March 2007 - Interest Notes
In this issue:Overfixing Foreclosures
By Jim Lewis, CML
Chairman of the Board
For several months now, Wall Street investors have continued to pull back from our industry. Losses, in the form of first payment defaults, delinquencies, and foreclosures, increased significantly during 2006, and the trend continued into 2007. Wall Street was not willing to accept those increased losses and investors seeking strong return on investment began to pull out of the market. One by one, sub-prime lenders that were backed by Wall Street have suspended operations and closed their doors as capital for more innovative non-traditional mortgage products has dried up. For the more traditional institutional investors who remain, underwriting standards have tightened and prices have risen. Sub-prime and non-traditional products will continue to be available, though on a more limited basis and at higher cost to consumers. As it has before, the market is changing - it is what it is.
Despite market corrections, some members of the Colorado legislature are absolutely determined to ‘fix’ the foreclosure problem in Colorado. For some legislators, it seems all too obvious that new laws must be passed to reduce or prevent foreclosures. Some point to a lack of licensing as one reason why the rate of foreclosure has risen in Colorado. However, that premise is flawed. Of the top ten states ranked with the highest rates of foreclosure, nine have had licensing in place for years. How then, would one find a correlation between licensing some people and/or some companies and a reduction in the rate of foreclosures in a given State? The inconvenient answer is that there is no such correlation. Others suggest that we ought to make deception and fraud illegal, which is already the case. Beyond these rather superficial perspectives, there are, unfortunately, several issues based in the premise of fixing foreclosures that pose significant threat to our industry and consumers in Colorado. Legislators are under pressure to ‘fix’ current circumstances – and there is only one tool in the legislative toolbox: pass new laws. Sadly, it appears that the legislature is poised to ‘overfix’ a problem that is not only beyond their control, but also to which our industry is already adapting.
On Monday, February 25, House Bill 07-1322 was introduced along with Senate Bill 07-203. Together, these bills seek to establish loan product suitability standards and a fiduciary responsibility for mortgage brokers, and change the current registration requirement for mortgage brokers to a license requirement - though without an entry exam. In addition, mortgage brokers would be required to provide closing documents for all closings at least two days prior to any closing. And, if all documents are not provided within that timeframe, the clock resets to a new two-day period until all documents are provided before the loan may close. Furthermore, these bills seek to remove a funding lender’s ability to obtain waiver of the Colorado homestead exemption from a borrower, which, in effect, would remove from lending consideration the first $45,000 value of any residential property in Colorado. In other words, borrowers would need to maintain at least $45,000 in equity at all times, either as a net equity down payment, or as existing equity. Finally, it appears that the bills seek to retroactively strike down waiver of homestead exemption so as to apply these standards to all existing loans. Yes, some very well intentioned legislators are proposing to overfix the problem of foreclosures in Colorado.
Suitability Standards for Mortgage Brokers
The Mortgage Bankers Association recently published a Policy Paper titled “Suitability – Don’t Turn back the Clock on Fair Lending and Homeownership Gains” (click here to download a copy of the Report), which explains why the imposition of a “suitability standard” on the mortgage lending industry will cause serious consequences for consumers and industry. The report notes that, “In light of the mortgage lending industry’s achievements in democratizing credit, the debate no longer concerns whether credit is sufficiently available to borrowers, but rather…whether the loans particular borrowers receive are in their best financial interests.” Advocacy groups and some Colorado legislators have suggested that such a “suitability standard” should be imposed on the mortgage industry to curb claims of lending abuses and foreclosures. The bottom line is that suitability standard would turn back the clock on hard-won fair lending and homeownership gains.
One of the points the advocacy groups make is that a suitability standard applies to the securities industry, and that it should serve as a model for the mortgage lending industry. In the securities industry, a stockbroker or insurance agent is responsible for selling to a level of risk that is suitable to the interests of his or her client. For example, if you wanted to invest conservatively, with lower risk and lower potential return, it would be unsuitable for a stockbroker to put your money into a high-risk initial public offering. Conversely, it may not be suitable for a stockbroker to invest in low-risk, low-return bonds for a client who is seeking high-returns and who is comfortable in high-risk scenarios.
There is fault in comparing that type of suitability standard to the responsibilities of a mortgage broker. First, the money flows in the opposite direction. People involved in the securities and/or insurance industries receive money from their clients and invest it on behalf of their clients. From moment one, they are using the client’s money to facilitate an investment. That makes sense: if someone represents you and takes your money, they have a fiduciary responsibility to act in your best interests. In our industry, however, a mortgage broker sells access to a lender’s money, not the borrower’s. Under current circumstances, a mortgage broker does not represent their customer; a mortgage broker is an independent, third party sales person. Thus, the suitability standard is not compatible with how our industry currently operates.
