The purpose of the Credit Scoring Committee is
to collect and publish perspectives on credit scoring in the mortgage
underwriting process, specifically with respect to potential disparities
between majority and minority homebuyers in the home search or credit
application process. The introductory article provided the context for
the issues addressed by the series. The second article dealt with lending
policy development, credit scoring model selection and model maintenance.
The topic of the third article in the series is
how lenders oversee the practices of their third-party brokers, especially
for compliance with fair-lending laws, pricing policies, and the use of
credit scoring models. We solicited feedback from industry, consumer and
regulatory representatives to ensure a variety of perspectives. The following
individuals provided their perspectives for the third installment in the
The Housing Advocates, Inc.
Mr. Kramer is a civil rights attorney, director and cofounder of The Housing
Advocates, Inc. (HAI), a fair housing agency and public interest law firm.
The organization, founded in June of 1975, receives monies from the U.S.
Department of Housing and Urban Development, private foundations, and
various local governments. One of the programs operated by HAI is the
Predatory Lending Project. The project provides legal assistance to low-
and moderate-income residents to prevent predatory lending activities
and other consumer fraud problems, especially in Wards 5 and 15 of the
City of Cleveland. When violations of the law are identified, they are
referred to private attorneys or to the Fair Housing Law Clinic. The clinic
is a joint venture between HAI and Cleveland State University, Cleveland
Marshall College of Law where second- and third-year law students have
an opportunity to do real life cases and to get experience outside the
Christopher A. Lombardo
Office of Thrift Supervision
Mr. Lombardo is the Assistant Director for Compliance in the Office of
Thrift Supervision's Central Region. Based in Chicago, he manages the
compliance examination, community affairs, and consumer affairs programs
impacting savings institutions in a seven-state area that stretches from
Tennessee to Wisconsin. Mr. Lombardo has 18 years of regulatory experience
that includes examination and examination management work with the Office
of Thrift Supervision (OTS) and its predecessors; regional office policy
and enforcement work with OTS and the Federal Deposit Insurance Corporation;
and compliance policy work in Washington, D.C. Mr. Lombardo has participated
in and led interagency policy initiatives. He has been active in examiner
and industry education. The OTS, an office within the U.S. Department
of the Treasury, is the primary federal supervisory agency for savings
associations. There are approximately 1,050 thrift institutions, and they
have assets of approximately $950 billion. OTS is headquartered in Washington,
D.C., and it operates through five regional offices. The agency's mission
is to effectively and efficiently supervise thrift institutions to maintain
their safety and soundness in a manner that encourages a competitive industry
to meet America's housing, community credit and financial service needs
and to provide access to financial services for all Americans.
HOPE HomeOwnership Center
Ms. Muller is the executive director of the HOPE Home Ownership Center
in Evansville, Ind. She has been with HOPE for about 12 years. HOPE provides
housing counseling services to residents throughout the entire Evansville
MSA. For 35 years, HOPE has been helping families assess their need for
housing and their ability to buy through credit and budget analysis and
has been certifying their eligibility for special innovative loan packages.
During the last year, HOPE served 450 individuals and families.
Retired, Department of Justice
Mr. Ross recently retired from the Civil Rights Division of the Department
of Justice. For more than 35 years, he worked on lawsuits brought by the
United States to enforce civil rights statutes forbidding discrimination
in voting, employment, education, public accommodations, housing and lending.
His position for many years prior to retirement was special litigation
counsel for the division's Housing and Civil Enforcement Section, where
he investigated and prosecuted matters involving a pattern or practice
of discrimination in home mortgage and consumer lending. Mr. Ross was
the division's lead lawyer in several landmark fair-lending cases.
The contributors to this installment in the article
series were asked to respond to the following statement:
While lending institutions may actively review
and assess their own credit scoring models for potential unlawful disparities,
it is also important for lenders to monitor their relationships with third-party
brokers. Mortgage brokers make credit available in communities that do
not have traditional lending institutions. Lenders establish relationships
with third-party brokers to reach these markets.
