obtain above par loans for consumers, the dynamics of the marketplace closely resemble the marketplace that Congress attempted to control with its passage of RESPA.
II. Prior attempts to curb yield spread premium abuse.
Because this problem has existed for over a decade (and because the lending industry has attempted various justifications for this seemingly obvious illegal practice), there has been extensive litigation. The industry had sought assistance from Congress in the past. Finally, in 1998, Congress issued a directive to HUD to write a Statement of Policy. Consumer representatives worked diligently with the mortgage industry and HUD to develop the language. The Statement of Policy that was issued by HUD in 1999 met with both consumer advocate and industry approval. Consumer advocates approved of the policy statement in large part because of the explicit direction provided to the lending industry on how a lender can properly pay a broker fee:
Mortgage brokers and lenders can improve their ability to demonstrate the reasonableness of their fees if the broker discloses the nature of the broker's services and the various methods of compensation at the time the consumer first discusses the possibility of a loan with the broker.
[T]he most effective approach to disclosure would allow a prospective borrower to properly evaluate the nature of the services and all costs for a broker transaction, and to agree to such services and costs before applying for a loan. Under such an approach, the broker would make the borrower aware of . . . the total compensation to be paid to the mortgage broker, including the amounts of each of the fees making up that compensation. If indirect fees are paid, the consumer would be made aware of the amount of these fees and their relationship to direct fees and an increased interest rate. If the consumer may reduce the interest rate through increased fees or points, this option also would be explained.(Emphasis added.)
With this clear direction on how to avoid liability for paying broker fees, consumer advocates reasonably believed that the mortgage industry would immediately adopt these recommendations and employ them in all future loans. This belief was wrong. Instead the industry continued as before – lenders continued to pay broker fees without evaluating either the services provided by the broker or whether the payment of the lender fee reduced the fees otherwise owed by the borrower. Because the benefit to the brokers and lenders was so great (higher fees for brokers, higher interest rates for lenders), the mortgage industry’s strategy was to continue its illegal practice, pay off the few individual actions brought against it and mount a massive effort to fight class action cases challenging the payment of these fees, which might actually cost the industry real money and cause the industry to change its behavior.
Initially after the 1999 Statement of Policy this strategy appeared to be working. Most federal courts generally denied class certification, requiring an intensely factual analysis to determine legality, while a few federal district courts did permit the class actions to proceed. This scene changed significantly however, when the 11th Circuit Court of Appeals issued a comprehensive analysis of RESPA's requirements regarding referral fees, the 1999 Statement of Policy, and upheld class certification, on June 15, 2001.
The crux of the analysis in the Culpepper case is that for HUD's Statement of Policy to be consistent with RESPA, a two-part test is necessary to determine the legality of the lender paid broker fees. First, whether the lender paid fee was for goods, services or facilities provided. Second, whether the total fee paid was reasonable. The court found class certification appropriate because –
the terms and conditions under which a lender pays the broker a yield spread premium can determine whether the yield spread premium is compensation for referring loans rather than a bona fide fee for services. There is no suggestion from the evidence or the argument here that Irwin negotiates yield spread premiums loan-by-loan, rather than paying them according to terms and conditions common to all the loans.
In essence, the Culpepper court was saying, if the lender paid a broker a yield spread premium without looking at whether services were provided, the lenders practice violated RESPA. Therefore, the first step of the two-part test – whether the lender paid fee was for services – could be answered without performing a factual analysis of each individual loan. Therefore, the court concluded that there was no reason that the case could not proceed as a class action. The court noted that the formula by which a lender paid broker fee is paid "does not take into account the amount of work the broker actually performed in originating the loan or how much the borrower paid in fees for the broker services."
The mortgage industry responded to the Culpepper case by immediately turning to HUD and seeking a "clarification" of the 1999 Statement of Policy removing all references to language, which would support the 11th Circuit court's analysis. The stated rationale was simply to "clarify" the "ambiguity" in the Policy Statement. Despite the fact that the 1999 Statement of Policy was unambiguous regarding how the industry could legally pay yield spread broker fees, the industry coyly requested:
HUD must issue decisive and clear rules that benefit both borrowers and lenders by creating a regulatory environment in which consumers can make informed choices and lenders can operate their businesses, without the constant prospect of having industry practices that benefit consumers challenged in litigation.
The industry portrayed a "clear rule" for the future as an appropriate trade-off for the requested "clarification of the 1999 Statement of Policy." This completely ignored the obvious – that HUD had already provided a clear rule, just as the industry is now requesting, in the 1999 Statement of Policy, which the industry had simply ignored.
II. HUD's Actions
In the weeks preceding the issuance of the 1999 Statement of Policy, HUD officials met with consumer representatives on dozens of occasions to work through many of the complex issues involved in this problem. Many of these meetings were also attended by representatives of the mortgage industry. In contrast, prior to the 2001 Statement, HUD officials met with consumer representatives three times, despite numerous requests and offers by these representatives to engage in a more substantial dialogue.
The consumer representatives tried to make clear to HUD officials these essential points:
The mortgage industry provided specific language to HUD to "clarify" the 1999 Policy Statement. HUD adopted every recommendation made by the industry. The crux of HUD's "clarification" comes on page 11, with the statement:
HUD’s position is that in order to discern whether a yield spread premium was for goods, facilities or services under the first part of the HUD test, it is necessary to look at each transaction individually. . .
