Yield spread premium
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Yield Spread Premium, or YSP, is the cash rebate paid to a mortgage broker based on selling an interest rate above the wholesale Par rate that the borrower qualifies for.
For example, If a mortgage broker offers a borrower a loan of $100,000 at an interest rate of 6.25%, and the Par rate is 6%, the broker may earn a Yield Spread Premium (YSP) equal to 1.0% of the loan amount. This $1,000.00 fee is paid by the lender directly to the broker as a "rebate." The mortgage broker earns "one point" directly from the lender "POC" (Paid outside Closing). Although the borrower is not charged the fee directly, the borrower does pay the fee indirectly by accepting a higher interest rate in exchange for lower fees.
In the U.S., mortgage brokers are required to disclose YSP as a fee "POC" (Paid Outside Closing) on page 2 of the HUD1 Settlement statement, inside the margin, away from the column marked "Paid from Borrower's funds at Settlement."
YSPs as a financial instrument are not controversial. What is controversial is how they are applied, and how and when brokers and lenders have to disclose their existence and their amount to the borrower.
Consumer groups such as the Center for Responsible Lending contend that disclosing the YSP to borrowers informs borrowers that the broker might be charging them a higher interest rate than they might otherwise qualify for. They point out that the YSP amount to a fee paid to the broker, and therefore its exact amount should be made known when the borrower commits to a broker ("locks in the rate"), rather than later in the loan process.
Conventional mortgage brokers (those who are not Upfront Mortgage Brokers) contend that this disclosure requirement puts them at a disadvantage when compared to Institutional ("Retail") Lenders, who do not have to disclose their YSP. In addition, they point out that there are truly legitimate reasons for a YSP, such as help in offseting closing costs for borrowers who are short of cash. For those borrowers, brokers use the YSP to help pay closing costs, as outlined below. Conventional mortgage brokers also point out that if only they were required to disclose their YSP, borrowers might not save money, but simply steered to retail lenders who would charge the same amount for a loan, but would appear better at first glance because they did not have to list those fees explicitly.
These arguments are further outlined below.
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[edit] Banks versus Mortgage Brokers and YSP
Lenders that fund loans and then sell them after closing do not need to disclose the amount of the yield spread premium they make. This is a HUD rule. On the other hand, brokers are forced to disclose the amount of yield spread they get from the bank. HUD's stated rationale is that Institutional lenders sell their loans in a true "Secondary Market Transaction" sometime after the loan is closed. This means that the loan is sold at a later time and their true "Yield Spread" or additional revenue is not yet known. Although the exact amount they earn may not be known, the fact is that they are earning revenue that they do not have to disclose to the borrower.
This difference gives institutional lenders an unfair advantage over a mortgage broker because when a borrower closes a loan with a mortgage broker, the borrower is fully aware of the revenue that the broker business earns on their loan.
Another disadvantage is that a mortgage broker, unlike an institutional lender, also has to disclose that he earns YSP on the Good Faith Estimate. There are two separate Good Faith Estimates, one for the broker, one for the institutional lender. The only difference is ONE SECTION, only on the Good Faith Estimate used by the mortgage broker. It states:
"COMPENSATION TO BROKER, Not Paid Out Of Loan Proceeds"
The broker must disclose a range, typically 0%-4% of the loan amount. Institutional lenders are exempt from this requirement.
[edit] "Giveaway to Big Business?"
Sometime on or around 2002, The Secretary of HUD, now Senator Mel Martinez, R-Florida, tried and failed to pass sweeping RESPA (Real Estate Settlement Procedures Act) reform legislation that would have further put mortgage brokers at a disadvantage by requiring mortgage brokers to credit borrowers the amount of yield spread premium that they earned, and then charge the borrowers a fee to recover the yield spread premium. Lenders would have still been exempt from that requirement.
For example, if a borrower went to his regular bank or to a large lender, they may receive a quote from them of 6.25%, Zero Points. The lender presumably would earn approximately one point when they sold the loan at some later date.