Lenders need to consider how their third-party
brokers comply with fair-lending laws and use credit scoring models. Lenders
who knowingly work with noncompliant brokers and take no action may be
liable as co-creditors. The following situations may lead to increased
regulatory risk exposure for the lending institution:
- The lender may build in a high broker overage
tied to the credit score.
- The broker may obtain a credit report or credit
score and use it to underwrite and price a proposed deal prior to submitting
it to a lender.
- A broker may screen applicants or steer them to
higher-priced products even if the applicant's overall risk profile
(credit score) does not necessarily warrant it.
Considering the credit scoring issues outlined
above, what strategies can lenders adopt to better manage their third-party
broker relationships? What can third-party brokers do to ensure compliance
with fair- lending regulations?
Response of Sandy Ross
The answers may be different, depending on whether
scores are to be used in the accept/deny context or for placing borrowers
in different price tiers. In either case, however, it is essential that
the broker be fully informed as to the lender's underwriting criteria.
Further, whenever the scores themselves are affected by the information
gathered by the broker, the broker must do as good a job as the lender
in documenting the borrower's qualifications.
When credit scores are used to accept or deny, the broker's obligation
is the same as it would be with manual underwriting. If the broker (a)
fails to obtain documentation or (b) screens out applicants without adherence
to the same processes the lender does with its direct applicants, both
the broker and the lender are headed for trouble.
When credit scores affect pricing, the broker must
depend on its full and accurate use of the lender's pricing criteria to
avoid surprises and legal problems. For example, if the broker thinks
it is presenting a "B" quality loan and has priced it with the
accordingly, the deal may not work if the lender prices it at "B-."
On the other hand, if a broker knows the borrower has "A" credit
but places the loan with a subprime lender at an unnecessarily high price
to increase the broker's profit (when that lender would accept higher
broker fees), the broker risks involving itself and the lender in deceptive
practices, violations of the Real Estate Settlement Procedures Act (RESPA)
and, if members of protected groups are adversely affected, possible violations
of the fair-lending laws.
Response of Edward Kramer
The Housing Advocates, Inc.
Financial institutions can have a great deal of control
over the practices of their third-party mortgage brokers, especially for
compliance with fair-lending laws, pricing policies, and the use of credit
There is a very close relationship between the traditional
financial institutions, mortgage brokers, and real estate agents. Brokers
know where to get their clients financed, and lenders have a history of
doing business with certain mortgage brokers and real estate agents. It
is a symbiotic relationship. Lenders know who is breaking the law and
who is skirting the law. They know who the "bad guys" are. In
fact, those were the words used by a mortgage broker who recently confided,
"We know in our industry, and certainly the financial institutions
know, which mortgage brokers are really doing a disservice to clients."
The reason mortgage brokers know the "good guys"
from the "bad guys" is that they have dealt with them over a
number of years. In a situation where there have been excessive defaults
on loans from the same mortgage broker, or if defaults often occur within
several months after the loans, it is not difficult for a financial institution
to gather evidence of what happened, and of potential wrongdoing. There
may have been problems with these loans: The applications are being falsified,
the income levels are being falsified, the credit report has inconsistencies
on it, or credit scoring doesn't really match. The credit score is not
sufficient to justify the loan.
On the opposite end of the spectrum, it would be
relatively easy for financial institutions to identify mortgage brokers
who try to maximize their commissions by charging some borrowers more
than what is usual and fair in points, rates and fees. These are situations
where borrowers should be able to qualify for traditional "A"
loans but are being offered subprime "C" loans.
One strategy for the financial institution to avoid
third-party liability is to test loan application files. In this fair-lending
review, the Truth in Lending Act (TILA) statement and the U.S. Department
of Housing and Urban Development's Good Faith Estimate documents regarding
the costs of the loan should be examined. Look at the cost of the appraisal
and other fees to determine if they may be excessive or unusual. Look
for credit life insurance packages built into the loan and see whether
the consumer is being required to pay up front for this credit life insurance
or for the life of the loan. If the financial institution begins to see
inconsistencies from broker to broker, that should send up a red flag.
