New Mortgage Regulations Could Bruise Housing Market

New regulations limiting mortgage brokers' compensation go into effect on April 1, and they might prove to be appropriate for an April Fools' Day. Though aimed at unscrupulous mortgage brokers, it seems the regulations will instead hit the nation's struggling housing market.

The Federal Reserve Board says that its regulatory goal is to "protect mortgage borrowers from unfair, abusive, or deceptive lending practices that can arise from loan originator compensation practices." The basic idea is to prevent loan officers from steering borrowers into riskier types of loans or a higher-than-average interest rate to make a higher commission.

Officially titled "Loan Originator Compensation amendment to Regulation Z," The new rules apply to mortgage brokers and the companies that employ them, as well as mortgage loan officers employed by banks and other lenders.

Closing the Barn Door....

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Since most of us only deal with mortgage loan origination fees when we buy a home or refinance a mortgage, the average citizen will have a tough time sorting out the often-arcane issues at stake. But the bottom line is straightforward: the already-limited mortgage market is about to become more limited, as small mortgage brokers are essentially being shoved out of business. Call it "unintended consequences" or a cloaked plan to channel more of the mortgage business to the "too big to fail" big banks -- but regardless of the motivations, the rules may end up limiting consumer choice and make it harder for home buyers to get a loan.

While the stated goal of the new rules is laudable, those in the mortgage industry say it's a case of closing the barn door after the horse has bolted: the risky, subprime-type mortgages that were the root cause of the problem have already vanished from the mortgage market.

Since the rules largely apply to small lenders and brokers who must sell the mortgages they originate to larger banks -- most banks and other direct lenders, including big mortgage companies that function like banks, are exempt from the new regulations -- then the limits will weigh entirely on smaller independent players.

Setting Ground Rules

Critics, including U.S. Senators David Vitter and John Tester, observe these rules will further concentrate a market already dominated by mega-large banks. According to the senators, two banks already originate 43% of the nation's mortgages. It's difficult to see how home buyers will benefit from the effective exclusion of small independent brokers and lenders.

What the regulations do is set some ground rules. For example, consumers must be offered the lowest possible interest rate and fees for which they qualify. They also limit loan officer and broker compensation in several key ways.

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According to the Federal Reserve Board, a loan originator "may not receive compensation that is based on the interest rate or other loan terms." In other words, a lender can no longer pay a loan broker a yield-spread premium, which is tied to the rate or terms of the mortgage.

Currently, the brokerage firm and the loan officer typically split this rebate, which is typically stated in "points," where each point equals 1% of the loan amount. Thus a loan origination might earn an $8,000 fee, $4,000 of which goes to the loan officer and $4,000 to the mortgage broker.

Under the new rules, the mortgage broker cannot pass on part of the commission to the loan officer, who must now be paid an hourly wage or salary.

The idea is to remove the incentive of the loan officer to push the consumer into a more lucrative loan -- but the result is to remove the incentive to remain in the independent mortgage business.

The Insider's View

Mark Helling, a licensed loan officer based in Ohio, summed up the view from inside the industry. "After April 1st," he says, "a loan officer will have to be paid the same rate whether it is an easy loan that takes two weeks to close or a foreclosed property in need of rehabbing for marginal borrowers that takes three months of work to close. Just when the country needs the most experienced and knowledgeable mortgage professionals to help liquidate the flood of foreclosed homes, the Fed is making it unprofitable for loan officers to accept these deals."

From the point of view of those in the mortgage industry trenches, what the rules do is increase the regulatory expenses of being in sales but eliminate the commissions that are the lifeblood of any sales enterprise.

The Fed Board also says the final rule "prohibits a loan originator that receives compensation directly from the consumer from also receiving compensation from the lender or another party." In other words, a loan originator cannot collect payments from both the consumer and the lender in a single transaction. If a broker is paid a commission by the lender based on the loan amount, then the broker is barred from charge the borrower "points" or fees for the loan processing.

This prohibits loan officers from paying borrowers' fees or issuing them a credit from their own commission. This has been a common practice within the industry -- and from the inside perspective, it has offered a flexible way to lower borrower's costs.

A Case of Overkill?

These major regulatory changes are being made in the service of fair lending practices. But to those seeing their livelihoods threatened, it looks like a sledgehammer is being used where a flyswatter would have sufficed.

"As far as trying to protect consumers from those seeking to charge a higher interest rate, with all of the competition out there for mortgage loans," Helling observes, "all a consumer has to do is check one or two other banks and they can quickly find out if they are getting a fair deal or not."

The rules will also interact in potentially harmful ways with the massive Dodd–Frank Wall Street Reform and Consumer Protection Act, the most sweeping financial regulation since the Great Depression.

At issue is section 1413 of the Dodd-Frank Act, which states that any violation of the loan originator compensation rules will offer the borrower a "defense to foreclosure" for the life of the loan.

In other words, if a delinquent borrower can go back and find some violation of the compensation rules in his/her mortgage origination, the lender is effectively barred from foreclosing on the borrower's loan.

Drying Up Competition

Given the risks this presents to banks, many observers -- including the two senators -- expect the large banks that typically buy mortgages from independent brokers and small lenders to shun these mortgages. Why buy a mortgage that could go sour via a future default -- that could preclude foreclosure as a remedy?

The net result of these rules could hurt the housing market in several ways. If mortgage brokers can no longer make enough in commissions to stay in business, then the mortgage options for home buyers will shrink. The most productive loan officers will find reduced incentives to their remaining independent, so there will be less competition offered to the big banks which already dominate the industry.

Perhaps most devastating, the financial institutions which have bought mortgages originated by brokers and smaller lenders will have a powerful incentive to avoid the risks that are being placed on these mortgages by the Dodd-Frank Act. The housing market may well sag further, as mortgage sources and competition dry up.

The need for thoughtful financial regulation has been made painfully apparent by the excesses of the credit and housing bubbles, but squashing legitimate independent loan originators and further concentrating the mortgage industry into the hands of the "too big to fail" banks seems counterproductive.