If a mortgage broker offered the borrower the same rate, 6.25%, the borrower would receive the one point YSP as a "Lender Credit to Borrower" Then, in order to earn the same fee as the institutional lender does above, the mortgage broker would have to charge the borrower a 1% "mortgage broker fee"
So, the mortgage broker deal would be 6.25%, 1 Pt. Fee paid by borrower to broker, plus 1 points paid by lender to borrower, whereas the institutional lender could offer the equivalent at 6.25%, zero points. It is possible that borrowers would prefer the simpler deal from the lender, even though they would pay the same number of points (zero), and get the same interest rate. These concerns are corroborated by an FTC study cited below.
HUD proposed broker compensation disclosures as part of its July 2002 RESPA reform proposal (HUD 2002a, 49134). Mortgage brokers would be required to disclose, in the Good Faith Estimate (GFE) provided to borrowers, any compensation received from the lender in connection with the origination of the loan. A major part of the compensation is any Yield spread premium (YSP) paid by the lender for a loan originated at an above-par interest rate. The YSP reflects the additional value to the lender of a loan originated at the higher interest rate. The proposed disclosure was motivated by a concern that brokers were placing borrowers in above par loans without their knowledge, and keeping the YSPs rather than passing them through to consumers in the form of reduced settlement costs. Direct lenders would not be required to make the same disclosure, even though they may be charging the same interest rate and settlement costs and earning the same compensation as a broker.
The compensation disclosures had a significant adverse impact on the respondents perception of loan costs and on respondents’ choice of loans. The disclosures caused a significant proportion of respondents to choose more expensive loans by mistake and caused a substantial bias against broker loans even when the broker loans cost the same or less than direct lender loans.
The findings of this study indicate that broker compensation disclosures are likely to harm rather than help consumers and competition in the mortgage market. --The disclosures are likely to lead a significant proportion of borrowers to choose more expensive loans by mistake. --The disclosures are likely to cause a substantial bias against broker loans that may reduce competition and increase the cost of all mortgages. --All three versions of the compensation disclosure tested in the study resulted in significant consumer confusion about loan costs and a substantial bias against broker loans. This included versions that moved the disclosure to a second page of the cost information.1
1 Federal Trade Commission
Bureau of Economics Staff Report
James M. Lacko
Janis K. Pappalardo
February 2004
[edit] No Closing Cost Loans Explained
YSP can also be used by a mortgage broker to offer "No Closing Cost" loans. For example, if a borrower takes a $800,000 loan and the total closing costs amount to $5,000, the broker could increase the interest rate that pays the broker a YSP of say 1% and the broker could then credit the borrower $5,000 of the $8000 made in YSP towards his closing costs. The broker would still earn $3,000 broker fee - all paid by the YSP.
Note that in that example, the key expression is "could" - the broker is under no obligation to share with the borrower the exact amount of the YSP received from the lender until closing time. So, if the broker steers the borrower towards a mortgage with a higher interest rate, the broker might receive a YSP of say 1.5%, resulting in $12,000 paid by the lender to the broker. Subtracting the $5,000 spent towards closing costs, the broker would have made $7,000 rather than $3,000 as in the original example. The borrower has no way to tell until closing time when it might be too late. All the borrower knows from the Good Faith Estimate he or she has received from the broker is that the YSP could be between 0% and 4%, as outlined above. For this reason, Upfront Mortgage Brokers (UMBs, see below) negotiate their entire fee with the borrower.
During the refinancing boom in 1998-2005, rogue mortgage brokers used the YSP to defraud wholesale lenders by colluding with borrowers as follows. A borrower would accept a much higher interest rate that would result in a huge YSP paid to the broker. For instance, for the $800,000 loan discussed above, a YSP of 3 points would result in a $24,000 cash payment to the broker. The broker would share the YSP with the borrower. Shortly after closing the loan, the borrower would refinance the loan at a lower interest rate, essentially avoiding paying back the YSP received in a higher interest rate over time. This practice, if used intentionally, defrauds the investors who paid the YSP in expectation of receiving higher interest payments while the loan is being paid back.