Such a pattern would result in a closer scrutiny of all new loans being
submitted by this particular mortgage broker.
Unfortunately, these predatory lending practices
are often being funded by financial institutions. This practice may be
driven by the need to comply with their Community Reinvestment Act (CRA)
obligations. The Act was meant to help meet the credit needs of all communities
in a bank's assessment area, including low- and moderate-income (LMI)
neighborhoods. However, in a perverse way, the CRA has in some cases had
the opposite effect. Banks, rather than trying to find and use their own
branch system of loan offices, instead closed down their own branches
and limited access and services to these customers. These banks have relied
upon third parties, such as mortgage brokers and real estate agents, to
generate CRA loans.
Lending to LMI borrowers can be profitable for financial
institutions, but it causes severe hardships for the consumer, who is
often a minority and/or female head of household. A third-party arrangement
allows unscrupulous mortgage brokers or real estate agents to misuse or
abuse the system. The banks are really looking at, "Will this help
me meet my CRA needs and will it meet our profit motive?" So when
some argue that this third-party system is more efficient, what they really
mean is that it is more profitable. However, this is not necessarily what
financial institutions should do if they are going to be good neighbors
and good businesses for our community. They need to make a commitment
to the community, which was the original purpose of the CRA. It was to
require banks to commit themselves to the community, to those areas in
their credit service areas that have not been served by them in the past.
What are the risks if financial institutions don't respond to predatory
lending issues being raised today? They face new and costly legislative
and regulatory initiatives. More importantly, they will face substantial
risk of litigation. Unlike TILA or other consumer laws, the federal and
Ohio fair housing laws place special obligations on the entire housing
industry, including financial institutions. One of these obligations is
that the duty of fair housing and fair lending is nondelegable. Almost
a quarter century ago, in one of the first cases involving a racially
discriminatory refusal to make a home loan, our federal court found in
favor of the victim of discrimination in Harrison v. Otto G. Heinzeroth
Mortgage Co., 430 F. Supp. 893, 896?97 (N.D. Ohio 1977) and held that:
Thus the Court has no difficulty in finding the defendant
Haugh liable to the plaintiff. Under the law, such a finding impels the
same judgment against the defendant Company and the defendant Heinzeroth,
its president, for it is clear that their duty not to discriminate is
a non?delegable one, and that in this area a corporation and its officers
are responsible for the acts of a subordinate employee, even though these
acts were neither directed nor authorized. This ruling troubles the Court
to some extent, for it seems harsh to punish innocent and well?intentioned
employers for the disobedient wrongful acts of their employees. However,
great evils require strong remedies, and the old rules of the law require
that when one of two innocent people must suffer, the one whose acts permitted
the wrong to occur is the one to bear the burden of it. [citations omitted]
This decision is not unique in the law. The courts
have rejected arguments from real estate brokers that they should not
be held liable for the discriminatory acts of their independent agents.
(Marr v. Rife, 503 F.2d 735 [6th Cir. 1974]; Green v. Century 21, 740
F.2d 460, 465 [6th Cir. 1984] ["Under federal housing law a principal
cannot free himself of liability by delegating a duty not to discriminate
to an agent."]). Furthermore, using the analogy to the Fair Housing
Act, the courts have found that finance companies have a non?delegable
duty not to discriminate under the Equal Credit Opportunity Act, which
cannot be avoided by delegating aspects of the financing transaction to
third parties. (Emigrant Sav. Bank v. Elan Management Corp., 668 F.2d
671, 673 [2d Cir. 1982]; United States v. Beneficial Corp., 492 F. Supp.
682, 686 [D.N.J. 1980], aff'd, 673 F.2d 1302 [3d Cir. 1981]; Shuman v.
Standard Oil Co., 453 F. Supp. 1150, 1153?54 [N.D. Cal. 1978]).
