Wednesday, March 19, 2008

HUD Proposal on Good Faith Estimate I: The Context

by Tanta on 3/19/2008 04:48:00 PM

HUD has just released yet another proposal for changing the disclosures required under the Real Estate Settlement Procedures Act (RESPA), a federal law that is implemented by regulations promulgated by HUD. I’m not terribly impressed by the proposal, but it’s hard to say why without a lot of background rambling. So I’m going to ramble. Those who aren’t up for it should skip this. In a future post, I’ll get into the specifics of what I don’t like about the proposed new GFE.

A quick recap: RESPA requires a lot of things, two of the most important of which being the Good Faith Estimate of settlement costs, known as the GFE, and the HUD-1 or HUD-1A Settlement Statement, the exact accounting of closing costs and settlement charges given to borrowers when the loan closes. The GFE is given at application. The idea when RESPA was first enacted was to prohibit lenders from giving low-ball estimates of costs up front, only to shock the borrower with a lot more costs at closing, when it was often “too late” for a purchase-money borrower (or a refi borrower with a rate lock expiring) to back out. The estimates of costs on the GFE have to match what’s on the HUD-1 within a certain tolerance, or else you have a regulatory problem. The GFE/HUD-1 rules have been around for decades. In the last few years HUD (the agency, not the document) has made a few attempts to revise them, all of which have failed for one reason or another. The current proposal is just the most recent in a long line of unsuccessful attempts to get control of the disclosure of financing costs to borrowers, most specifically in the case of brokered loans (although the new rules would apply to retail lenders as well).

In some ways, what HUD is doing is formalizing the brokered application model into the RESPA disclosure scheme, a decade or two after certain problems and concerns first arose. One of the troubles that wholesale lenders have had for a long time is making sure they’re meeting RESPA rules for when the GFE has to be given to the applicant; the rule has for a very long time been that the disclosures must be provided within three business days of “application.” But what is the date of “application”? The date the broker takes an application from a borrower, or the date the wholesaler receives an application from the broker? From the borrower’s perspective, of course, this is easy: it’s the day you gave the broker sufficient information to complete the application. This implies that it is the broker’s job to provide you with the GFE. (And for what brokers charge borrowers, you might well think providing a written estimate of closing costs isn’t so much to ask.)

But the wholesaler has always had a problem here, because the wholesaler is going to close that loan and the wholesaler is going to have the “RESPA risk,” or the risk that the disclosure was inaccurate or not provided in a timely fashion. As with other things, it has never especially mattered that it might be the broker’s “fault”; brokers haven’t got the money to make you whole on fines, penalties, recissions and re-closings of loans, or sales of loans as “scratch and dent” because the higher-paying investors won’t buy a loan with iffy RESPA docs in the file. So wholesalers developed this habit of simply “redisclosing” or providing a GFE for the borrower within three days of getting the application from the broker, even if the broker had already supplied one. This was supposed to assure that whatever the broker did, the wholesaler complied with RESPA and made sure that the fees disclosed on the GFE were fees the wholesaler was comfortable with charging on the final settlement statement.

That meant several things, one of which is that borrowers were usually waiting the three full business days to get a GFE, and were paying application fees before getting one. At minimum, borrowers were paying for credit reports, since in these days of risk-based pricing, you don’t get a GFE until we know what your rate/points are, and we don’t know that (even approximately) until we know what your FICO is. RESPA, which predated such practices, was based on the assumptions of an older way of doing business, in which an application could be submitted and an estimate of costs given well before any “processing” on a loan, like ordering a credit report, commenced. Of course, once a borrower has paid a fee to get a GFE, it’s much less likely that borrower will “shop around” and pay several other lenders the same fee to get alternative GFEs.

It also pretty much erased—and then some—the wondrous efficiencies we had achieved at least since the mid 90s with cool technology. I am hardly the only person to have spent centuries of her life she’ll never get back in meetings and task forces and committees and piles of documentation and user testing working on rolling out “point of sale” (POS) technology that would allow loan officers armed with laptops and a portable printer to take a complete application right there, on the granite countertops, at the open house, and print out a pretty, complete GFE, right there on the granite countertops. With a dial-up connection, the LO could run the loan through an AUS and even hand out a commitment letter (subject to getting the appraisal and so on). Ah, the glorious days of progress, when we congratulated ourselves on providing a GFE to applicants in three business minutes.