Such a position, if deferred to by the courts, would almost certainly preclude class action suits, thus removing the only effective legal recourse to challenge and change this practice. In fact the 2001 Statement of Policy collapses the two-part test articulated in the 1999 Statement into a single analysis; which represents a serious departure from not only the 1999 Statement, but the Congressional directive in RESPA.
HUD’s action is absolutely crippling to consumer rights, as it removes any incentive the industry has to cooperate with any future action that HUD might take to address the egregious practice of upselling mortgage loans. In his press release, Secretary Martinez claims to be pursuing a reform to require full up-front disclosure of all total compensation to be paid to the broker. However, even if HUD initiates a proposed rulemaking to do this (which was not proposed in the October 15 Statement), and even if the regulation goes beyond the meaningless recommendations in the 2001 Statement, it will be a regulation without any effective enforcement mechanism.
III. Making yield spread premiums work for consumers
Several years ago, Congress requested that the two federal agencies most familiar with the implementation of the laws involved in the mortgage process – HUD and the Federal Reserve Board – evaluate the complex issues of improving and streamlining the mortgage process, while addressing predatory lending. In 1998, these two agencies issued a comprehensive report. This Joint Report, in addition to proposing comprehensive reform to address predatory lending, also proposed two alternatives to address the fact that the current system does not ensure a truly competitive marketplace for mortgage loans.
One alternative would be a dramatic change in the system governing the disclosures consumers receive both when they apply for the loan and when they close the loan. The other alternative is to beef up the current system and require information to be provided which is meaningful.
Alternative One. In the Joint Report, HUD indicated its commitment to actually improving the system of shopping for mortgages, rather than continue the confusion. The primary mechanism for accomplishing a more open system would be to require mortgage lenders (and brokers) to provide a guaranteed interest rate and closing costs before collecting any application fees from consumers.
As the charges for mortgage loans are often based on the borrower’s creditworthiness and the value of the collateral, some underwriting would have to be performed by the creditors before the guaranteed rate could be provided. To its credit, HUD agreed with consumer advocates and proposed that "consumers be provided guaranteed information about closing costs, interest rate and points early enough so that they can shop and make informed choices."2
On the other hand, the large mortgage lenders have been pushing hard for a change in the law which would mandate a guaranteed closing costs "package, " without a guarantee for rates and points. In this way, the lenders could market their loans based on the closing cost package. Consumer advocates have opposed the closing cost package by itself because it would be like marketing tires to car buyers before they purchase the car: a borrower would likely apply for a loan based on the guaranteed closing cost package, without receiving any guarantee of the interest rate or points. Encouraging borrowers to apply for loans based only the closing cost package would end up costing borrowers in at least two ways: 1) if the actual closing costs incurred by the lender for the loan exceeds the anticipated amount, there would be nothing to prevent the lender from increasing the interest rate or the points charged on the loan to make up for the difference; 2) in fact, there is nothing to prevent the lender from increasing the price of the loan to borrowers who have already paid so much money to apply for the loan, that they cannot afford to go elsewhere for their home loan.
Alternative Two. HUD also proposed a change in the rules governing early disclosures. These early disclosures need to be transformed into commitments to deal with the issue of deceptive yield spread premiums.
The mortgage industry has consistently stated that it wants to ensure that yield spread premiums remain legal so that borrowers can benefit from their use – such as by reducing the up-front closing costs required to be paid from cash or equity. We as consumer advocates agree. We think the following principles , if followed, would guarantee that yield spread premiums would be legal and beneficial for consumers.
These principles accomplish several things. First, the consumer knows upfront how much the mortgage broker will charge. Second the consumer is given the opportunity to choose how this payment will be paid. Third, and most importantly, the broker compensation remains the same regardless of method of payment. This point is crucial, because it eliminates any anti-competitive incentive the broker has to place the borrower in a loan with an interest rate greater than they otherwise would qualify. In other words, whether the borrower chooses a below par loan, a par loan or an above par loan with a yield spread premium, the broker compensation will remain the same. This is not how the system works today and it must be changed.
In summary, yield spread premiums have been a source of mortgage lending abuse for a number of years. Finally, when the federal courts began to seriously hold the mortgage lending industry liable, the industry, instead of reforming its ways turned to HUD for salvation. HUD, instead of protecting consumers, cast its lot with mortgage lenders and attempted to protect the anti-competitive marketplace that currently exists. HUD’s ultimately cynical policy clarification was not only disappointing but an abdication of their mandate to protect and promote homeownership. We can only hope that in the future, HUD will rethink its decision and issue regulations that adopt principles that not only claim to protect consumers, but in practice actually do.
Proposed Changes to Regulation X
Total compensation received by a mortgage broker for bringing together a borrower and a lender to obtain a federally related mortgage loan for the borrower includes all payments made by the borrower directly to the mortgage broker in cash or in the form of any thing of value, all payments received from the proceeds of the loan, and all payments received from the lender or any other settlement service provider that are directly related to the brokering of the loan.
Par rate means the interest rate offered to a mortgage broker (through lender’s price sheets) at which the lender will fund 100% of the loan with no premiums or discounts to the mortgage broker.
§ 3500.14(g)(4): The payment of a fee by a lender to a mortgage broker related to the making of a federally related mortgage loan shall not violate Section 8 of RESPA (12 U.S.C. § 2607) or § 3500.14 if all of the conditions set forth in this subsection are satisfied.
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