Office of Thrift Supervision
Before addressing a financial institution's relationships with mortgage brokers, we ought to identify three undeniable facts that represent changes in the mortgage business landscape over the past decade.
First, financial institutions increasingly rely on fee income. Interest rate spreads are, and are likely to remain, razor thin. Second, automation (including credit scoring), securitiza-tion and specialization have revolutionized who does what and how they do it. Third, financial institutions rely on independent mortgage brokers to maintain a steady supply of loan originations. Employees in financial institution branches typically no longer generate the business. Call this progress-in-action in a free enterprise system or call this a recipe for disaster. In reality, the system is far from free: It is heavily regulated. With the scourge of predatory lending, personal and individual disasters have become more common or at least more widely recognized. Systemic disasters remain rare.
We also ought to clarify our terminology. As is most common, I will consider the financial institution (insured depository institution) to be the funding, originating lender and the independent broker to be the point of contact with the applicant/borrower and the processor of the loan. The lender-broker relationship is covered by a mutual agreement that the other party is suitable and reliable. The lender provides the broker with the bank's underwriting guidelines, highlighting any deviations from market standards. The lender provides the broker with rates, fees and term information—weekly, daily or as needed. Operating under a lender-broker arrangement, the broker registers a rate lock-in and processes the paperwork. The loan passes down one of two main paths: The lender table-funds the loan and reviews it afterward, or the lender reviews and approves each loan package prior to closing.
Numerous custom and hybrid lending arrangements exist. However, one ought to consider what a financial institution examiner sees: performing loans; the occasional rejected deal, if the lender documented it; and the occasional defaulted loan. The examiner does not know what transpired between the broker and the borrower. The examiner does not know who ordered, paid for or prepared the application. Lenders should know this information and ought to be highly selective about the brokers who bring them business, and lenders ought to be expert in spotting a loan that yells: "Run, don't walk, from this deal!" The general standard to which the lender should be held responsible for the broker's act, error or omission is a "knew-or-should-have-known standard."
The compliance examiner assesses how well a financial institution manages its compliance risks and responsibilities. Regarding relationships with mortgage brokers, this most notably includes compliance with laws such as the Fair Housing Act, Equal Credit Opportunity Act, Home Mortgage Disclosure Act, Fair Credit Reporting Act, Real Estate Settlement Procedures Act and Truth in Lending Act. These laws are relatively new; in addition, there are rules governing the privacy of consumer financial information, consumer protection rules for insurance sales and the Flood Disaster Protection Act. This demon strates that we're not describing free enterprise as envisioned in the 18 th century by Adam Smith.
Beyond the U.S. Department of Housing and Urban Development's advertising rules implementing the Fair Housing Act and the Federal Reserve Board's advertising rules implementing the Equal Credit Opportunity and Truth in Lending acts, thrift institutions are prohibited from any inaccuracy or misrepresentation regarding contracts or services, including any and all aspects of their mortgage lending. The examiner gets a glimpse of lender activities and an even briefer look at what the broker has done. Well-managed financial institutions make it a point to take a good look at what the broker has done, but it is very difficult for the lender to police the broker's activities. With the growing awareness of predatory lending, most lenders now have systems in place to detect transactions that involve fee packing, equity stripping and flipping. Lenders have shifted from presuming that the refinancing deal presented for funding is what the borrower originally needed or wanted, and many are applying some sort of benefit-to-the-borrower standard.
As a general observation, mortgage market automation (including the general use and acceptance of credit scoring), standardization and specialization have not posed great hazards for most financial institutions. They have internally motivated systems for identifying and correcting problems outside the supervisory and enforcement process. The fee-driven nature of the business and reliance on broker business do pose hazards, however. Every financial institution has stories of mortgage brokers who proposed compensation arrangements that would violate the Real Estate Settlement Procedures Act. Most lenders have stories of broker efforts to push unsophisticated individuals (with or without marginal credit scores) into higher-priced deals that offer greater compensation to the broker. The former issue of unearned fees and kick
backs is fairly easy to spot. The latter defies detection, often until much damage has been done.
The uniform interagency examination procedures adopted by the federal banking supervisory agencies for fair lending focus on activity at the margin. In general terms, it is in transactions involving marginal applicants that underwriting discrimination may be identified. The same holds for pricing and the use of credit scoring. A financial institution needs to have a vigorous review system in place for the actions of brokers in this regard. This review system should reinforce the lender's message about the kinds of deals it is seeking and the kind of treatment that will be extended to individuals who are prospective customers of the institution.
Aside from individual credit transactions, it is lenders straying far from the mainstream market who are most exposed to allegations of credit discrimination. Regulators are more sensitive to issues involving innovation, automation, cost control and stability of income. It is in this testing of new ideas that we try to draw a line between acceptable and unacceptable risk-taking. Financial institutions whose stated or unstated goal is to skate on the edge of the law should expect and be prepared to deal with problems—some of them potentially huge.
Lenders need to seek assurance that scoring representations accurately reflect their applicant's score, particularly when the score drives the approve/deny decision but also when it results in a loan-pricing or product-steering decision and, ultimately, when it impacts broker or lender compensation, even indirectly Aside from scrutiny of documents, lenders should require that the broker provide copies of all credit reports and scoring information generated in connection with a mortgage application. The lenders should also require copies of all loan applications generated. The final application that the borrower sees, but may not read, at closing may bear little resemblance to the representations of the broker and borrower from start to end of the transaction.
The lender may be restricted under his correspondent agreement from making direct contact with a mortgage applicant. However, the broker should be willing to encourage lender contact to learn the applicant's understanding of the lending process, rather than lose all of that lender's business and see the borrower damaged along the way.
A short survey completed by the borrower after the closing can be a very useful evaluation tool for lenders. The purpose is to identify particular brokers' deals that were closed under some duress or involved fees and terms to which the borrower did not understand or agree. These issues are best dealt with before the borrower is in default or sitting in the office of his congressional representative.
In closing, the vast majority of financial institutions manage their mortgage broker relationships in an acceptable manner, as we have found from years of regular compliance examinations. Our more recent and detailed inquiry into the ability of financial institutions to steer clear of predatory lending practices while working through independent brokers and seeking fee income has both reinforced the observation that the industry is doing a good job and highlighted some new concerns. That credit scoring and improved access to individual credit information have added speed and have reduced cost is generally accepted. What has been done with that new information remains an open question for both lenders and regulators.
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