For many mortgage industry participants and consumers the implementation of the Dodd-Frank legislation has resulted in unintended consequences. Loan originator compensation is a category that stands out as an instructive example of unintended consequences stemming from legislation.
These consequences have restricted jumbo loan financing terms for consumers. The rational and impetus behind the changes to loan originator compensation were well intended. The idea was to curb the excessive and at times, predatory, fees and the steering of borrowers into inappropriate loans to generate higher revenue and commissions.
In the stampede to protect consumers a couple of common misconceptions were widely held by those formulating the legislation. The two myths were the majority of loan brokers were responsible for the predatory, greedy pricing and the worst excesses were across the board on all loans.
First only a small minority of loan brokers or their originators were culpable and for the most part the worst examples of overcharging involved subprime lending. The inconvenient truth is banks and retail mortgage banks with their much larger number of originators and powerful marketing were just as guilty of bad behavior. Do the two names, Countrywide Bank and Ameriquest Mortgage ring a bell?
But I digress in defending the majority of loan brokers who conduct business professionally. The fact remains the convoluted legislation that included loan origination compensation practices took effect on April 1, 2011. Up through the 11th hour, HUD and various regulating bodies issued new and at times conflicting interpretations of the legislation.
In the end the rules that were implemented were not, in my opinion, in synch with the original legislative intent and resulted in unintended consequences. Let's consider a specific example involving the brokering of jumbo loans to an investor.
Mortgage bankers face a serious financial dilemma implementing the April 1, 2011 rules when brokering jumbo loans. Normally mortgage bankers strive for best execution for the consumer, originator and the house utilizing a wide variety of loan investors and different delivery paths. These paths include brokering loans, banking loans for immediate sale, servicing released, banking loans for immediate sale, servicing retained, and selling pools of loans in bulk that have been aggregated and serviced temporarily by the mortgage banker or a designated outsource.
Prior to Dodd-Frank mortgage bankers were indifferent to loan originator compensation as a factor in selecting the best financial execution for their jumbo loans. I don't think Dodd-Frank envisioned or desired best execution decisions changing at the expense of both businesses and consumers. However, for some consumers seeking jumbo loans the change in loan originator compensation rules has negatively impacted offering the best pricing and terms. Why is this the case?
Mortgage bankers have two ways or choices to compensate loan originators and set pricing under the new rules. The first option, referred to as lender-paid compensation, is to set the rate and the origination fee to reflect the loan investor's lowest rate/rebate combination. Generally this is the rate with a 1% rebate on jumbo loans. If the mortgage banker/broker elects this option they cannot offer the consumer a lower rate unless the borrower is willing to pay discount points. This rule applies even in a competitive situation.
Prior to the rule change loan originators could and often did pay all or a portion of the closing costs as well as discount points out of their compensation proceeds. Under the new rules this option is no longer allowed leaving some consumers disadvantaged. The other major issue with this compensation option is the mortgage banker is often contractually obligated to pay most if not all the rebate from the investor to their loan originators.
In this scenario, consumers may not get optimal pricing and the mortgage banker may not make any money. If the mortgage banker selects a higher rate and rebate combo from the investor in an attempt to eke out a profit, they run the risk of being priced out of the market and not getting any jumbo business at all. By comparison let's consider option two, consumer paid compensation. The rules for consumer-paid compensation allow the mortgage banker to offer lower rates in competitive situations if the consumer is willing to pay additional discount points as well as the loan originator's compensation. The catch is the loan originator cannot receive compensation directly from the loan but instead must be on a fixed salary arrangement. So if the mortgage banker elects option two to be more competitive, the consumer must pay out of pocket origination fees and discount points, and the mortgage banker has the risk of higher fixed overhead by having their loan originators on salary.
This compensation dilemma disappears if the mortgage banker has the investor option, and the warehouse capability, to close loans in their own company name as a correspondent. Under the new Dodd-Frank rules, loans sold under a correspondent relationship are considered secondary market transactions and are largely exempt from the loan originator compensation rules described above. This is permissible since compensation is not disclosed to the consumer. Most if not all conforming as well as FHA/VA loans are funded and sold on a correspondent or direct lender basis to the GSEs as pools in the secondary market.
However, in the world of jumbo loans, a world that is much smaller today with the GSEs much higher loan limits, very few investors offer a correspondent solution because of the attendant higher risks. As a result mortgage bankers as well as smaller banks and credit unions have little choice but to broker their jumbo loans. And because of the compensation dilemma outlined above, some companies avoid offering or have curtailed jumbo lending. In the end some consumers are hurt by the lack of freely competitive jumbo pricing.
In my opinion, not only should the CFPB avoid adopting a flat fee rule for purchase transactions, a rule change presently out for comment, but CFPB should revisit all the current rules surrounding loan originator compensation. Changes to loan originator compensation could eliminate the negative unintended consequences of implementing Dodd-Frank. A similar review exercise has just been announced for the rules pertaining to Basel III so perhaps positive change is in the air.
Craig Cole is CEO of Emerald Consulting LLC.