It’s not exactly an accident that the acronym “POS” means both point-of-sale and piece of . . . stuff. There were any number of problems with the POS technology, not the least of which was those portable printers, which were “portable” as long as you didn’t expect them to be “printers” and vice versa. Many lenders got gung-ho about giving their loan officers the authority to issue commitment letters at POS, and found themselves committed to making loans that the underwriting department wouldn’t have approved on PCP. There was also, it transpired, a little problem with those pesky consumers. It turned out that what they really wanted out of life wasn’t always to stand around at an open house giving personal information to an LO and getting not just “estimates” but a commitment letter they were feeling pressured to sign without any cooling-off period or shopping around. As is often the case, the industry told itself customers were really interested in speed, when in fact the industry was really interested in speed and the customers had to be made to see reason about it. I can remember at one point a local competitor of mine proudly announcing it didn’t offer that “high-pressure tactic” of POS technology, and that competitor took a lot of our business.

The issue for retail originators was having an LO out there like a loose cannon with a laptop, making quickie commitments often based on quickie evaluation of the borrower’s seriousness or capacity. Those commitments were always supposed to be “subject to” finally getting all the real documentation and verifications and so on, but some loan officers figured out that such a heavily-conditioned commitment is hardly much of a commitment—it just encouraged people to “shop around”—and so “competitive pressures” led to leaving out a lot of those conditions. In fact, at least one of us believes that the “stated income/stated asset” phenomenon really began here. The Official Story in the industry is that it grew out of perfectly reasonable ways to underwrite self-employed borrowers with complicated financial lives, and somehow spread to W-2 borrowers with a single checking account when we weren’t looking. I don’t personally remember it happening that way.

The issue for wholesale lenders was even worse, since the brokers often weren’t quite sure which wholesaler they’d be closing this loan with—it would depend on who paid the richest premium, often, and that couldn’t be established until they got back to the office and checked rate sheets. So the brokers would hand out GFEs based on wild-arsed guesses of the fees required by the wholesalers, leading to endless situations in which the fees charged on the final settlement statement were pretty far off the original estimate, leading to endless situations in which regulators and consumer attorneys had to remind everyone what the “good faith” part of GFE meant. That was when the broker actually bothered to hand out a GFE, or do it within the holy three days. The wholesalers concluded it would be better for them to “re-disclose” on receipt of the application package (later, the electronic submission) from the broker. Aside from the monumental customer confusion that creates—which GFE is the “real one”?—it began to dawn on at least a few wholesalers that duplicating too much of the work the broker was supposed to be doing was approaching the same operating cost structure of a retail lender. It wasn’t just the disclosure issue, after all. You had to re-verify the broker’s verbal verification of employment and order (and review) a field review appraisal to reality-check the appraisal you let the broker order and so on until there wasn’t much the broker did that you didn’t also do.

The obvious answer to that was to make the borrower pay for it all. You began to find GFEs showing “underwriting fees” and “document preparation fees” all over the place, for instance. Now, underwriting your loans and drawing up your closing documents used to be considered basic overhead, you know, and lenders covered that in an origination fee charged to borrowers (or in the margin on the interest rate). The only time you ever charged a “doc prep fee” to a borrower was a situation in which you actually had to draw up unusual, complex documents—like a convoluted trust agreement or one of the gnarlier “hold harmless” agreements—that you needed to actually pay outside counsel for. You never charged anyone a separate fee for standard mortgage docs; that was like charging them for the air conditioning in the closing room. But in the wholesale model, you had to find some way for the broker to draw up GFEs and the wholesaler to then do it again and the whole thing to remain profitable for everyone. All kinds of other things, like flood hazard determinations and tax service contracts, that we always had to obtain for loans but that we always just covered out of the origination fee, started to appear as separate items on the GFE and HUD-1.

