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"The recent case of Culpepper vs Irwin Mortgage Corp may force wholesale lenders to stop paying yield spread premiums to mortgage brokers. Is this good or bad for borrowers?"
Recent ruling on YSPs
Yield spread premiums (YSPs) are points paid by lenders for high-rate loans. Points are an upfront charge expressed as a percent of the loan. On low rate loans, lenders charge points whereas on high rate loans, lenders pay points. In prior columns, I called points paid by lenders "negative points" or "rebates". In the trade, they are called YSPs.
For example, a lender offering a 30-year fixed-rate mortgage at 7% and zero points might offer the same loan at 7.50% with a YSP of 1.5 points.
YSPs provide a useful option to some borrowers. For those with little cash, YSPs make possible no-cost mortgages, on which settlement costs are paid by the lender. For those who expect to be in their house only a few years, YSPs permit a favorable exchange of higher rate for lower fees.
Controversy arises in connection with YSPs that are retained by mortgage brokers as all or part of their compensation. Under the Real Estate Settlement Procedures Act (RESPA),YSPs retained by brokers are legal if they are "reasonably related" to the value of the services provided to the borrower. But class-action lawsuits against lenders paying YSPs to brokers have claimed that such payments are referral fees, paid for steering borrowers to high-rate loans. Referral fees are illegal under RESPA.
After many rejections, this claim was recently accepted by the US 11 th Circuit Court of Appeals in the Culpepper vs Irwin case. This decision has put the industry in a dither. It exposes wholesale lenders to potential claims on existing loans where brokers retained YSPs, and it would force them to stop offering YSPs through most brokers in the future.
The reality is that sometimes YSPs retained by brokers are reasonable compensation for services, and sometimes they are indefensible.
Indefensible YSPs can arise when borrowers mistakenly assume that the broker's only compensation is the fee paid directly by the borrower, and they don't shop alternative sources. In due course the YSP received by the broker is disclosed, but too late for the borrower to do anything about it.
Indefensible YSPs can also arise when market interest rates decline during the period between the initial price quote to the borrower and the lock date, and the borrower is not aware of it. For example, assume a broker quotes 7% and 1.5 points to the borrower when the wholesale quote is 7% and zero points, with the broker retaining the 1.5 points markup. When the loan is locked, market rates have come down and the wholesale lender is offering a YSP of 1 point for a 7% loan. The broker retains the YSP as extra income.
But these tricks are not unique to brokers. Retail lenders dealing directly with borrowers can also exploit those who don't shop, or who don't monitor the market during the period prior to the lock. In fact, it is easier for lenders because they leave no incriminating evidence.
Suppose the borrower in the example above had received the initial quote of 7% and 1.5 points from a retail lender instead of a broker. If the lender locked those terms despite a decline in market rates, the borrower would be exploited in exactly the same way. The only difference is that the broker leaves a paper trail—the YSP shows up in closing documents—but the increase in the lender's income is not disclosed.
If wholesale lenders stop offering YSPs through brokers because of fear of legal liability, business would shift from brokers to retail lenders. Borrowers who are cash-short or have a short time horizon would go to lenders to get no-cost mortgages.
In addition, many brokers would join "net branches" of small retail lenders as loan officer employees. Since net branches allow their loan officers to maintain their operating independence, the predators among them could abuse borrowers just as they did before. But because their employers are lenders who are not required to disclose their income from loans the way brokers are, their abuses would be invisible.
Wholesale lenders should continue offering YSPs to Upfront Mortgage Brokers (UMBs) because UMBs credit YSPs to borrowers, avoiding abuses that might generate legal liability. Long-term, that would encourage growth of UMBs and be good for borrowers. In the short-term, however, this would be far outweighed by the shift of brokers to net branches, which would be bad for borrowers. On balance, therefore, I favor legislation if needed to nullify the recent court decision.
