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July 8, 2002
"In a recent speech, associate general
counsel of HUD John Kennedy said that �the various fees and junk fees lenders
and settlement providers charge have not changed in 30 years.� Can you explain
why, with all the technological innovations in the mortgage business, settlement
costs have not come down?"
The market for settlement services works very
badly, and Federal legislation designed to fix the problems has instead made
them worse.
Settlement service charges fall into two
broad categories. The first are charges made by lenders, expressed in dollars
rather than as a percent of the loan. These are sometimes referred to as
"junk fees" and are discussed in other columns, including Legal
Thievery at the Closing Table. The second category of charges, discussed
below, are those made by third parties involved in the lending process.
Third-party service providers (TPSPs) include firms offering mortgage insurance,
title insurance, appraisals and credit reports.
The market for third party settlement
services works poorly because the borrower pays for the services, but the lender
selects the TPSP. This results in "perverse" competition �
competition that raises prices to consumers, or prevents them from falling as
they should when technology drives down the costs of TSPSs.
Competition by TPSPs is perverse because it
is directed to the lenders who select them, rather than to the borrowers who pay
them. TPSPs compete by providing services free or below-cost to lenders, or by
finding legal ways to pay the lenders. All such methods of competing for the
favor of lenders drive up the costs of TPSPs, who pass on the costs to
borrowers.
As one example, lenders would benefit very
little from negotiating lower mortgage insurance premiums for borrowers, but
sharing the profit in excessively high premiums can be very profitable. A legal
way to do this is for lenders to create mortgage reinsurance affiliates that
share the mortgage insurance premium revenue paid by borrowers. Of course, the
affiliates also share the risk, but since the insurance is over-priced, it is
profitable to the lender.
The remedy for perverse competition is
remarkably simple. All it requires is a rule that all third-party services that
are required in connection with a mortgage loan must be paid for by lenders and
cannot be billed separately to borrowers. Lenders would then include the cost as
part of the price of the mortgage.
If lenders had to pay for third-party
services, TPSPs would have to compete for lender business by lowering prices
rather than offering kickbacks. Effective competition would replace perverse
competition. As the cost of services fell with development of better technology,
the price to lenders would fall. Competition in the loan market would force
lenders to pass on the savings to borrowers.
Such a rule would force the mortgage industry
to operate in the same way as the automobile industry. Automobile manufacturers
don�t force buyers to purchase tires, transmission systems, electrical
systems, and upholstery separately. If they did, the price of automobiles would
be substantially higher. Rather, the manufacturers purchase the components
themselves at highly competitive prices, and bundle them into a complete
automobile that is sold for one price.
Unfortunately, Congress took a different tack
when it passed the Real Estate Settlement Procedures Act (RESPA) in 1974. RESPA
was based on two fallacies. The first was that the proper way to deal with
payments from TPSPs to lenders that raised settlement costs to borrowers was to
declare them illegal. This was bound to fail because it left intact the
incentives for TPSPs to compensate lenders.
HUD was made the policeman, but with
thousands of potential violators, the funds available for enforcement have never
been even close to adequate. Small players routinely violate a law they don�t
respect, while large players find legal (if costly) ways around it � such as
the reinsurance affiliate I mentioned earlier.
The second RESPA fallacy was that borrowers
could drive down the cost of settlement services if they were armed with the
proper information. RESPA thus decreed that borrowers be provided with the
estimated cost of each settlement service in a HUD-designed "Good Faith
Estimate" of settlement costs (GFE).
This was also bound to fail because borrowers
don�t want to negotiate separately for each settlement service, and they
couldn�t do it effectively, even if they wanted to. Lenders continue to select
the TPSPs under RESPA, and borrowers continue to be impotent.
But the GFE has proved to be less than
useless. The GFE designed by HUD hinders effective shopping of lender
fees. See Legal Thievery
at the Closing Table.
Copyright Jack Guttentag 2002
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