Subprime Mortgage Study Exposes Yield Spread Premium Money Trap
Collegiate Study Analyzes Mortgage Broker Profits
The subprime mortgage crisis helped make a mess of America’s economy, to the point where credit repair has become a questionably attainable goal at best. The path toward more house than Joe Consumer can handle financially was paved by upside down transactions with mortgage brokers. When compared with direct lenders, working with mortgage brokers generally stretches out the time it takes in which to close a mortgage loan and introduces the consumer into murkier financial waters.
Swimming with Yield Spread Premiums
A yield spread premium (YSP), according to the Center for Responsible Lending (CRL), is “a bonus a lender pays to reward a mortgage broker for placing, or steering, a borrower into a higher-cost loan than the borrower qualifies for.” That would typically include hefty prepayment penalties that keep the consumer stuck in the loan long enough to extract higher profits. The CRL points out that resulting foreclosure cases harm not only the borrower, but society as a whole in the form of lessened property values and tax revenues.
Studying the Gross Profits of Yield Spread Premiums
That’s what Antje Berndt, Burton Hollifield and Patrik Sandas of Carnegie Mellon University and the University of Virginia set out to expose in their paper “The Role of Mortgage Brokers in the Subprime Crisis.” They play a large role in the recent American mortgage market, as they are a centerpiece of subprime loans. And by the authors’ estimate, subprime mortgage loans accounted for at least 75 percent of all mortgages originated as late as 2006.
“What were the explicit and implicit incentives for mortgage brokers to match borrowers with different types of mortgages?” ask the authors. Furthermore, “Did these incentives change during the run up to the crisis?”
How Does the Yield Spread Premium Work?
Lenders provide the mortgage broker with a set of incentives. One example the authors give is a lender paying the broker a kick-back for offering more expensive loans to consumers. Sure, it gets them in a home for a while, but it works against their financial best interests. The broker, given this incentive, is working to aid the borrower first and the consumer a distant second. Or at least that’s the theory that the authors explore. They search for evidence in the records of one of the largest subprime loan originators – New Century Financial Corporation – from 1997 through March 2007. The authors study info on borrower creditworthiness, loan purpose, appraised value of the property, property location and type, type and terms of the mortgage loan, loan service records and info on broker involvement. This leads to the profit portrait.
How Does the Loan Origination Process Work?
In five steps, here’s what New Century does:
- Brokers attract borrowers to complete loan applications. Applications are sent to a New Century account executive (AE) or the company’s Web portal.
- AEs forward apps to New Century managers for documentation review.
- If documentation is in place, AEs send loans through the underwriting process, where the approval or denial decision is made, based upon the consumer’s credit and mortgage histories. The interest rate and terms are set at this time and the home is appraised.
- If approved, the loan goes to a closing agent.
- After loan documents are sent, documents are sent via closing agent to a funding officer, who sets the wire process in motion.
Think New Century was Approving Every Subprime Consumer?
You’d be wrong, say the authors. Of the 330,000 subprime loans funded in 2006, there were nearly that many who were either withdrawn by the consumer (buyer’s remorse) or denied outright. Either way, brokers were being compensated for a good year’s work in the subprime market, it would seem.
Speaking of compensation, loan origination and credit fees play a significant role in a broker’s payment. But then there are those YSPs. The more higher-rate loans brokers originate, the more they stand to make in profit. Think that customers were being nudged (perhaps too gentle a term?) toward YSPs? Considering that brokers don’t have to disclose the yield spread premium until after the closing statement is signed, there’s very little mess until after the consumer has already opened a vein to sign the contract in blood, so to speak. YSPs account for around 65 percent of broker revenue, according to the authors. The average dollar revenue per loan was around $7,000.
Underwriting the Risky
Based upon a borrower’s characteristics (credit quality, willingness to pay, etc), the broker presents financing options to the consumer. One or more lenders receive funding requests from the broker, and the lenders make the ultimate decision. “The loan will be originated,” write the authors, “if the lender’s surplus is positive so that the lender agrees to the funding, if the gains from trade between the borrower and the broker are positive, and the fees will be set so that the surplus is split between the borrower and broker in proportion to their bargaining power.”
Other Mortgage Loan Profits
A hybrid mortgage loan (aka a fixed-period adjustable rate mortgage) is another profit machine for brokers, pumping up their returns by about 28 percent. Mortgages with “limited documentation or stated documentation” increase broker profits by 33 percent and 18 percent, respectively. Those mortgages that have prepayment penalties (yield spread premium territory) offer 29 percent greater profits. In the case of a refinancing where cash is taken out, the authors found that broker profits nearly doubled.
Some other factors that influenced ability to reap excess profit included broker experience and strength of broker-lender relationship. Lenders likely viewed such brokers as have greater bargaining power over consumers, particularly with mortgage contracts where documentation was minimal and the consumer was gullible enough to sign on. Complex mortgages with minimal documentation for the consumer (not to mention a skilled broker) roped in their share of what amount to many foreclosures. That’s hardly an environment for consumer credit repair, it would seem.
High Profit Loans and Borrower Delinquency
You can only ask so much from borrowers with limited means. As the underwriting criteria for New Century and numerous other mortgage lenders was too slack, the result was expensive mortgages without people who could pay for them. Yield spread premiums created the profits brokers desired and the lenders were happy just to see loans originated, regardless of realistic ability to pay in many cases. Thankfully, the Obama administration has paid close attention to restructuring the mortgage loan market, but will it be enough to allow consumers to find avenues for credit repair? That remains to be seen. In the meantime, if you’re looking to take out a mortgage or refinance, here’s a mortgage calculator. Do the math before a lender or broker does it for you and has you paying their yield spread premiums.