It was and still is argued all over the place that these practices are really pro-consumer, since it’s a clearer “itemization” of the real cost of credit than some all-in “origination fee” or “broker fee.” Had the origination fees shrunk proportionally to the newly added itemized fees, that might have been plausible. But in way too many cases, you were paying the same origination point you had always paid, plus $40 for a flood cert and $75 for a tax service contract and $100 for doc prep and on and on and on. In fact, you were paying so much in fees at closing that you were in real danger of not being able to scrape up that much cash—or increase your loan amount enough—to cover them and get a loan closed. This was (pre-RE bubble) a huge problem with refis. Refis are brokers’ bread and butter in low-rate environments, and it’s hard to convince people to refi for a 25 bps drop in rate—which people did—with that nasty cash requirement.

The solution was obvious: find a wholesaler who is willing to price a higher interest rate at a “premium,” and use that premium to “credit” the borrower, or to do the now-ubiquitous “no cost closing.” Of course it’s plenty of “cost”; it’s really just a “no-cash” closing. Obviously there are only certain actual historical rate environments in which this kind of thing will work in the prime lending world: if you’ve got borrowers wanting to “take advantage” of new, lower interest rates to refinance, you can’t always charge them the highest rate out there in order to produce enough premium to pay inflated closing costs with. It’s the kind of thing that might work in the beginning of a steep rate drop, like the 2002-2003 period, when existing loans on the books had a high enough interest rate that they could refinance into a current “premium” rate and still show a rate reduction. The trouble is, if you do too much of that on a wide scale—and the turnover in the entire nationwide mortgage book in 2002-2003 was enormous--it gets harder to do it again. Once the prime mortgage book had “reset” itself to very low current rates via a refi boom, it was hard to tempt them with a premium to current market, unless fixed rate mortgages hit 4.00%. They didn’t, so someone had to invent a mortgage product that seemed like a lower rate to borrowers but that also paid enough hefty premiums that closing cost inflation could be masked. The Option ARM, among others, stepped into the breach and here we are.

The comments to this thread will be choked with outraged mortgage brokers who will once again give you the same old story that “premium” closing cost credits are a god-send to us average schmucks who don’t have several grand sitting around to pay closing costs with, but who oughta get the benefit of lower rates just like the Big People, etc. They will tell you that there are too many “competitive pressures” preventing brokers and wholesalers from larding up settlement statements with both origination fees and a boat-load of “itemized” fees. They will tell you that there are all kinds of perfectly “legitimate” reasons why the final settlement statement you get has all these fees and charges on it that weren’t on the GFE, most of which are your fault for delaying the process or not following what you were told. They will tell that they shop around to get the best rate for you, and deserve to be compensated for that, but that it is the consumer’s responsibility to shop around for several shop-arounds so that they can assure themselves of getting the cheapest deal on the fees. They will tell you that while they don’t do it, retail lenders do it too, so we should stop picking on brokers.

My problem here is with the basic mechanism of, in essence, financing your closing costs in this way (by taking the higher rate to get the “credit” that reduces the amount of cash you bring to closing). It is simply ripe for abuse because there is (now) such a large segment of the borrower world who do not already have prime-quality fixed rate loans, who are desperately focused on monthly payment, not total cost over the term of a loan, and who simply do not have the basic financial skills necessary to do the cost/benefit analysis of fees versus interest rate, even if they could afford to pay three separate credit report fees at $40 a pop to several different brokers in order to amass several different GFEs so that they could find a way to save back the $80 in “wasted” fees and then some. Not to mention the fact that they are, as a group, generally the most susceptible to high-pressure sales tactics (this is true generally of a lot of people with heavy consumer debt and thus low FICOs; they are just incapable of saying “no” when the clerk at Macy’s offers “10% off today’s purchase with Instant Credit!”).

