October 13, 2014

In a recent article I proposed that Fannie Mae and Freddie Mac be removed from limbo and given a new mission: to create a better primary mortgage market. Among other things, this would include the elimination of third party settlement costs. To borrowers, these are a horrible yet unnecessary source of complexity, confusion and overcharges. Existing attempts to deal with the problem through government-mandated disclosures, rules against markups and prohibitions of referral fees have only added to the complexity of the process without preventing overcharges.

Third party settlement costs could be eliminated by implementation of one simple rule: any service required by lenders as a condition for the granting of a home mortgage must be purchased and paid for by the lender. Lenders would be free to embed these costs in the price charged the borrower, but the borrower would then have to deal with only one set of prices.

What difference does it make whether, e.g., the title insurance policy that protects the lender is purchased by the borrower, or by the lender who bills the borrower for it?  It makes an enormous difference. Prices paid by borrowers indirectly in the price of the mortgage would be substantially lower than the inflated prices they now pay directly to third party providers.

Under existing arrangements, competition by third party providers to sell title insurance, mortgage insurance, appraisals and other required services is directed not at the consumers who pay for the services but at the lenders who refer consumers to service providers. Such competition is “perverse” because it raises the costs of third party providers that must be covered by their prices. Lenders use their strategic position as a referral source to get a piece of the action, receiving  free or underpriced services provided by the firms to which they refer business, or by participating in the ownership of such firms. One lender I know has an ownership interest in both a title agency and an appraisal management company, and has its loans underwritten for free by a mortgage insurer.

Consider what would happen if automobiles were sold like mortgages. When you asked the price, the dealer would say "This is the price of the body and motor only. The transmission system, tires, electrical system, and upholstery must be purchased from "A," "B", "C" and "D". The price you pay at delivery will include the payments to these other 4 firms, and right now we can only provide an estimate of what these payments will be."

The result of this would be an increase in the total price of the automobile. If the automobile manufacturer only provided the chassis and motor, it would become indifferent to the prices of the other components because the consumer would be buying them from other firms. Instead, the automobile manufacturer (or its dealers) would have an incentive to use its access to the consumer to collect referral fees from the component manufacturers. The manufacturers of the components would compete for referrals, which would raise referral fees, and with them the prices paid by the consumer.

In fact, automobile manufacturers bundle all the components, selling a complete automobile at a single price. To sell to them, component manufacturers must compete in terms of price and quality, rather than referral fees. Competition among the automobile manufacturers forces them to pass on most of the benefit to the consumer.  

The bundled-product approach that works so well in the automobile market would also work in the mortgage market.  Lenders would compete for customers by quoting prices for the entire package of services, which would cause them to use their market clout and superior knowledge to bargain aggressively with third party service providers for the lowest possible prices. And competition between lenders would force them to pass on most of the benefits to consumers.  

In some cases, lenders would decide that a particular service is not needed or not worth the price, and they would do without it. Under existing arrangements, that  never happens.

In 2002, HUD tried to foster a package approach with a single price, but participation would have been voluntary and it never got off the ground. The mortgage bankers did not support it, and neither did the consumer groups. Fannie Mae and Freddie Mac, if authorized to create lender networks, would have the clout to do it because they could make the complete- package-of-services approach a requirement for participation in the network.