Mortgage referral fees and the public interest: 40 years of bungles

Part 1 of 3

Markets don't work well when one party to transactions has much more information than the other party, especially when the party with better information also controls the process. The two best illustrations of this rule are the markets for medical services and home mortgages.

In principle, government regulation can make such markets work better by 1) reducing the information gap between the parties transacting with each other through a system of mandatory disclosures; and 2) by limiting the ways that the parties controlling the process can use that control to benefit themselves. The all-important caveat is that the regulations adopted work as intended. Bad regulations increase transaction costs without accomplishing their objective. This has been the case for 40 years of ill-advised efforts by the federal government to eliminate referral fees in the home loan market.

Referrals are pervasive in the home mortgage market

Real estate and mortgage transactions involve a large number of diverse players who sell services that consumers purchase. Since they are in the market very seldom, consumers typically don't know who all the players are, or even what they do. They are thus heavily dependent on referrals from those who have this knowledge.

Lenders usually select the appraiser and credit reporting agency on home purchases, and all third-party service providers on a refinance. Mortgage insurers are always selected by the lender. Realtors and builders have referral power on home purchase transactions, referring consumers to lenders and to title agencies.

Referral fees and referral power

Referral fees are payments made by service providers to other parties as quid pro quo for referring customers. Referral power is the ability to direct a client to a specific vendor. Referral power is based on specialized information possessed by the referrer, and the authority of the referrer in the eyes of the client. Regulatory efforts to reduce settlement costs to borrowers by eliminating referral fees have not worked largely because they have left referral power unchanged.

Lenders as referrers and recipients of referral fees

Mortgage lenders are both referrers and recipients of referrals. When they steer a borrower to a title company for the purpose of purchasing title insurance, they act as referrers, and the title insurance cost paid by the borrower includes the referral fee to the lender. When a real estate agent or builder sends a borrower to a lender and receives something of value in exchange, the lender is the recipient, and the benefit provided to the agent is the referral fee. The first two articles in this series are about fees paid to lenders as referrers, and the third one is about fees paid by lenders as recipients of referrals. The policy challenge in both cases is to develop rules that will minimize the costs imposed on consumers.

Why are referral fees considered "bad?"

One reason is the widespread prejudice that charging for something that takes no effort, or almost none, is like being paid for nothing. We undervalue information. A second reason for the hostility to referral fees is the fear that payment for referrals will degrade the quality of the service. If a real estate agent collects referral fees from lenders, does he send borrowers to the best lenders, or to the ones willing to pay the referral fee? This is a legitimate concern. The third reason is a concern that referral fees raise the cost to the client. If service providers have to pay referral fees, they are going to charge more in order to cover that cost. This is the major concern with regard to referral fees in the home mortgage market. It is why referral fees in this market were made illegal under the Real Estate Settlement Procedures Act (RESPA). Congress was offended by high mortgage settlement costs and the prevalence of referral fees, which they saw as related. The rationale of the restrictions imposed by RESPA is that "kickbacks or referral fees … tend to increase unnecessarily the costs of certain settlement services ..." (RESPA, Section 2601 (a)). But Congress was wrong about that. Settlement costs are raised by referral power, not by referral fees, and RESPA fails to address referral power. Not surprisingly, therefore, the RESPA prohibition of referral fees has not reduced settlement costs at all, a fact acknowledged by HUD, which had the unpleasant task of enforcing RESPA before creation of the Consumer Financial Protection Bureau.

Referral fees do not raise settlement service prices to consumers

Referral power raises prices to consumers, not referral fees. When there is referral power, service providers compete not for the favor of consumers but for the favor of the referral agents. Such competition raises the costs of service providers, which are passed on to the consumer. If regulations eliminated referral fees but referral power was left untouched, service providers would find other ways to market themselves to the same referrers. The resulting marketing expenses could well be higher than the referral fees.

Next Week: The Failures of RESPA and a Simple Remedy

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

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