Now apply this case law to financial institutions
that refuse to monitor their relationship with mortgage and real estate
brokers. These lenders can be subjected to substantial damage awards.
Playing ostrich will not insulate them from any illegal actions of mortgage
brokers and real estate agents with which they deal. If there can be shown
a pattern and practice, then financial institutions are assumed to have
control. They have the ability to say "yes" or "no."
They have a right to monitor and determine whether or not these "independent
actors" are breaking the law. If they knew or should have known,
they can be held liable.
Financial institutions and mortgage brokers should
also follow another example of the real estate industry. The larger real
estate firms have their own in-house fair housing program to train their
staff. Large companies have their own programs because they want to make
sure that their real estate agents are aware of the law and of company
policies. They want these policies implemented. All employees and independent
contractors must know the law, the company's policies, and that everyone
will uphold fair housing and fair-lending laws.
Response of Christopher A. Lombardo
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), securitization, 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
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 their 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 demonstrates that we're not describing free
enterprise as envisioned in the 18th 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 does 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 kickbacks 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
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
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 provides 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 post-closing lender survey completed by the
borrower can be a very useful evaluation tool for lenders. The purpose
is to identify and isolate to particular brokers deals closed under some
duress or involving 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 has
added speed and reduced cost is generally accepted. What has been done
with that new information remains an open question for both lenders and
Response of Kathleen Muller
HOPE HomeOwnership Center
The use of credit scores alone does not ensure that
credit remains available to persons who would qualify for a low-interest
loan. Lenders should always have multi-criteria that help to balance or
offset shortfalls in a person's credit score, which could be reduced by
the use of subprime lenders or by a hesitancy to utilize credit at all.
For example, if a customer scores 10 to 25 points less than the minimum
score determined to be necessary for loan qualification, but he has three
or more years on the job, that strength of character could offset the
low score. In addition, third-party mortgage brokers who do not try to
look at credit scoring in a flexible way-such as looking at work history-and
rely on poor scores without honest subjective analysis may benefit from
During a recent training session in Evansville, Ind.,
on "Predatory Lending: A Professional Alert," for brokers, appraisers,
inspectors, title agents-all those who deal with the consumer along the
path to getting a mortgage-Nick Tilima of Education Resources suggested
that "most consumers who contact a mortgage broker expect the broker
to arrange a loan with the best terms and at the lowest possible rate.
Most mortgage brokers do just that, and charge a reasonable fee for their
services. However, in the subprime market, there are mortgage brokers
who do just the opposite. That is, the broker will attempt to sell the
borrower on a loan with the most fees and highest rate possible so that
the broker will get more compensation. Some of these brokers may charge
fees of 8 to 10 points. In addition, the broker may get additional compensation
from arranging a higher-than-necessary interest rate for the consumer.
For example, the consumer may qualify for an 8 percent interest rate,
but if the broker can sell the consumer a 9 percent rate, he can keep
the differential." To address this issue, standardized fee schedules
would go a long way to provide fair lending to individuals with lower
Brokers and lenders also should be aware that high
credit scores do not necessarily mean a loan is guaranteed. What may have
generated the score to begin with-the ability to handle many credit lines
on a timely basis-enhances most credit scores. However, the lender is
ignoring the fact that multiple obligations also burden the person's ability
to repay a new debt.
Since lenders and brokers may take advantage of a
consumer's lack of knowledge or poor credit rating to charge high interest
rates and hidden fees, disclosure and pre-loan education is a must. At
a minimum, everyone should be required to have some sort of education
before buying or refinancing a house. Consumers would be well-advised
to address the credit problems that keep them from being considered for
a prime loan; but if they cannot correct these problems, they should be
aware of the availability of subprime loans that are not predatory.
Code of Ethics for Lenders
As part of its efforts to fight predatory lending in Evansville, the Tri-State
Best Practices Committee, of which I am a member, developed a Code of
Ethics for Lenders. Lenders should require their third-party brokers to
adopt this code to help ensure compliance with fair-lending laws:
- Protect all they deal with against fraud, misrepresentation
or unethical practices of any nature.
