Mortgage brokers, who originate up to two-thirds of home loans, have exploited their lack of federal regulation to loosen lending standards in ways that sparked today's high mortgage-default rates among borrowers with weak credit.
Hearings before Congress this year made it clear that mortgage brokers and nonbank lenders took advantage of a regulatory gap to make unsound home loans to people with the weakest credit history, preying especially on minorities and the working poor.
Now Congress must decide how best to bring brokers, who originated about 70 percent of so-called sub-prime loans over the past two years, under some form of federal regulation.
The Mortgage Bankers Association, in its latest report, found that during the first three months of this year about 15.75 percent of sub-prime adjustable-rate mortgages were behind on payments by 30 days or more.
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That's an all-time high. And the figure is widely expected to grow. Experts predict that 1 in 5 sub-prime adjustable-rate home loans - as many as 1.5 million - will default by the end of next year. More than $2.28 trillion worth of adjustable-rate loans reset from 2007 to 2009.
Mortgage brokers are often the first link in the process of securing a home loan, so many borrowers think the brokers are working for them.
Wrong. No federal law says mortgage brokers have any fiduciary duty to borrowers, and with the exception of California, most states don't stipulate that duty either.
That's why brokers are front and center in the sub-prime debate. Federal law doesn't define whose interests they're supposed to represent: borrowers or lenders?
This was clear during a Senate Banking subcommittee hearing June 26. Sen. Robert Menendez, D-N.J., met silence when he repeatedly asked a panel of industry players whether they thought they represented borrowers.
Brokers work with lenders to offer home buyers a range of finance choices. But unbeknown to many borrowers, lenders give brokers financial incentives to steer home buyers into loans with higher interest rates, especially ARMs. Some such loan rates can spike up brutally high.
Such resetting loans - sometimes called exploding ARMs - constitute the overwhelming portion of sub-prime loans that are now delinquent or in default.
Absent clear laws to hold brokers accountable - as rules do for real estate agents and financial planners - abuses in the sub-prime mortgage market will continue, said Michael Calhoun, the president of the Center for Responsible Lending in Durham, N.C.
"It's like a football game. If you don't prohibit holding, you're going to have a lot of holding," he warned senators.
Brokers complain that they're being singled out unfairly, noting that they're not alone in originating home loans. So do big banks, credit unions, mortgage bankers and lightly regulated nonbank lenders - many of them now bankrupt or headed there because of their sub-prime loans.
"We feel like we're being picked on at this point," complained Harry Dinham, until recently the head of the National Association of Mortgage Brokers in McLean, Va.
Even state regulators concede that new rules must apply broadly.
"The problem is that in the real market, you have a lot of folks who stratify more than one of these definitions," said William Matthews, a senior vice president for the Conference of State Bank Supervisors. "I may be a large mortgage-brokerage company or a local or regional lender, and some loans I will broker and on some loans I will lend. You have a lot of hybrid activity so you can have a full product line."
But brokers are uniquely problematic because of lenders' reward systems. Typically a broker receives a fee or commission equal to anywhere from 1 percent to 3 percent of the loan's value as a reward for steering customers to a lender.
If a broker guides a borrower who qualifies for a lower-rate loan into a loan with a higher interest rate, which makes more money for the lender, the mortgage broker earns a higher bonus. This is called a "yield-spread premium."
Sometimes borrowers accept a higher interest rate in exchange for less cash down or for improvements such as landscaping done at the time a loan closes. Sometimes, borrowers are steered into unsuitable loans.
"Are yield-spread premiums abused? Absolutely. Do borrowers understand what they are paying in yield-spread premiums? The vast majority of time they do not," John Robbins, the chairman of the Mortgage Bankers Association, told senators.
Hearings have documented how brokers steer borrowers with weak credit into loans that reset and carry steep penalties if the borrowers try to pay off the loans before they reset. These make it difficult to refinance or pay off loans before they shift to punishing high interest rates.
To clarify that brokers should serve borrowers, Sen. Charles Schumer, D-N.Y., introduced legislation that would create suitability standards. It would make mortgage brokers and the lenders they work with legally liable for loans issued to borrowers who can't afford them.
The bigger question Congress faces is how to impose federal regulation on mortgage brokers, who are now regulated at the state level, quite unevenly.
On June 29, the Federal Reserve issued "best practices" guidance to sub-prime lenders - advising against "prepayment penalties," for example - but the Fed lacks the power to enforce its guidance on mortgage brokers.
If Congress tried to federally regulate brokers, that could require a new bureaucracy at a time when the federal budget is under a severe squeeze. A more attractive alternative is creating a national licensing system and standards of conduct that would be set by the federal government but enforced by state regulators.
Such a system would target individual brokers and the companies they work for, collecting data about complaints, fraud and the like.
The Conference of State Bank Supervisors is finalizing a national registry and database that will make it harder for fly-by-night operations or brokers to jump from state to state. The registry would provide a track record for consumers to evaluate.
"If you look at where at least some of the problems are, quite often it is with the individual loan originator," said Gavin Gee, Idaho's director of finance, who began trying to regulate all loan originators last year. "If you've got a rogue originator ... if they commit fraud in one company, that company may terminate them. But they just go to work for another company."