Mortgage referral fees and the public interest: forty years of bungles

This is the second article in a three-part series which began last week in HomesSaturday.

The Real Estate Settlement Procedures Act, or RESPA, was aimed at reducing settlement costs paid by mortgage borrowers by eliminating referral fees, but as indicated in Part 1 of this series, it has not succeeded. Part of the problem is inadequate enforcement.

There are so many referral agents in real estate markets, and so many ways they can receive something of value from service providers, that the regulator would need an army of examiners to shut them all down. HUD, which administered RESPA for many years before responsibility was shifted to the Consumer Financial Protection Bureau, never deployed an army of examiners and it is doubtful this will change under the CFPB. Hence, thousands of small referral agents will continue to receive referral fees, if in disguised form, with impunity.

The other part of the problem is the referral agents that are too large to be overlooked by regulators take advantage of provisions in RESPA that legalize referral fees that conform to certain guidelines. They have been able to continue receiving payments that are referral fees de facto but not de jure.

The captive affiliate

RESPA does not prevent a firm in one industry from entering another industry, even when the express purpose is to exploit referral power. For example, a Realtor or lender can establish their own title company and refer business to that company, which can be a joint venture or an entity wholly owned by the referrer. The title agency must be a bona fide company, meaning that it must have the capital required by a title company, it must have its own employees and place of business, and so on. A sham company that is actually operated by another title company would be a RESPA violation. Since the capital investment required is considerable, this option is feasible only for firms able to generate a volume of referral business large enough to justify the investment.

Larger lenders have also invested in appraisal management companies, which proliferated after the financial crisis as a device to meet new regulatory requirements designed to assure the independence of appraisals. The company stands between the lender and the individual appraiser. Lenders cannot influence appraisals, but they can and many do collect referral fees through their ownership interest in the companies. And while alert borrowers can select their own title companies, and some do, they cannot select their appraisal management company because the company must be approved by the lender.

Marketing agreements

Marketing agreements are the other major way appraisal fees are legally sanitized, but a lender is more likely to be the service provider than the referrer. In a typical arrangement, a builder will refer clients to a lender, who will pay the builder's marketing expenses. This is discussed next week.

The bottom line of the RESPA rules governing referral fees is that payment of such fees is legal so long as it is done in ways that are extremely costly and inefficient. The rules are a bonanza for lawyers but a dead-weight loss for everyone else. In discussing potential fixes, I will distinguish cases where lenders are the referrers, discussed immediately below, and cases where they are the recipients of referrals, which are discussed next week.

Solution

Where lenders are referrers, the cure is simple.

Referral fees now collected by mortgage lenders in connection with title insurance, appraisals, credit reports and all other services they require borrowers to purchase, could be eliminated by the adoption of one simple and easily enforced rule: any service required by a lender in connection with a home loan must be purchased by the lender and included in the price of the mortgage.

This rule would eliminate the lender's referral power, which is based entirely on the mortgage being sold as an unbundled product.

If mortgages had to be sold as a bundled product with all the inputs purchased by the lender, as is the case for automobiles and most manufactured products, referral fees would disappear and settlement costs would drop like a rock. The cost of title insurance, appraisals and other services would be included in the price of the mortgage, just as tires are included in the price of automobiles, but the incremental cost to the borrower would be small relative to the unbundled price. Competition by third party providers to sell lenders would force the prices down, and price competition by lenders would force them to pass the savings on to borrowers.

The problem with this simple solution is that it has no political constituency. Lenders won't support it because it is not in their financial interest; title insurers and other service providers won't support it for the same reason. But why consumer groups never propose it is more puzzling. The only plausible reason that comes to mind is that converting the mortgage into a bundled product would make the mortgage market work effectively for borrowers, and effective markets eliminate the need for consumer groups.

• Contact Jack Guttentag via his website at mtgprofessor.com.

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