During the heady days of the housing boom, unscrupulous mortgage brokers steered trusting borrowers into overpriced loans to earn bigger commissions.
It was one of the reasons the housing market tanked, taking the economy with it. Now, several years later, new Federal Reserve rules are set to kick in to eliminate this practice by restricting how loan originators are compensated.
The industry is resisting. The National Association of Mortgage Brokers sued the Federal Reserve Board this month in an attempt to prevent the new rules from taking effect April 1. The trade group predicts the restrictions would cause "immediate, devastating, and irrevocable harm" and ultimately lead to the industry's extinction.
But borrowers need the protection. Navigating the mortgage world is difficult. In a report last fall, the Federal Reserve found that many consumers are unaware of how loan originators are compensated and the potential conflicts of interest.
"Consumers often wrongly believe that brokers have agreed or are required to obtain the best interest rate available," according to the Fed report. And that misperception, the Fed says, can lead them not to take steps to make sure they are getting the best deal.
Consumer advocates are cheering the Fed's new rules as a way to prevent the kind of loan abuses that have led to a rash of foreclosures, upending homeowners and communities.
"Paying brokers to charge homeowners more is one major reason why we had an epidemic of abusive loans," says Alys Cohen, staff attorney for the National Consumer Law Center. "Changing the incentives is essential to establishing a fair market."
A borrower, for example, might pay a broker an upfront fee for services rendered. But the borrower might not realize that the lender, too, may be compensating the broker for locking in a higher interest rate.
Brokers can use this so-called yield spread premium to reduce a borrower's upfront closing costs, or they can keep all the money themselves. During the real estate boom, shady players collected fat fees by offering high-rate loans even when borrowers qualified for better terms.
The new rules, which apply to mortgage brokers and loan officers, aim to eliminate these conflicts of interest.
Under the rules, mortgage brokers and loan officers can't be compensated based on the interest rate or other terms of the loan. Also, if loan originators are being paid directly by the consumer, they won't be able to collect payments from lenders or others.
And brokers and loan officers would be banned from steering consumers into loans to earn more money — unless that loan is in the consumer's interest. Borrowers might want a higher-rate loan under certain circumstances, such as when it would reduce their upfront costs.
The National Association of Mortgage Brokers argues in its lawsuit that brokers work hard to find customers the best rates. Limits on compensation are already causing brokers to leave the industry and brokerages to close, the group warns. And less competition in the marketplace, the suit states, will ultimately lead to higher loan prices and fewer choices for consumers.
"The Fed has really gone too far on this. They are fundamentally setting fees," says Thomas Shaner, executive director of the Maryland Association of Mortgage Professionals.
Some smaller brokerages have closed shop in Maryland because of the economy and other reasons, and Shaner expects the Fed rules to cause more to do the same.
But consumer advocates and some mortgage experts don't buy all these arguments.
If interest rates and fees go up, which they will, it won't be because of the new compensation rules, says Jillayne Schlicke, founder of the National Association of Mortgage Fiduciaries, a professional group advocating for the creation of an ethics code for loan originators.
"It will be because we're facing more foreclosures today than we ever had. That's why lenders will raise rates," she says.
Kathleen Day, spokeswoman for the Center for Responsible Lending, says the new rules won't put brokers out of business if they put the customers' interests first.
"If they do that, by word of mouth, they will get more business. That's how a free market works," she says.
In the market for a mortgage?
•Shop around. Contact a mortgage broker, bank and credit union for an estimate of fees and interest rates.
•Ask for references from the most recent customers, especially in the neighborhood where you are buying. Find out from the borrowers whether they were satisfied with their loan and the loan originator.