April 30, 2013

On April 4, 2013, the Consumer Financial Protection Bureau (CFPB) announced that it had taken “enforcement actions to end what the Bureau believes to be improper kickbacks paid by mortgage insurers to mortgage lenders in exchange for business.” The kickbacks take the form of dividends paid by captive reinsurers that purport to be a risk-sharing device but are in fact a method of paying lenders for the referral of business.  “Illegal kickbacks distort markets and can inflate the financial burden of homeownership for consumers,” said CFPB Director Richard Cordray.  

CFPB is right that mortgage reinsurance arrangements are really kickbacks for the referral of business, but it is wrong in suggesting that  eliminating them will reduce costs to borrowers.  In my view, it is just as likely, perhaps more likely, that the cost to borrowers will increase. 

Borrowers have been over-paying for mortgage insurance over the years, and also for title insurance and property appraisals, and the underlying reason is the same.  In all three markets, the seller of the service is selected by the lender but the cost is paid by the borrower. This situation inevitably raises prices to borrowers relative to what they would be if the sellers had to compete directly for the patronage of the borrowers who pay for the services. 

When sellers are selected by borrowers, selection is largely based on the price of the service. When sellers are selected by lenders, selection is based on whatever things of value the seller can bestow on the lender, who is largely indifferent to the price paid by the borrower.    

Payment of dividends from a reinsurance affiliate is only one method used by mortgage insurers to compensate lenders for referrals. Smaller lenders are compensated by free services, including free loan underwriting, which can be justified on the grounds that the insurer has to underwrite for its own protection.  

In the case of title insurance and appraisals, the most common device used to compensate lenders for the referral of business is shared ownership of the title agency or the appraisal management company to which the lender refers its business. If done by the book, meaning that the affiliate does the work of such an agency and is not a sham, these arrangements are legal. 

From the standpoint of the service sellers, all such arrangements are marketing expenses, which must be covered by the prices they charge borrowers.  Shutting down one particular method of compensating lenders for business referrals forces them to adopt other devices which could well be  more costly. If so, prices will rise rather than decline.  

The key to price reductions for borrowers is to force service providers to compete in terms of the price paid by borrowers, as opposed to competing in terms of bribes paid to the lenders who select them. There is a little bit of price competition going on now in the title insurance market, where astute borrowers are shopping for their own deals on-line. In the mortgage insurance and property appraisals markets, however, there is nothing happening and little prospect that anything will happen without a major change in the rules.  

The needed rule change is extremely simple, and also extremely logical. The rule should be that any service required by lenders as a condition for the granting of a mortgage should be paid for by the lender, with the cost embedded in the price of the mortgage. In one swoop, this rule would replace competition in the bribes paid to lenders with competition in the prices paid by lenders.  

If you are not convinced that this rule change would benefit borrowers, consider this hypothetical: suppose new automobiles were sold without tires, and that to get tires you were directed to a tire agency approved by the dealer, who would add the price of the tires to his bill. Is there any doubt that the price of the car plus tires would be higher than the price now that includes the tires?  

And don’t overlook the free bonus.  The existing set of complicated rules establishing the legality or illegality of various ways that lenders compensate service providers, would be eliminated. 

I doubt that CFPB has the legal authority to make this change now, but it can and should ask Congress for the authority it needs to do the job for which it was chartered.