Has Dodd-Frank Slayed the Mortgage Monster?
There's that scene in Young Frankenstein, when Gene Wilder's character, pronounced "Fronkensteen," cries out, "Give my creation life!" And so, on April 1, just ahead of us, a Rule promulgated by the Federal Reserve Board, complementing provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act, will come into existence and originating mortgage loans will be changed forever. Government is a reactive body rather than a proactive body. However, some in the mortgage loan origination business strongly believe that the compensation reform to take effect on that day is a solution without a problem.
How We Got Here...
If we could take a ride in the residential loan time machine and revisit 2006, the lending landscape would be a treacherous place to navigate. Fueled by an insatiable need for mortgage product to be resold in the more sinister world of collateral debt obligations and synthetic securitization, the grunts on the ground churned out millions of the now infamous subprime loans to supposedly unsuspecting consumers. With the housing market devastated and foreclosures out of control, something had to be done to protect consumers from either their naiveté or their bad borrowing habits, or both. So Congress and the Federal Reserve had a choice. They could attack the real causes of the problem inherent in the banking industry and punish those responsible for allowing subprime financing to flourish in the first place (hint: the few large lending institutions that control what's left of the national residential lending market) or they could pick a less powerful target, the mortgage loan originator, as the way to "solve" the foreclosure mess and stabilize the housing market.
The Story Thus Far
As we approach April 1, plenty has already changed in residential lending. Besides significantly tighter underwriting protocols, there are national licensing requirements for mortgage loan originators, as well as much more accurate disclosures on the "good faith estimate" of closing costs that is presented to a borrower at the time a loan application is submitted. Many states have ramped up their oversight of the industry, resulting in the nefarious unskilled boiler room guys taking the proverbial hike. With this in mind, I spoke with a friend and experienced mortgage broker, Dan Shlufman, to get his take on where things are headed for the industry. It didn't take long to get to the word on his mind and on the minds of almost everyone in the loan origination community: compensation.
Saying Goodbye to the Yield Spread Premium
From my conversation with Dan, and from everything that I've read, the residential lending industry is holding its collective breath, as the compensation scheme for loan originators will be completely revised in a couple of weeks. In the past, a mortgage broker could be compensated by both the lender and the borrower, which allowed the mortgage broker the flexibility to fashion a loan product, based upon the complexity of the loan, the borrower's credit and a variety of other factors. The compensation that flowed from the lender side, an amount previously unknown to the borrower but now disclosed on the good faith estimate, is referred to in the lending business as the "yield spread premium." This additional compensation often allowed for the reimbursement of closing costs, payment of seller closing concessions, and more importantly, additional income to the mortgage broker. Right or wrong, and however you might characterize the nature of this compensation received from the lender, the "YSP" was a key component of how residential lending functioned and how folks in the lending industry made a living. But no more.
How Will a Loan Originator be Compensated?
Effective April 1, the YSP will be eliminated and the mortgage broker must either be compensated by the lender or the borrower, but not both. In addition, the compensation scheme must be based upon only a percentage of the loan, not to exceed three percent, no matter how large or small the loan amount may be or the difficulty in clearing the loan for closing. In essence, it's one size fits all. Further, the mortgage broker must provide the borrower with the lowest interest rate options and a variety of available loan products, to avoid "steering" the borrower to higher interest rate loans, a practice that benefited only the originator by providing a greater yield level. As if this were not complicated enough, there are other related changes that impact how mortgage brokers compensate their employees who generate the loans, putting additional pressures on keeping businesses profitable. Although many of the rotten apples that facilitated the housing crash are gone, and in many respects, the originators have themselves to blame for the legislative overreaction, those remaining in loan origination are being forced to accept changes that may no longer have relevance in today's restricted lending environment.
A Classic Case of Unintended Consequences
Being a country rife with conspiracy theories, there are some who would argue that the purpose of these changes is to eliminate an entire industry and force the consumer to deal only with a few large lending institutions to obtain residential loan financing, which often translates into higher loan closing costs. Conspiracies aside, the change in how compensation is calculated will no doubt cause a further exodus from an already shrinking profession, resulting in many consumers having no choice but to rely on the few institutional players who now control the marketplace. In order to stay in business, the mortgage origination survivors will be incentivized only to seek out borrowers with better credit scores and larger loan amounts. Those troublesome borrowers and bad credit risks will be knocking at the doors of the institutional lenders, who so far have shown little appetite for lending to even the well-qualified consumer. If the above transition occurs, higher loan transaction costs for the borrower seem inevitable at a time when any increase in the cost of purchasing a home could tip the delicate balance of the nascent recovery in the wrong direction. Although the transparency as to how compensation is paid and how it is calculated has been geometrically improved by Dodd-Frank and its progeny, whether or not the consumer will ultimately benefit and whether the housing market will improve in light of these changes, is yet to be seen.