It is easy, however, for some legislators to embrace the suitability standard concept for mortgage brokers because it’s very easy to identify a home as being the largest investment that many people will ever make. It is difficult, however, in the current market with flat property values and 100% financing, to assume that people are actually ‘investing’ in their homes. When considering the issue of suitability, we must consider that consumers who want to cash out the equity in their homes have the right to do just that - it is their asset to do with what they wish. The mortgage product suitability standard assumes that the loan originator should interview consumers, understand their needs, and then sell – as oppose to recommend – only those products that are suitable to the borrower’s needs and ability to repay. The result of this legislation could be that if a loan originated by a mortgage broker goes into foreclosure, the Division of Real Estate or a court could consider whether the mortgage broker failed to act in the best interests of the borrower. If so, the mortgage broker could be penalized and, ultimately, removed from practice in Colorado for up to five years.
Beyond those concerns, the mortgage broker suitability standard is troublesome in that it seems to go beyond that which exists for the securities industry where, for example, a consumer can determine their own level of risk tolerance. A consumer who is willing to accept greater risk in some investment opportunity can instruct the stockbroker to make a risky investment – and that would be the client’s decision. However, it seems that if proposed legislation passes in Colorado, consumers who overrule a mortgage broker’s advice, might still have some claim against the mortgage broker should their loan go into foreclosure. Again, I see this as a classic case of overfixing a problem.
There are many societal issues that supplement my concern over the suitability standard for mortgage brokers. According to MBA’s suitability study, the highest percentage reason for foreclosure is “loss of job or other curtailment of income” (41.5%). The next reason is “illness or death in the family” (22.8%), and the third is “excessive debt” (10.4%). Based on that study, it would appear that factors beyond the mortgage broker’s control are at least six times more likely to affect foreclosure than are unsuitable loan products. Even then, the concept of “suitability” conveniently ignores the fact that consumers are often determined to obtain the lowest possible payments, even if by way of a short-term introductory interest rate or negative amortization.
The issue of fiduciary responsibility
A person who represents or negotiates on behalf of another is considered to be acting in a fiduciary role. Colorado Senate bill 07-203 and House bill 07-1322 combine to establish requirements that mortgage brokers will represent the borrower(s) in loan transactions, rather than remain as independent sales people. Currently, there is no fiduciary relationship in the mortgage industry. If there were, it might be found between a wholesale lender and a mortgage broker because there is a written agreement between those two entities. However, such agreements generally specify that the broker is not an agent. Rather, the broker is positioned as an independent, third party sales person. Furthermore, borrowers sign documents that disclose that the mortgage broker is not an agent on their behalf. The mortgage broker’s role is not to get the borrower the “best deal,” rather to offer the borrower(s) options so that the borrower(s) can make the best decision for themselves.
The fiduciary responsibility for mortgage brokers means that brokers would represent the borrower and accountable for the borrower’s decisions. Thus, brokers would no longer sell access to a wholesale lender’s money. In effect, they would act as an agent of the borrower and negotiate terms with the wholesale lender – which works against the spirit of most, if not all, existing wholesale lender/broker agreements.
At this point, a few legal questions bear consideration: Can a mortgage broker act in the best interest of a client (as opposed to them simply being a customer)? If a mortgage broker must act as a fiduciary of the borrower, would accepting a Yield Spread Premium violate the fiduciary relationship? Could a broker sell a stated income loan without violating their fiduciary responsibilities? Arguably, no.
Unintended Consequences
There is a significant concern in the industry for the potential of discrimination, redlining and other problems (see pages 16 & 17 in MBA’s study). If there is a fiduciary requirement to only sell products that are suitable, an individual might readily rely on that requirement to say that a particular product is not suitable for a certain borrower while it is suitable for another borrower. Consider whether a suitability standard would have a greater impact or a lesser impact on a community that is predominantly made up of borrowers who have low- to-moderate income. Would it have a greater effect or a lesser effect on a community that has a higher minority population? As CMLA President Chris Holbert noted in the Denver Business Journal (February 23 – March 1, 2007, “Colorado foreclosures: The buck stops where?” pages A1 & A32): “Ten years ago, the accusation against my industry was called ‘redlining.’ [People said] that we weren’t making enough loans, especially in minority communities … five years ago, the accusation was that we were doing loans in those communities but were charging too much. ‘Redlining’ became ‘predatory lending.’ And today, there’s a certain aspect of truth to say that we’re being accused of making too many loans and not charging enough. Looking out two, three, five years, I fully anticipate that my job will be what it was 10 years ago: [answering the accusation] ‘You’re not making enough loans in the city and county of Denver.”
Just as HMDA data can demonstrate that minorities are turned down for loans at a greater frequency than non-minorities, the suitability standard would have greater effect in minority communities than others. The question of suitability suddenly takes precedence over the more passive requirements of ethnicity, race, gender, and other protected classes. While we are prohibited from making lending decisions on those protected criteria, mortgage brokers would suddenly be required to determine “suitability” as the overriding consideration.