- Adopt a policy that will enable them to
avoid errors, exaggeration, misrepresentation or the concealment of
any pertinent facts.
- Steer clear of engaging in the practice of law
and refrain from providing legal advice.
- Follow the spirit and letter of the law
of Truth in Advertising.
- Provide written disclosure of all financial
terms of the transaction.
- Charge for their services only such fees as are
fair and reasonable and which are in accordance with ethical practice
in similar transactions.
- Never condone, engage in or be a party
to questionable appraisal values, falsified selling prices, concealment
of pertinent information and/or misrepresentation of facts, including
the cash equity of the mortgagor in the subject property.
- Not knowingly put customers in jeopardy of losing
their home nor consciously impair the equity in their property through
fraudulent or unsound lending practices.
- Avoid derogatory comments about their competitors
but answer all questions in a professional manner.
- Protect the consumer's right to confidentiality.
- Disclose any equity or financial interest
they may have in the collateral being offered to secure the loan.
- Affirm commitment to the Fair Housing Act
and the Equal Credit Opportunity Act.
This concludes the third installment in our series. The Federal Reserve
System's Mortgage Credit Partnership Credit Scoring Committee thanks the
respondents for their participation. The fourth installment will deal with
training of staff, the level and consistency of assistance provided to prospective
borrowers in the loan application process, and the degree to which applicants
are informed about the ramifications of credit scoring in the mortgage application
and underwriting process.
The topic of the third installment of the Perspectives
on Credit Scoring and Fair Mortgage Lending discussed how lenders oversee
the practices of their third-party brokers, especially for compliance
with fair-lending laws, pricing policies, and the use of credit scoring
models. Following publication of that article, the Federal Reserve System's
Mortgage Credit Partnership Credit Scoring Committee received a letter
from the Mortgage Bankers of America (MBA) offering comments on the issues
identified in the third article. The Committee thanks the MBA for sharing
its insights on the third-party broker issues. The letter from the MBA
April 24, 2002
Dear Credit Scoring Committee:
The Mortgage Bankers Association appreciates the
opportunity to comment on issues being considered by the Federal Reserve's
Mortgage Credit Partnership/Credit Scoring Committee. The Mortgage Bankers
Association of America ("MBA") is a trade association representing
approximately 3000 members involved in all aspects of real estate finance.
Our members include national and regional lenders, mortgage brokers, mortgage
conduits, and service providers. MBA encompasses residential mortgage
lenders, both single-family and multifamily, and commercial mortgage lenders.
In order to adequately assess the fair lending responsibilities of mortgage
bankers in brokered transactions with regard to the underwriting or pricing
of mortgage loans, it is imperative to fully understand the structure
of the mortgage banking transaction and distinguish among the roles of
the different players involved.
Banker vs. Broker
Although there are wide variations in the roles performed
by the numerous entities involved in mortgage lending transactions, there
are several fundamental distinctions that can be drawn between the functions
of the mortgage banker and the mortgage broker. Although entities vary
greatly in terms of amounts and types of services they perform, it is
possible to provide generalized descriptions of their functions in the
mortgage loan transaction.
The core function of the mortgage banker is to supply
the funds necessary for the making of a mortgage loan. As the "lender"
of the moneys in the transaction, the central role of the mortgage banker
entails the performance of all the necessary underwriting analysis on
a loan transaction and the actual funding to close a loan, using either
its own funds or funds acquired from warehouse lines of credit. Generally,
mortgage lenders do not make loans in order to retain the asset as an
investment. Rather, a mortgage lender will usually sell its residential
mortgage loans immediately in the "secondary market."
