Questions About Mortgage Referral Fees

February 6, 2006, Revised June 28, 2006, December 13, 2007

Referral fees are payments made by service providers to other parties as quid pro quo for referring customers. Referral fees should be distinguished from referral power, which is the ability to direct a client to a specific vendor. The major concern with regard to referral fees in the home mortgage market is that it raises prices to borrowers. This overlooks that a service provider who is barred from paying referral fees has to find another way to market to those with referral power, and the alternative could well be more costly. The way to reduce settlement costs is to eliminate referral power by requiring lenders to pay for all third party services they require from borrowers.

What Are Referral Fees?

Referral fees are payments made by service providers to other parties as quid pro quo for referring customers. For example, a real estate agent is rewarded for sending a borrower to a loan provider. The reward, whatever form it takes, is a referral fee.

Referral fees should be distinguished from referral power, which is the ability to direct a client to a specific vendor. Referral power is based on information and authority of the referrer, and ignorance of the client. The real estate broker has information about the reliability of loan providers, and may have authority in the eyes of the borrower. The borrower may be ignorant about loan providers

Not everyone with referral power collects a referral fee. For example, I have sent many mortgage borrowers to Upfront Mortgage Brokers but I have never collected referral fees from them.

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.

If the refrigerator repair person comes to our house and has to tinker around to fix it, we pay his $50 fee without a murmur. If he tells us over the telephone to flip the XC switch and give it a kick, assuming this works, we are affronted at being billed $50, even though the value received by us – a refrigerator that now works -- is exactly the same.

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 specialists, does he send borrowers to the best loan providers, 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. It seems plausible that 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 overlooks that a service provider who is barred from paying referral fees has to find another way to market to those with referral power, and the alternative could well be more costly.

Why Are Referral Fees Pervasive in the Home Mortgage Market?

Because referral power pervades this market. Real estate and mortgage transactions involve a large number of diverse players who sell services that consumers are required to 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. Referral power in this market is based largely on the ignorance of consumers.

Realtors and builders have referral power on home purchase transactions, referring consumers to lenders and title agencies. Lenders and mortgage brokers usually select the appraiser and credit reporting agency on purchases, and all third party service providers on a refinance. Mortgage insurers are always selected by the lender.

Do Referral Fees Raise Settlement Service Prices to Consumers?

No, referral power raises prices to consumers, not referral fees. 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.

Referral fees are a consequence of referral power. If we had a magic wand that immediately eliminated all referral fees but left referral power intact, it is as likely that prices to the consumer would rise as it is that they would fall. To service providers, referral fees are a marketing expense. Remove them and service providers would have to find other ways to market themselves to the same referrers.

Consider: A consumer (C) is required to purchase a service and looks to referrer (R), who directs him to service provider (S). S prices the service well above the lowest price he would be willing to accept because he must market to R and R is not sensitive to a price he doesn’t have to pay. Indeed, the high price allows S to pay R a referral fee. If the referral fee cannot be paid, S has to find another way to induce R to refer him to C, and that could cost S more than the referral fee. Elimination of referral fees, therefore, would not cause S to reduce his price.

Why Are Referral Fees Illegal Under 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 the Real Estate Settlements Procedures Act (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, and RESPA fails to address referral power. Not surprisingly, therefore, the RESPA prohibition of referral fees has not reduced settlement costs at all, a fact acknowledged by HUD which has the unpleasant task of enforcing RESPA.

Has RESPA Prevented Referral Fees?

No. There are too many referral agents, and too many ways they can receive something of value from service providers. HUD would require an army of examiners to shut it down, and it has never had such an army. The fact is that thousands of small referral agents continue to receive referral fees, if in disguised form, with impunity.

HUD does what it can, and in 2005 it stepped up its enforcement efforts. It settled enforcement actions against 12 referrers, all major players, who included lenders, title insurers and real estate brokerage firms. (In 2004, there were only 2 such cases.) While small players continue to operate below HUD’s radar screen, these enforcement actions do encourage larger players to find legal ways to exploit their referral power.

Does RESPA Allow a Realtor to Own its Own Title Company?

Yes, 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. However, the title company 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.

Indeed, there are firms that will put any lender or Realtor in the title insurance business by creating a title agency for them, which can be a joint venture or an entity wholly owned by the referrer. These firms guarantee that the title companies they create are RESPA compliant. Since the capital investment required is considerable, this option is available only to firms able to generate a volume of referral business large enough to justify the investment.

Is Income of Captive Title Companies Not Referral Fees?

In the eyes of HUD and RESPA, it is not. The reality, however, is that the income the Realtor derives from the title company continues to be based on the Realtor’s referrals, indeed, the title company would not exist except for such referrals. You can change the name of an animal from "elephant" to "dog", but that animal remains a ponderous pachyderm with big ears, and so it is with referral fees.

Is Any Public Purpose Served by Legalization of Referral Fees?

I suppose enforcing the law is a public purpose, even when the law is a stupid one. All the other consequences are negative.

Setting up a RESPA-compliant firm to legalize referral fees is an option available only to fairly sizeable firms. Smaller firms have to choose between observing the law at their loss, or violating it.

Requiring a referrer to incur the expense of creating a new service provider, when they would otherwise prefer to deal with an existing provider, is a waste. New firms should be formed when there is a real market need for them, not to enable existing firms to collect referral fees without violating RESPA.

What Should be Done About High Settlement Costs and Referral Fees?

To reduce settlement costs requires either that referral power be eliminated, or that it be redirected to benefit consumers. One approach is to suspend the prohibition of referral fees for any firm that combines a mortgage loan and all settlement services connected to it in one package offered at a single guaranteed price. A lender who was a packager, for example, instead of referring customers to title insurers and the like, would negotiate the best prices they could with each service provider so that they could offer competitively-priced packages to consumers.

This approach was proposed by HUD in 2002. I supported it, even though the details were devilishly complicated, but most industry groups didn’t and their opposition killed it.

My approach, which would sidestep RESPA altogether, is to enact a legal rule that is as simple as it is obvious: any third party service required by lenders must be paid for by lenders. This would be mandatory rather than voluntary as in the HUD approach. (This and the HUD proposals are discussed in detail in HUD's Proposals For Reform).

If lenders paid the charges, they would be included in the rate, of course, but would cost borrowers far less than now. Competition by third party providers to sell lenders would force the prices down, and rate competition by lenders would force them to pass the savings on to borrowers.

I am confident that this proposal would garner no more industry support than the HUD proposal. Hence, I’m proposing a second-best approach which has the virtues of simplicity and (likely) industry support. It is to scrap the RESPA prohibition on referral fees. The prohibition was misguided to begin with and never reduced settlement costs, which was the rationale for enacting it.

What the RESPA prohibition has done is to encourage wasteful affiliations, the sole purpose of which is to legally sanitize referral fees. If unchecked, for example, there soon won’t be a lender or Realtor of any consequence who does not have its own title agency. Another consequence is disrespect for the law, which can only be enforced selectively.

Unlike the other proposals, scrapping the prohibition on referral fees won’t change the market overnight. But by giving free rein to the application of the newest technology by innovative competitors, settlement costs will gradually come down. It is time HUD proposed to Congress that the RESPA prohibition on referral fees be scrapped.

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