Compounding this effort to overfix problems that are generally beyond the reach of our State government, Senate bill 07-203 seeks to transition mortgage broker registration to a license requirement, though without a test for entry. It appears that the primary reason for the proposed change is that calling the regulatory requirement a “license” would allow the Division of Real Estate to require mortgage brokers to maintain Errors and Omissions insurance in addition to the $25,000 surety bond that is required under the current registration requirement.
The State of Colorado should do a better job of understanding the failed concepts of registration and licensing that exist in 48 other states. Whereas, in most states (35 at last count), bonding requirements for “mortgage brokers” applies only to a brokerage (the firm), Colorado is now one of only three States in which bonding is required of individual persons who broker mortgage loans.
Now, to the point of providing closing documents to the borrower(s) at least two-days prior to closing, it appears that standard would be applied only to mortgage brokers. The reason for this is, once again, federal preemption. Therefore, the CMLA Board of Directors and I are very concerned about the unintended consequences this would have for mortgage brokers and their “clients” – assuming that brokers are required to act as fiduciaries. In situations where borrowers want to close a loan quickly, for whatever reason, a preempted entity would be able to close a loan in at least two less days than could a mortgage broker. Clearly, this would provide a more uneven playing field, which is contrary to CMLA’s holistic view of our industry; legislation should seek to benefit consumers, not serve to harm one segment of our industry while benefiting another. Since registration and licensing requirements CANNOT apply to all loan originators or all mortgage companies, we ought to avoid such regulatory models and seek aggressive enforcement for all, which can be applied to all loan originators and all companies.
Potential Disaster Hopefully Averted
As for the proposed legislation seeking to remove a funding lender’s ability to obtain waiver of the Colorado homestead exemption from a borrower, it appears that issue may be removed from Senate bill 07-203. On that point, there is broad industry opposition and a clear threat to a consumer’s ability to buy, sell, or refinance real property in Colorado. It seems that consumer advocates may have considered the effort as a $45,000 way to get back at ‘greedy’ lenders who want to ‘take away people’s homes’.
However, even the most aggressive anti-business legislators understand that lenders do not want the house; we want the payments. Furthermore, that many consumers of low-to-moderate income would be harmed if their effort resulted in a mandatory minimum down payment and/or equity balance of $45,000.
Still, it seems that some legislators are determined to overfix our industry, apply greater regulation to local small business people, and ultimately limit Colorado’s ability to recover from our current foreclosure problem, and thereby limit our ability to “boom” in the future.
Time to take action!
Members and friends, this is serious. As long as I’ve been in business, I’ve been aware that a faction of people continue to believe that registration or licensing will somehow ‘raise the bar’ on professionalism and get all the bad actors out of our business. But what the legislature is concerned about – and is acting upon – is the issue of foreclosures. In doing so, they are ‘overfixing’ our industry. Consider that such ‘fixes’ were not put in place in 1989 – the worst point in foreclosure history in our State, and also the doorstep to the best 10 to 12-year period in real estate in Colorado. If these ‘fixes’ had been put in place in 1989, how might that have limited the boom of the 1990’s?
Legislators today are running scared because of the extent of the current bust. Choosing to ‘overfix’ the problems we are facing today will have little or no effect on the current bust cycle. Their hope is that these ‘fixes’ might reduce the number of foreclosures the next time we encounter this cycle – and it is just that, a market cycle. But we have to be responsible and ask the question: How much harm would their legislative efforts cause today and how will they limit our ability to boom in the future?
Some legislators have a very high level of confidence in a ‘solution’ that could serve to stifle our economy. At the same time, I fear that many mortgage originators have lost track of this discussion. If you’ve read to this point, you’ve proven me wrong. If you’re a mortgage broker, a wholesale lender, or a service provider who relies on mortgage brokers or other loan originators, make a copy of this newsletter article and show it to those who need to see it. These legislative actions could devastate third party originations and the mortgage industry as a whole in our state. We need your involvement, we need your attention, and, when appropriate, we may need you to contact your State Representative and State Senator. If you are not already on the CMLA email distribution list, please go to www.cmla.com, click on the “Send us your email and we’ll keep you informed” red button and add your name to our email list. Pay attention and be prepared to act!
While strong consumer protection is essential to the public interest, it is equally essential to assure a regulatory environment that serves and does not stem innovation in the marketplace. Lenders need to be able to offer a variety of products and credit terms to borrowers. Ours is the greatest system of community investment to ever exist, and we need to protect that system. Any actions taken to restrict the flow of mortgage capital into our state do not serve to help our economy, consumers, or your career.
Thoughts, comments? Email me at chairman@cmla.com
