Saturday, December 16

Financial Legislation of 2010 — Yield Spread Premiums

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The flailing mortgage industry may receive yet another blow as the Senate, despite heavy lobbying from the financial and mortgage sectors, passed a new financial reform bill on a 59-39 vote.

The new bill contains provisions for more financial oversight, more transparency on derivatives trade, and, most significantly for the mortgage industry, the elimination of Yield Spread Premiums (YSP). Yield Spread Premiums are rebates that lenders pay to mortgage brokers (the middle man) in exchange for the brokers charging borrowers a higher interest rate than the market par rate on loans. For example, if a broker can secure an interest rate of 5.60% versus the par rate of 5.25% from the borrower, the broker may get a increase in YSP paid by the lender from 1% to 1.8%. Congress’s aim in eliminating YSPs is to eliminate this incentive for mortgage brokers to push higher interest rates onto the borrower.

Is this really a good idea though? Brokers are already required by law to disclose their YSPs (ironically lenders are under no such obligations), although admittedly the disclosure comes rather late in the loan process. Also, market equilibrium forces curb any exorbitant profits garnered from YSP’s since borrowers can just choose to borrow from the competition instead. Mortgage brokers earn profits from two main sources: origination fees and YSP’s. An origination fee is a percentage of the loan size, usually fixed, charged in exchange for the broker’s services. In order to cover the operation expenses of running a business, mortgage brokerages must maintain a certain level of profit. Thus, if Yield Spread Premiums were eliminated as a source of profit, mortgage brokers would be forced to raise their origination fees in order to compensate for the loss. That is, they would have to charge a larger percentage of the loan size in order to maintain the same profits. From the borrower’s perspective, the larger upfront costs may deter them from borrowing or from using mortgage broker services. This would either drive down demand in the market or drive borrowers to seek loans directly from lenders; both scenarios play out unfavorably for mortgage brokers. If big banks (lenders) were the problem to begin with, creating an influx of borrowing directly from them seems counterintuitive. Lender profits will see a dip from the elimination of YSP’s. The inability to garner gains from above-par interest rates takes away another source of profit. The overall impact on the mortgage industry may very well be more negative than positive.

As it stands, the provision currently applies to all mortgages, not just to those in the subprime market. The same bill also contains a provision requiring lenders to retain a minimum 5% stake in their mortgage deals. The newly passed bill by Senate must be reconciled with the earlier reform bill passed by the House last December. The new financial reform bill is estimated to be ready for Obama’s signature before July 4th. If it were to become law, its legislative effects are not expected to go into effect for another 12 to 24 months.

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