Mortgage lenders can, and do, engage in "retail
loan origination," which is the part of the process that entails
everything from advertising and solicitation of the loan product to the
taking of the loan application and performing some or all of the processing
of the application information. When mortgage lenders engage in the "retail"
portion of the loan business, they deal directly with the potential borrowers,
and thus perform such "origination" functions as interviewing
and counseling borrowers, gathering personal information and taking the
necessary steps to process, underwrite, close and fund the loan. The "retailing"
of loans requires not only the time of lender personnel, but also the
bearing of the cost of real estate ownership or rental, i.e., the "bricks
and mortar," as well as the expense of payroll and benefits, business
machines, supplies, insurance and other costs necessary to maintain a
The mortgage broker, in turn, specializes only in
the loan "origination" portion of the transaction. By doing
business with a mortgage broker, the lender will save on all these operating
costs. In addition to sparing the lender the "brick and mortar"
and other retail office expenses, brokers will perform many of the services
required to originate loans that Lender would otherwise have to perform.
Mortgage brokers also allow a lender to broaden its market and reach customers
who, because of geography, or a lack of contact or knowledge, might otherwise
have never accessed the lender's products, thereby increasing competition.
As such, the broker will take a consumer's application,
will counsel the applicant and process the application, and will then
ship the loan package to the lender for proper underwriting, and eventually,
closing of the loan. In some instances, the lender may actually close
the loan in the broker's name with the lender's funds ("table funding").
It is also worth noting that the role of the mortgage
broker vis-à-vis the consumer and vis-à-vis the mortgage
lender can vary greatly. In the vast majority of cases, however, the broker
will have developed relationships with various lenders, and will serve
as the "retailer" of the lenders' loan products to consumers.
In that role, the broker serves as an independent contractor with respect
to both the consumer and the lender. In such instances, the broker/lender
relationship is non-exclusive, and the broker is under no obligation whatsoever
to submit any borrower's loan application to any particular lender for
approval and funding. On the contrary, brokers are free to choose any
one of several wholesale lenders' products for a particular borrower.
Over the past several years, the process of mortgage
loan underwriting has gone through considerable evolution. In today's
world, the mortgage industry is increasingly relying on automated underwriting
systems to assess the risk of applicants in a more efficient and fair
manner. These automated systems function by permitting lenders to input
pertinent borrower information into the computer and allowing the program
to assess the applicant's risk profile under pre-set lending guidelines.
The guidelines used under these systems vary greatly. Most automated systems
incorporate guidelines created either by secondary market investors, including
the Fannie Mae and Freddie Mac, or mortgage insurers. In some instances,
they may be proprietary systems created by the mortgage lender itself
based solely on its own lending and risk experience. The common factor
under these automated systems is that they perform the underwriting process
efficiently and in very quick timeframes, providing fair and non-biased
loan decisions based only on the data entered into the system.
It must be noted, however, that even the most advanced
automated underwriting systems allow for significant discretion by lenders.
These systems are designed to complete a standard underwriting analysis
leaving more complicated loan decisions to human underwriters. In fact,
automated systems are generally designed so that no applicant is ever
denied a loan on the basis of artificial intelligence alone. When an applicant's
loan file information does not meet the standards established under the
lender's system, the computer will "refer" the loan to "manual"
underwriting to allow a human analyst to reconsider the loan file and
approve it, determine if it fits into a special or alternative loan program,
or deny it altogether. The important item to note is that although automated
underwriting systems increase efficiency and lower cost by quickly approving
applicants with clearly satisfactory loan risk profiles, they leave the
decision-making in borderline or more complicated cases to lenders, who
must still make the hard calls.
The Nature of the Credit Decision and the Role of
The ultimate decision of whether to lend to any specific
applicant, is not a "science" involving strict mathematical
formulas. Rather, it is an "art" that relies heavily on various
underwriting factors that are assigned differing weights depending on
the experience or risk preference of the lender or investor. There are
a myriad of factors that come into play in mortgage lending determinations.
Some of the more common factors analyzed by underwriters are loan-to-value
ratios, debt-to-income ratios, bank reserves, down-payment size, down-payment
source, loan type, loan duration, among many others. Credit scoring is
just one factor in the analysis. The "art" of underwriting does
not lie in assigning numerical values to any of these factors, along with
"pass" or "fail" ratings. Underwriting requires that
each factor be accounted for and interpreted in light of the other factors
and in the context of each applicant and property. In the end, the final
decision is based on a judgment call regarding the full set of circumstances
that are unique to each borrower and each transaction.
