Understanding Yield Spread Premiums

The New York State's Governor's office requested that the New York Association of Mortgage Brokers (NYAMB) provide an explanation of the use of the Yield Spread Premium and what suggestions they have to curtail the abuse of it. Don Romano drafted their response and it is presented here.

Yield Spread Premium (YSP) is an important tool available to brokers in servicing the applicant. As is the case with any tool, its improper use results in damage. The goal is to implement a mechanism that will eliminate the ability for abuse of YSPs yet maintain the consumer’s options in determining the most advantageous way to pay for his or her mortgage.

The real cost to a consumer for a mortgage is paid through a combination of interest rate and points. We are defining a “point” as any upfront fee that is priced as a percentage of the mortgage amount. A discount, broker or origination fees are all the same. Each one is priced as a percentage of the mortgage amount and higher upfront fees on the same mortgage will yield a lower interest rate on the mortgage.

There are 2 features of YSP that open the door to abuse. One is the difficulty of the consumer to easily understand how YSP works and the other is a weakness in the current disclosure regulations. It is our opinion that the door for abuse can be closed through a revision to the current regulation.

Before we delve into the workings of YSP it is important to recognize that it is cost effective for Lenders to work through a network of Brokers. Due to the cost saving to the Lender, a lender offers a wholesale price structure to the broker. Through this pricing mechanism a Broker can offer pricing that is competitive with the pricing that Lenders offer directly to the public.

The mortgage application process is very labor intense, with the majority of the hours being dedicated to customer service. The volume of mortgage applications taken by a Lender varies greatly from year to year. This makes it difficult for Lenders to hire and keep good people since the number of employees that are required will be different from year to year.

Getting past the customer service component and looking at the actual underwriting process we find the next benefit. A Lender is forced to take an application from a consumer in any condition the consumer decides to present it. The application may not be filled out completely, it may not be signed, the supporting documentation may not be there or what’s there isn’t complete. This results with more man-hours being spent on the file.

When a Lender conducts business with a broker, it is a business-to-business relationship. The Lender can dictate to the broker what condition a package needs to be in before it gets to underwriting, require the broker to confirm the package meets certain guidelines before submission, demand a minimum closure rate on packages that are submitted, etc. The Lender can pick and choose which brokers it wants to work with and can stop dealing with a broker for any reason.

Now we can focus on how YSPs are utilized. As we have already said, the cost of a mortgage is a combination of points and interest rate. A consumer engages a Mortgage Broker’s service to arrange for the placement of a mortgage. For this example we will assume the consumer agrees to compensate the broker 1.0% of the mortgage amount for his services. We are also going to use an over simplified pricing model for the purposes of our example.

The mortgage is committed and the rate is set at 6.0% plus a 1-point broker fee. Straightforward enough, the consumer pays a 6.0% annual interest on his mortgage for as long as it’s outstanding and writes out a check to the Broker for 1.0%. The consumer also has the option to lower his monthly payment by increasing his upfront costs. He could decide to pay 2-points instead of 1 and lower his interest rate to 5.75% or he can decide to pay 3-points instead of 1 and lower his interest rate to 5.50%. These additional points are paid to the lender to make up for the reduction in the monthly mortgage payment.

The concept of paying more upfront in order to pay less over time is easy for the average person to understand. If paying more upfront lowers the payments over time then the opposite is also true. The less you pay upfront the more you pay over time. For a consumer that is either tight on cash or prefers to maintain a higher cash reserve after closing this is an important option to consider.

If 3-points buys an interest rate of 5.50, 2-points buys a rate of 5.75% and 1-point buys an interest rate of 6.0% is it surprising to find that if the consumer elects to pay a 6.25% interest rate, it entitles the consumer to pay 0 points upfront? It’s not a difficult concept for the consumer to understand. As long as the intention of the Broker, or the originator, is to bring clarity to the explanation then the consumer will have no problem in understanding.

Those in the business who are looking to abuse the use of YSP don’t want clarity. The poorer the understanding of YSP by the consumer, the better it is for the abusers. This brings us to feature number 2, the weakness in the current disclosure regulations.

The exact dollar value of a YSP isn’t determined until the mortgage rate is locked. A NYS Registered Mortgage Broker doesn’t have the authority to commit a lender to fund a mortgage application or commit a lender to a particular rate. The current regulation requires a Broker to disclose the exact fee that an applicant agrees to compensate the Broker for his services and a maximum amount the Broker can receive from the lender in the form of a YSP. There is nothing in the regulation that requires any connection between the upfront broker fee and any YSP. This situation creates the opportunity for abuse.

Going back to our example. The consumer starts off expecting a rate of 6.0% and a 1-point broker fee. Our consumer ends up closing at 6.50% with 1-point. He doesn’t really know why the rate changed. It could have been that the consumer didn’t qualify for that particular rate and the lender needed to charge more. Maybe there was a change for the worse in the market price for the mortgage between the rate quote and the rate lock. Or it could have been that the Broker just wanted to abuse the system by representing that he was making only 1-point on the mortgage but in reality was making 3, 1-point from the consumer and 2-points in the form of YSP.

Yes, we can definitely prevent this from happening by banning the use of YSP, but at what cost? When the power chain saw was initially sold to the public there were many injuries. Instead of banning the sale of this product, they modified the mechanism by adding an automatic brake making the tool substantially safer. We’re suggesting a similar modification to the existing regulation.

The residents of New York State are faced with the highest closing costs of any State in the nation. The biggest hurdle for the first time homebuyer is raising the cash needed to buy a home. One of the most important tools a Broker has at his disposal is YSP because it allows him to offer his clients the ability to offset out of pocket expenses with a higher interest rate.

Recently the State of Massachusetts implemented regulations with the intention of eliminating a broker or banker’s ability to steer an applicant into a mortgage that generated a higher profit than the quality of the applicant deserved. The language of the regulation implied a banning of YSPs. Immediately, Lenders began to stop the origination of mortgages in the State. The regulation was put on hold, meetings were held with the industry groups and the language was modified.

We need to be careful when drafting new regulations in order to make sure that we don’t restrict the availability of mortgages to the public. It’s important that we don’t repeat the mistake that Massachusetts made.