To be honest with you, too many people in this business do not fully understand its cost structure. There’s just a massive confusion all over the place about the difference between “financing costs that are paid up front at the closing of a loan” (as distinguished from interest charges that are paid in the future) and “settlement costs.” There are quite a few things you have to cough up money for at the settlement of a mortgage that are really “prepaid items,” not finance charges. For instance, the money you bring in to fund your tax and insurance escrow accounts. You have to pay real estate taxes and homeowner’s insurance anyway; you either pay it yourself once or twice a year or you pay it on the “installment plan” by paying your lender one-twelfth of it a month. In order to get an escrow account established up front, you’ll probably have to put two months or so worth of escrow payments in the account to start it out (because the annual bills will be due the first time before you’ve managed to make twelve payments, basically, given the lag between closing a loan and the first payment due date). Escrow funding is a relatively large-dollar item on most loans compared to things like a $75 tax service fee, but it’s not the kind of thing shopping around will do you any good with, since it is what it is (assuming lenders get their hands on a realistic estimate of RE taxes) and there’s no “markup” in it—it’s your money, the lender is just taking it up front as a deposit into your escrow account.

It is easy enough, unfortunately, to low-ball the estimated escrow funding amounts on a GFE while larding up on actual finance charges. If borrowers are only comparing this lender’s total to another lender’s total, they can be highly misled about who has the cheapest “closing costs.” And almost all lenders charge a higher rate (or more points) to borrowers who are allowed to get a “waiver” of escrow accounts. If you aren’t paying attention, you might be comparing a GFE from one lender that includes two months’ worth of tax and insurance payments in “closing costs” to a GFE from another lender that includes no escrow dollars but increases your interest rate by 12.5 bps.

The same thing goes, on a less expensive plane, with things like surveys and pest inspections. It might be a lender requirement that you get one of these things, and you might be willing to play dice with your hard-earned money by ignoring survey lines or signs of termite damage if you weren’t required not to by some lender. But the fact remains that (unless the lender is conspiring with the surveyor or exterminator/inspector to get a “kickback”) you’re paying for a real good or service there that doesn’t benefit the lender only. A tax service fee, on the other hand, benefits the lender and investor, not you. You will get your tax bills directly from the county; you don’t need to pay someone to track them. A tax service fee is a classic case of a “finance charge” in the regulatory sense: it is a cost you incur because you are financing the property, that you wouldn’t incur in a cash purchase of the same home. This is why mortgage insurance, unlike your homeowner’s insurance, is considered a “finance charge.”

There are other things you might pay at a mortgage settlement that are a little murkier, conceptually. You wouldn’t pay for a lender’s title insurance policy in a cash sale, but you would (if you were sane) pay for a title search and an owner’s policy. You wouldn’t pay for an attorney to prepare a deed of trust (a “mortgage”) in a cash sale, but you’d pay for a grant deed (otherwise you wouldn’t have legal ownership of the home you’re buying). Appraisal charges aren’t considered “finance charges” for regulatory purposes, on the assumption that a reasonably competent cash buyer would also get an appraisal, although I’m willing to bet that most people think of them as “finance charges” or things you wouldn’t have to pay if the lender didn’t make you and that benefit only the lender.

All this matters for regulatory purposes—the rules about how lenders disclose “finance charges” as distinct from “settlement costs”—but it also matters because there has for some time been something very important getting lost in discussions of “closing costs” or the cost of mortgage credit. A lot of those costs are real estate transaction costs. We have been hearing for years on end, during the boom, that people “who are only going to stay in the house for two years” shouldn’t be “having to pay for a 30-year fixed rate.” We don’t hear many people wondering why you’d buy a home in that situation in the first place.

The reality in most markets across nearly any time period you care to name is that it’s almost never worth buying a house to live in for two years. It pretty much requires a bubble for the RE agent commission and the title search and the survey and the pest inspection and the deed recording fee and so on, let alone the true “finance charges,” to pay for themselves in two years. But there has been a shift in rhetoric and terminology that seems to lump “transaction costs” into “financing costs,” allowing people to “make sense of” buying a house you plan to live in for only two years because you can find some lender who will let you finance the transaction costs through this premium-rate “closing cost credit” deal.

