Markets don't work well when one party to transactions has much more information than the other party, especially when the party with better information also controls the process. The two best illustrations of this rule are the markets for medical services and home mortgages.
In principle, Government regulation can make such markets work better by 1) reducing the information gap between the parties transacting with each other through a system of mandatory disclosures; and 2) by limiting the ways that the parties controlling the process can use that control to benefit themselves. The all-important caveat is that the regulations adopted work as intended. Bad regulations increase transaction costs without accomplishing their objective. This has been the case for forty years of ill-advised efforts by the Federal Government to eliminate referral fees in the home loan market.
Referrals Are Pervasive in the Home Mortgage Market
Real estate and mortgage transactions involve a large number of diverse players who sell services that consumers purchase. Since they are in the market very seldom, consumers typically don't know who all the players are, or even what they do. They are thus heavily dependent on referrals from those who have this knowledge.
Lenders usually select the appraiser and credit reporting agency on home purchases, and all third party service providers on a refinance. Mortgage insurers are always selected by the lender. Realtors and builders have referral power on home purchase transactions, referring consumers to lenders and to title agencies.
Mortgage lenders are both referrers and recipients of referrals. When they steer a borrower to a title company for the purpose of purchasing title insurance, they act as referrers, and the title insurance cost paid by the borrower includes the referral fee to the lender. When a real estate agent or builder sends a borrower to a lender and receives something of value in exchange, the lender is the recipient, and the benefit provided to the agent is the referral fee. This article only deals with lenders as referrers.
Why Are Referral Fees Considered "Bad?"
One reason is the widespread prejudice that charging for something that takes no effort, or almost none, is like being paid for nothing. We undervalue information.
A second reason for the hostility to referral fees is the fear that payment for referrals will degrade the quality of the service. If a real estate agent collects referral fees from lenders, does he send borrowers to the best lenders, or to the ones willing to pay the referral fee? This is a legitimate concern.
The third reason is a concern that referral fees raise the cost to the client. If service providers have to pay referral fees, they are going to charge more in order to cover that cost. This is the major concern with regard to referral fees in the home mortgage market. It is why referral fees in this market were made illegal under the Real Estate Settlements Procedures Act (RESPA). Congress was offended by high mortgage settlement costs and the prevalence of referral fees, which they saw as related. The rationale of the restrictions imposed by RESPA is that "kickbacks or referral fees... tend to increase unnecessarily the costs of certain settlement services . . . ." (RESPA, Section 2601 (a)).
But Congress was wrong about that. Settlement costs are raised by referral power, not by referral fees.
Referral Fees and Referral Power
Referral fees are payments made by service providers to other parties as quid pro quo for referring customers. Referral power is the ability to direct a client to a specific vendor. Referral power is based on specialized information possessed by the referrer, and the authority of the referrer in the eyes of the client. Regulatory efforts to reduce settlement costs to borrowers by eliminating referral fees have not worked largely because they have left referral power unchanged.
When there is referral power, service providers compete not for the favor of consumers but for the favor of the referral agents. Such competition raises the costs of service providers, which are passed on to the consumer. If regulations eliminate referral fees but referral power is left untouched, service providers will find other ways to market themselves to the same referrers. The resulting expenses could well be higher than the referral fees.
The Failure of RESPA
The RESPA prohibition of referral fees has not reduced settlement costs at all, a fact acknowledged by HUD which had the unpleasant task of enforcing RESPA before creation of the Consumer Financial Protection Bureau. One reason is lack of effective enforcement. There are so many referral agents in real estate markets, and so many ways they can receive something of value from service providers that the regulator would need an army of examiners to shut them all down. HUD, which administered RESPA for many years before responsibility was shifted to the Consumer Financial Protection Bureau (CFPB), never deployed an army of examiners and it is doubtful that this will change under the CFPB. Hence, thousands of small referral agents will continue to receive referral fees, if in disguised form, with impunity.
The other part of the problem is that the referral power of firms that are too large to be overlooked by regulators has not been reduced by RESPA, inducing them to find other ways to use that power to their advantage without violating the law. For this purpose, RESPA has been most accommodating, enabling large players to continue receiving payments that are referral fees de facto but not de jure.
The Captive Affiliate
RESPA does not prevent a firm in one industry from entering another industry, even when the express purpose is to exploit referral power. For example, a Realtor or lender can establish their own title company and refer business to that company, which can be a joint venture or an entity wholly owned by the referrer. The title agency must be a bona fide company, meaning that it must have the capital required by a title company, it must have its own employees and place of business, and so on. A sham company that is actually operated by another title company would be a RESPA violation. Since the capital investment required is considerable, this option is feasible only for firms able to generate a volume of referral business large enough to justify the investment.
Larger lenders have also invested in appraisal management companies, which proliferated after the financial crisis as a device to meet new regulatory requirements designed to assure the independence of appraisals. The company stands between the lender and the individual appraiser. Lenders cannot influence appraisals, but they can and many do collect referral fees through their ownership interest in the companies. And while alert borrowers can select their own title companies, and some do, they cannot select their appraisal management company because the company must be approved by the lender.
The bottom line of the RESPA rules governing referral fees is that payment of such fees is legal so long as it is done in ways that are extremely costly and inefficient. The rules are a bonanza for lawyers but a dead-weight loss for everyone else.
The Cure Is Simple
Referral fees now collected by mortgage lenders in connection with title insurance, appraisals, credit reports and all other services they require borrowers to purchase could be eliminated by the adoption of one simple and easily enforced rule: any service required by a lender in connection with a home loan must be purchased by the lender and included in the price of the mortgage. This rule would eliminate the lender's referral power, which is based entirely on the mortgage being sold as an unbundled product.
If mortgages had to be sold as a bundled product with all the inputs purchased by the lender, as is the case for automobiles and most manufactured products, referral fees would disappear and settlement costs would drop like a rock. The cost of title insurance, appraisals and other services would be included in the price of the mortgage, just as tires are included in the price of automobiles, but the incremental cost to the borrower would be small relative to the unbundled price. Competition by third party providers to sell lenders would force the prices down, and price competition by lenders would force them to pass the savings on to borrowers.
The problem with this simple solution is that it has no political constituency. Lenders won't support it because it is not in their financial interest; title insurers and other service providers won't support it for the same reason. But why consumer groups never propose it is more puzzling. The only plausible reason that comes to mind is that converting the mortgage into a bundled product would make the mortgage market work effectively for borrowers, and effective markets eliminate the need for consumer groups.
For more information on consumer advocacy issues in the mortgage market, or to compare mortgage offerings from multiple lenders in a fair, unbiased environment please visit my website The Mortgage Professor