How to Eliminate Third Party Settlement Costs
In a recent article I proposed that Fannie Mae and Freddie
Mac be removed from limbo and given a new mission: to create
a better primary mortgage market. Among other things, this
would include the elimination of third party settlement
costs. To borrowers, these are a horrible yet unnecessary
source of complexity, confusion and overcharges. Existing
attempts to deal with the problem through
government-mandated disclosures, rules against markups and
prohibitions of referral fees have only added to the
complexity of the process without preventing overcharges.
Third party settlement costs could be eliminated by
implementation of one simple rule: any service required by
lenders as a condition for the granting of a home mortgage
must be purchased and paid for by the lender. Lenders would
be free to embed these costs in the price charged the
borrower, but the borrower would then have to deal with only
one set of prices.
What difference does it make whether, e.g., the title
insurance policy that protects the lender is purchased by
the borrower, or by the lender who bills the borrower for
it? It makes an
enormous difference. Prices paid by borrowers indirectly in
the price of the mortgage would be substantially lower than
the inflated prices they now pay directly to third party
Under existing arrangements, competition by third party
providers to sell title insurance, mortgage insurance,
appraisals and other required services is directed not at
the consumers who pay for the services but at the lenders
who refer consumers to service providers. Such competition
is “perverse” because it raises the costs of third party
providers that must be covered by their prices. Lenders use
their strategic position as a referral source to get a piece
of the action, receiving free
or underpriced services provided by the firms to which they
refer business, or by participating in the ownership of such
firms. One lender I know has an ownership interest in both a
title agency and an appraisal management company, and has
its loans underwritten for free by a mortgage insurer.
Consider what would happen if automobiles were sold like
mortgages. When you asked the price, the dealer would say
"This is the price of the body and motor only. The
transmission system, tires, electrical system, and
upholstery must be purchased from "A," "B", "C" and "D". The
price you pay at delivery will include the payments to these
other 4 firms, and right now we can only provide an estimate
of what these payments will be."
The result of this would be an increase in the total price of the automobile. If the automobile manufacturer only provided the chassis and motor, it would become indifferent to the prices of the other components because the consumer would be buying them from other firms. Instead, the automobile manufacturer (or its dealers) would have an incentive to use its access to the consumer to collect referral fees from the component manufacturers. The manufacturers of the components would compete for referrals, which would raise referral fees, and with them the prices paid by the consumer.
In fact, automobile manufacturers bundle all the components, selling a complete automobile at a single price. To sell to them, component manufacturers must compete in terms of price and quality, rather than referral fees. Competition among the automobile manufacturers forces them to pass on most of the benefit to the consumer.
The bundled-product approach that works so well in the
automobile market would also work in the mortgage market.
compete for customers by quoting prices for the entire
package of services, which would cause them to use their
market clout and superior knowledge to bargain aggressively
with third party service providers for the lowest possible
prices. And competition between lenders would force them to
pass on most of the benefits to consumers.
In some cases, lenders would decide that a particular
service is not needed or not worth the price, and they would
do without it. Under existing arrangements, that
In 2002, HUD tried to foster a package approach with a single price, but participation would have been voluntary and it never got off the ground. The mortgage bankers did not support it, and neither did the consumer groups. Fannie Mae and Freddie Mac, if authorized to create lender networks, would have the clout to do it because they could make the complete- package-of-services approach a requirement for participation in the network.