The reality of things is that no lender makes any money charging premium interest rates to recover costs it didn’t charge the borrower at settlement if the borrower pays the loan off in a short period of time (unless it was a really really big premium). This is where your “prepayment penalties” came from; it’s also where all these expensive post-settlement fees (like the notorious fee for getting a payoff quote or a release of the old lien in a refi) come from. The economics of making “bridge loans” (short-term loans) at “permanent loan” terms just doesn’t work if you don’t collect fees up front. You can get by with a small enough percentage of your loans behaving like that—credit card lenders can get by with a small enough percentage of people who pay in full every month, and Best Buy can get by with a small enough percentage of people who do the “one year same as cash” thing and pay it off before a finance charge is imposed. But nobody can handle everybody behaving like that. Not for long.

And it’s not just home buyers, it’s refinances. It simply isn’t rational for an investor to “pay up” for a high interest rate if said loan is going to refinance at the next little market bump. But people will refinance, these days, for amazingly small rate increments, for two reasons. First, loans are a lot bigger than they used to be, while incomes haven’t been growing. That means that the dollars at stake in monthly payment savings become more significant even with small decreases in the interest rate.

The second reason is where this gets into a vicious cycle: people refinance at the drop of a hat because they don’t pay the closing costs in cash. They either roll the costs into the loan—driving balances up over time and creating even further incentive to refinance again—or they get that “premium credit” thing, which means that the borrower has a built-in incentive to refinance the new loan as quickly as possible. This dynamic creates regular income for brokers who get paid for each refi, but it doesn’t always do much for investors.

A great deal of this business over the last several years of refinancing people out of perfectly affordable fixed rate loans into these toxic ARMs came about because there was no longer any way to price a premium-rate fixed rate loan at a lower rate than what the borrowers already had. However, the market was full of “dumb money” that would pay 105 for a “high quality” Option ARM—not to mention the “low quality” ones. Many people focus on “YSP” as broker compensation, and that’s a big issue. Some of the sleazier brokers took those five points from the wholesaler and the borrower didn’t see a five point credit on the HUD-1. My point, though, is to question whether the ones who did get a closing credit really got such a great deal.

Would borrowers have balked at doing the refi to start with if they had had to pay at least some of the closing costs in cash? Would they have paid a touch more attention to those prepayment penalties they were signing up for if it had occurred to them that the only way a “no cost closing” can be profitable to a lender is by extending the life of the loan long enough for the costs to come out of the interest paid each month? Would borrowers have been more likely to catch on to an ARM masquerading as a fixed rate or nasty ARM terms “hidden” in a big pile of legalese if they had a realistic sense of how low 30-year fixed rates are likely to go on any given day? There is something terribly wrong with lenders who give out misleading disclosures, and I don’t blame borrowers for lender sleaziness. But there is also something terribly troubling about the apparent fact that a lot of people thought they were getting a 30-year fixed rate loan at 1.95%. That is much too good to be true. Why didn’t it occur to anyone that that’s much too good to be true?

To see this as strictly a “disclosure” issue is to simply cop out, as far as I’m concerned, on the question of a very old-fashioned view of what loan officers and brokers were supposed to be doing, which is explaining things like the fee/rate tradeoff, the point of prepayment penalties, and the likely range of prevailing market rates on fixed-rate loan quotes. “Educating” your borrowers is just off the table. All we’re left with is “disclosing” loan terms that truly educated borrowers probably wouldn’t have anything to do with, and relying on borrowers to “shop around” in a market in which they still have no idea what the “going rate” is.

We’ve gone, just in my career in this industry, from taking three whole business days to get a GFE into a consumer’s hands, because we did them with adding machines and typewriters and snail mail, to taking three whole minutes to do that with only reasonably fancy technology, and back to taking three whole days again because there are too many intermediaries in the process (all of whom have to get paid). And HUD is, after years and years of this practice going on, finally working up a way to disclose premium-rate closing cost credits right when the terrible market distortions partially due to that practice are melting down the credit markets. Behind the whole thing lurks the ideology that regulators are not there to tell anyone what is an allowable business practice; they’re there to just make sure you “disclose” what you’re up to. It is aided and abetted by a “consumer advocate” lobby who frequently seems to believe that “complexity of disclosures” is the problem, rather than unrealistic expectations consumers develop based on the onslaught of marketing they get from the industry, which tries to tell you there is a free lunch if you act now.

Once you and I have recovered from this post, we’ll look at some of the details of the new proposed GFE. I do hope it will make more sense after this ramble.