Wholesale lenders introduced different practices to combat this type of fraud. First, they limit the amount of YSP they pay at 3 or 4 points. Second, for YSPs higher than 1 to 2 points, they require that the broker get permission from the lender before locking in the loan. This requirement allows the lender to apply more scrutiny and identify potentially fraudulous transactions before funding the loan. Third, lenders might have contractual clauses with brokers that would require brokers to pay back any YSP received if the borrowers refinanced within a certain period of time after closing (say 6 months.) Finally, some lenders charge higher fees to brokers who frequently sell loans that are being refinanced quickly, or those lenders stop doing business with such brokers altogether.
[edit] "Kickbacks or Compensation: The Case of Yield Spread Premiums"
According to a study by Howell E. Jackson and Jeremy Berry from Harvard Law School conducted in 2002, loans that include a YSP are typically $800 to $3000 more expensive than loans without a YSP. On average, mortgage brokers earn $1,046 more when closing loans that contain a YSP than on loans without one. More than 75% of borrowers with loans that included YSPs could have used a less expensive method to help pay closing costs. In one extreme case, an unscrupulous broker charged a single mother $9,000 on a loan of $43,750, including $2,650 in YSP that bumped the interest rate from 10% to 13.74%.
Upfront Mortgage Brokers (see below), however, earn the same fee for a loan with and without a YSP, because their fee is fixed. Any money paid by the lender that exceeds the agreed upon fee will be refunded to the borrower.
Sources:
Yield Spread Premiums: A Powerful Incentive for Equity Theft published by the Center for Responsible Lending
[edit] Upfront Mortgage Brokers
Upfront Mortgage Brokers (UMBs) are a group of mortgage brokers who have agreed to disclose the total fee they earn upfront. At closing time, they will refund any YSP they receive to the borrower, except that which is required to cover their fee, which is negotiated upfront. In essence, UMBs practice voluntarily what the 2002 RESPA reform would have required all mortgage brokers to do. Contrary to the belief that this would result in customers choosing too expensive loans, UMBs provide loans at wholesale ("at par") rates to consumers with a known markup negotiated between the borrower and the broker. A UMB typically provides the borrower with direct access to the lender's wholesale price sheet, allowing the borrower to decide what interest rate to buy and whether to pay points to receive a lower rate, or whether to accept a higher rate in exchange for a YSP from the lender. In both cases, the broker's fee is the same. Therefore, the broker has no interest in steering the borrower towards higher interest loans that might result in higher YSPs, and therefore a higher fee for the broker. The borrower can pick exactly what rate to buy and how many - if any - points to pay for a lower interest rate or receive in exchanging for accepting a higher rate. Non-UMBs (aka traditional mortgage brokers) only provide the interest rate and points and hide how much YSP they will receive until closing, in effect hiding their true fees until it is too late (or very difficult for the borrower to back out.)
The argument for UMBs was made by Jack M. Guttentag, Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Prof. Guttentag's argument is that preparing a mortgage is providing a service, and as such, should be subject to a negotiated fee. The opposing argument is that brokering a mortgage is like selling a product, in which case the broker doesn't have to make known their markup upfront. In addition, non-UMBs point out, having to declare their fee might put them at a competitive disadvantage when compared to institutional lenders who are allowed to roll the costs associated with the loan preparation into the interest rate without having to disclose that fact, as outlined above.
There are several hundred UMBs in the United States. They recently formed the Upfront Mortgage Brokers Association or UMBA. Brokers that are members in the UMBA agree to a Upfront Mortgage Broker Commitment that outlines their principles.
Upfront Mortgage Brokers Association
Upfront Mortgage Brokers, page maintained by Prof. Guttentag