Pricing of the Loan
In wholesale broker transactions, lenders will generally
offer a variety of loan products to the broker, along with prices at which
it will purchase each product. Using complex and proprietary computerized
models, lenders will generate prices for their wholesale mortgage products,
and these prices will typically change daily. This pricing information
is then transmitted to the approved mortgage brokers in what are known
as "rate sheets."
In general terms, the "price" that a lender
is willing to offer for a particular loan product is a function of the
predicted value of that loan when it is resold in the secondary market.
The pricing may also differ based on the credit quality of the loan. Furthermore,
numerous other price adjusters may be imposed by the lender to reflect
risk characteristics, such as loan amount, two to four family dwellings,
high rises, loan-to-value ratios, etc. Furthermore, the wholesale price
lenders make available to mortgage brokers differs from the "retail"
price in that it excludes many of the costs that are necessary to advertise
and originate the loan to the consumer such as the cost of the broker's
In wholesale loan transactions, it is the mortgage
broker who ultimately sets the "retail" price that the consumer
eventually pays for the loan. The fact that brokers have the ultimate
role in establishing final "retail" prices is vital. As described
above, the broker has a crucial role in the transaction. The broker serves
as the "retailer" of the loan in providing the "bricks
and mortar" that would otherwise be provided by the lender. The broker
markets and advertises the lenders' loan products. The broker also provides
an array of originating and processing services to the borrower and lender.
The broker then executes the loan documents in favor of the lender or
closes the loan in its own name ("table funding"). In all instances,
the broker is performing real services, providing real goods, and interfacing
with consumers. As the provider of such services, mortgage brokers require
compensation. It is the broker-not the lender-who in negotiation with
the consumer must appropriately make the final determination of how the
broker will price its own services.
It is essential that brokers retain the independence to price their own
services in order to assure that they meet the individual needs of their
customers, as well as their cost structures and operating expenses. In
today's mortgage market, mortgage brokers will retail the products of
various lenders to consumers and recover their own costs (plus profits).
The flexibility in pricing allows them to receive their payment in a way
that accommodates the borrower's available cash for closing. For instance,
the borrower can pay all of the broker's costs directly, or alternatively
they can have the lender pay some or even all of these costs (a payment
commonly called a yield spread premium) in exchange for a slightly higher
interest rate. When the process works right, brokers and borrowers select
the best loan options to meet the consumers' needs and negotiate the terms
of the loan within the constraints imposed by the lender's rate sheet.
Lenders are "once-removed" from this negotiation process, and
are generally indifferent as to the pricing option combination of interest
rate and upfront closing costs selected by the borrower and broker pursuant
to the lender's rate sheet except insofar as the lender ultimately receives
the same return after it sells the loan on the secondary market.
Lenders recognize that some brokers may attempt to
gouge consumers. For this reason, many lenders cap the fee that the broker
can receive in order to protect customers. However, such caps are designed
only to limit discretionary pricing not eliminate the negotiation process
between the broker and borrower. Caps therefore are not intended to and
do not ensure that all borrowers pay a uniform price. In fact, the unavoidably
individualized nature of each loan transaction would dictate otherwise.
Comments on Specific Questions
As demonstrated by the description of the lending
process set forth above, the framing of certain questions posed by the
Committee reflect certain misconceptions about the lender-broker relationship.
- The lender may build a maximum broker
overage tied to the credit score.
It is generally true that lenders may impose "caps"
or maximum limits on the compensation that brokers can collect on any
given transaction. These "caps" are generally imposed in order
to assure that loans originated by mortgage brokers are fully compliant
with applicable RESPA and Fair Lending requirements. It is important to
note, however, that these "caps" are generally not structured
on the basis of maximum limits on the points charged over the 'par' rate.
