New rules take aim at loan pricing, yield spread premiums
But this arrangement would violate its intent and spirit. The hapless borrower would be protected against any one LO attempting to gouge him for an overage, but would have no basis for choosing between different LOs offering different prices except by price shopping.
Forcing borrowers to shop not only different lenders but different LOs working for the same lender would not make life easier for them.
Note that I am not forecasting that lenders will do this, only that they might without breaking the rules.
The rule as it applies to brokers
In contrast to LOs working for lenders, brokers receive wholesale prices from the lenders they deal with, which means that there is no commission embedded in the price. For example, on a 30-year fixed-rate mortgage, the broker's price sheet might show 4.625 percent at 1 point, 4.75 percent at zero points, 5 percent at 1 point rebate from the lender, and 5.25 percent at 2 points rebate.
Brokers can pass the wholesale price on to the borrower and charge the borrower a fee for their services. For example, they could offer 4.75 percent at zero points and charge 1.5 points directly to the borrower. The much more common practice, however, is to quote a higher rate and retain the rebate as their compensation.
This would be 1 point on the 5 percent loan or 2 points on the 5.25 percent loan. Rebates, when retained by the broker, are referred to as "yield spread premiums," or YSPs.
Note that YSP is not the counterpart of overage. The LO has a commission built into the price, and an overage is extra compensation. In contrast, YSP is the broker's entire commission if no fee is paid by the borrower, which is usually the case. Of course, YSP can be reasonable and it can also be outrageous.
The application of the new rules to brokers is clear in one respect: Brokers can be paid by the lender or the borrower, but not by both. The real issue, however, is how it deals with YSP, and on that score the rules are hopelessly muddled.
The YSP muddle
Because the new rules say very clearly that compensation to a broker cannot be based "on a mortgage transaction's terms," and because YSP is based on the rate, it would seem to follow that YSP must be illegal. And if that is the case, brokers thenceforth could be paid only by borrowers.
Yet if one reads further into the rule, it is clear that it is not the Federal Reserve's intent to make all YSPs illegal. If the Fed wanted to do that, it could have done it very simply by a rule that says so. The rule that the broker can't be paid by both the lender and the borrower clearly suggests that in the Fed's eyes, the broker can be paid by the lender. Because all such payments constitute YSP, the Fed has accepted the legitimacy of YSP.
An example of a broker being paid by a lender in the Fed's Compliance Guide reveals the source of the Fed's confusion.
"For example, suppose that for a loan with a 5 percent interest rate, the originator will receive a payment of $1,000 from the creditor as compensation, and for a loan with a 6 percent interest rate, a yield spread premium of $3,000 will be generated. The originator must apply the additional $2,000 to cover the consumer's other closing costs."
The Fed is assuming here that the broker is receiving a base payment of $1,000 from the lender, similar to the LO commission that is built into the retail price, and that YSP is an extra payment, comparable to an overage.
But this is wrong -- brokers are quoted wholesale prices, and there is no base payment to the broker embedded in wholesale prices. All payments received by brokers from lenders are YSP. The $1,000 on the 5 percent loan in the Fed's example is YSP, and because the Fed views it as legitimate, and because there is no rule capping the size of YSP, the $3,000 YSP must be equally legitimate.
Industry reactions to the muddle
I have come across two possible responses from the industry if the existing muddled rule becomes effective. One is for brokers to charge their entire fee to borrowers, and credit any YSP to the borrower to cover other settlement costs. The borrower would decide on the trade-off between the rate and the YSP. In my view, that would be a good outcome for borrowers.
Another possible response that would be terrible for borrowers, yet consistent with the rules, is for brokers to post a fixed YSP with each lender that would set the broker's compensation with that lender. If the broker posted 1 percent YSP with lender A, 2 percent with lender B and 3 percent with lender C, the broker could charge what he can induce the borrower to pay by selecting the lender that provides the desired level of compensation. This is obviously a flagrant violation of the intent of the rules, because it would sanction the very worst broker practices.
Resolving the muddle
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