Rather, lenders generally set maximums based on fees that they will pay
to the broker for origination services performed. The broker, on the other
hand, determines what dollar amount it must collect on any given transaction
(limited, of course, by the "cap" that may be specified by the
lender), and then builds this fee into the yield spread pricing that is
ultimately offered to, and negotiated with, the consumer.
Although the credit score is an important tool in the underwriting of
the loan, many lenders do not use credit score to set the maximum broker's
compensation. Nevertheless, mortgage brokers may access the applicant's
credit score directly prior to submission to a lender in order to assess
the applicant's creditworthiness and the lenders and products that may
be best for the applicant. Mortgage brokers may also price differently
based on credit score as a proxy for how difficult the loan approval process
likely will be. As per federal law requirements, the broker's compensation
is calculated on the basis of services performed or goods provided by
the mortgage broker so the mortgage broker can charge more for loans that
will require more work on the mortgage broker's part. Other than by perhaps
setting outside numerical caps, and requiring adherence to applicable
state and federal laws, lenders are not involved in the setting of broker
compensation on individual loans.
It is not possible for a lender to stop mortgage broker price discrimination
without fixing loan price which it cannot do. Furthermore, a lender is
unlikely to have all loans originated by a broker and thus does not know
the broker price on all of the broker's loans in order to perform a fair
lending analysis. Even if the lender had the data and could engage in
such an expensive and onerous review, the only recourse would be to stop
doing business with the broker thus reducing the access of credit to borrowers
in that marketplace.
- The lender may provide brokers with access
to the lender's scoring programs.
This statement is generally inaccurate, and to the
extent such access occurs, it is of negligible impact in the market. As
set forth above, lenders use scoring programs that are developed by large
industry players such as Fannie Mae or Freddie Mac, as well as programs
developed in-house, on the basis of the lender's own lending experience.
In the latter case, the programs are proprietary and are therefore not
shared with third party originators. Even in cases of lenders that employ
programs used by large industry participants, such programs may be "tweaked"
and altered to reflect the lender's experience, regional variations and/or
risk preferences of the particular lender.
- The broker may obtain a credit report or credit
score and use it to underwrite and price a proposed deal prior to submitting
it to a lender.
The "pulling" of credit scores or credit
reports by mortgage brokers prior to the submission of the loan package
to the lender is a longstanding and non-controversial practice in the
mortgage industry. In fact, mortgage brokers must be able to ascertain
an applicant's credit background in order to perform the critically important
duties of properly advising and counseling borrowers. The fact that this
practice is generally accepted is demonstrated by HUD pronouncements under
existing RESPA rules and regulations. In a statement of policy dated issued
in 1999 (64 FR 10080), HUD identified various services that are normally
performed by brokers in the origination of a loan. Among those items,
HUD describes various counseling-type activities that specifically include
"prequalifying prospective borrowers" and "assisting the
borrower in understanding and clearing credit problems." Under each
of these functions, brokers must have access to credit reports and credit
scores in order to properly guide and counsel prospective borrowers.
Although brokers may do a preliminary underwriting
review in order to assist the consumer in choosing a lender and product,
typically, the broker does not perform the final underwriting nor make
the credit decision. Many broker agreements with lenders do not have a
repurchase obligation because the broker does not have the capital or
access to capital required to fund a loan. As a result, only correspondent
lenders would have the ability to make a credit decision since they would
also have a repurchase obligation if the loan did not meet the lender's
underwriting requirements. In the rare instance that a broker is engaged
in underwriting, it performs this function under some type of outsourcing
agreement, following the lender's strict guidelines, and acting as the
lender's agent. In this capacity, and pursuant to federal law, it is clear
that the lender would remain liable for all fair lending consequences
that flow from the actions and decisions of its "broker-agent."
Stephen A. O'Connor
Vice President, Government Affairs
Mortgage Bankers Association of America
1919 Pennsylvania Avenue, NW
Washington, D.C. 20006-3438