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All Boxed In With Regulatory Packaging

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March/April 1999 - Volume 78, Number 2

By Richard McCarthy, ALTA® Director of Research

During the summer of 1998, the Department of Housing Development (HUD) and the Federal Reserve Bank (FED) issued their Joint Report to Congress Concerning Reform to the Truth (in) Lending Act and the Real Estate Settlement Procedures Act. While there are many recommendations in the report that would improve the lending/settlement process and would benefit consumers, at least one major recommendation is troubling and may not serve consumers well at all.

To improve RESPA, the Report requires a good faith estimate of all costs that the creditor anticipates that the borrower will have to pay in connection with closing a loan. According to the Report, "HUD has interpreted RESPA to require that the good faith estimate cost disclosures must bear a reasonable relationship to the actual charges. RESPA does not impose liability on a creditor for an inaccurate or incomplete estimate . . . The figures disclosed on the good faith estimate need not be firm or guaranteed. Thus there are few incentives for creditors to incur costs to increase accuracy . . . actual charges may be higher because the estimates may not have been prepared with sufficient regard for their accuracy."

To improve the accuracy of the good faith estimates, the Report recommends either:

1) guaranteed costs for the settlement services with an exemption from Section 8 of RESPA; or

2) imposition of an accuracy standard on the good faith estimate.

An exemption to Section 8 prohibition of referral fees would be granted to the firm that offers packaged settlement services if a guaranteed price for the comprehensive package of services needed to close the loan is offered, and the interest rate and points for the loan are disclosed. The lender is not required to either indicate what is in the package or what the prices are for the individual components of the package. We do not believe that creditors would choose the accuracy standard approach since they could be penalized for inaccuracies caused by settlement services providers that are beyond their control. Rather, creditors would prefer to take the necessary elements of the process under their control through guarantees and pass the guaranty on to the consumer.

Because the results of regulatory packaging will have far reaching implications for how all settlement service providers will do business in the future, ALTA® asked Dr. Robert M. Feinberg, Professor and Chair, Department of Economics, American University, to comment on the HUD/FED Report.

In his Introduction, Dr. Feinberg states: "Packaging will produce minimal benefits at best, while imposing potentially significant costs on consumers and smaller settlement service providers, and risk to the real estate settlement industry....any benefits which might result from packaging would likely be distributed unevenly across regions and individuals.... possible costs ....include higher prices to certain groups of customers, elimination of settlement service providers that could have long-term competitive implications, conflicts of interest, and risk of harming small business and disrupting a system that generally works well at present." (emphasis added)

The following are direct excerpts selected from Dr. Feinberg’s article, Economic Implications of Real Estate Settlement Packaging.

The settlement cost guarantee discussed in the report does nothing to help consumers in searching for the best financing package (and in fact may hinder this search), since it reduces the transparency of financing comparisons. It is difficult enough for consumers to evaluate the best financing deal (both on purchase and refinancing) when confronted by an array of fixed and variable rate products, each with alternative possibilities of points, amortization periods, and other features. Adding to the mix a lump sum for settlement costs, especially if not itemized and not complete, will make comparisons among lenders even more complicated.

To the extent that packaging is intended to achieve the second goal stated above (informing consumers of the full cost of a real estate transaction) the proposal is clearly inadequate, as there are too many exclusions from the package.

Consider the issue of reducing consumer search costs. Unless there is full disclosure of the particular services in the package ("itemization") and the option to consumers of substituting provider of particular settlement services ("freedom of provider selection") ? the latter requiring information on prices (perhaps in terms of credits given consumers for substitution) of these elements -- at a useful point in the transaction less information will be provided to the consumer than at present. The Fed/HUD recommendations state that "consumers want to know what services they are purchasing (report, p.33) and so they suggest that a list of services ? but not individual service prices ? might be provided by the date of settlement. This late and incomplete information is clearly inadequate to the goal of providing either full information or the enhancement of a consumer’s ability to shop around.

Unless itemization of expenses for services which are part of a package and freedom of provider selection are required, consumers who are well informed about the settlement process or are willing to take the time to shop will be prevented from getting the best deal, which will tend to raise prices on average. And unless service providers are identified by name early in the process, consumers are prevented from being able to judge the quality of these services provided in whole or in part for their benefit that are included in a given package.

The clear presumption of the Fed/HUD recommendations seems to be that lenders do operate in a highly competitive market; from this they draw the conclusion that packaging will push prices down by putting all closing costs in lenders hands. However, for certain classes of consumers (rural, poor credit, unusual size and type of loans, those in the inner city) there may be limited sources of credit, suggesting market power by lenders in those market sectors; for these consumers the effect of packaging may be to raise the total cost of closing.

Given oligopsony (buyer) power by large lenders over settlement service providers and at least pockets of market power possessed by lenders towards consumers, there is no guarantee that any discounts received on these settlement services will be passed on to consumers as opposed to being reflected in higher markups. In fact, without itemization and freedom of provider selection ? the type of information required by a competitive market ? this pass-through of discounts to consumers is quite unlikely.

The costs of packaging are of the following types: (1) raising prices on settlement services to selected groups of home-buyers; (2) the threat of long term availability problems, especially for smaller providers of certain settlement services, which may have implications for future levels of competition in the real estate settlement market; (3) reduced purchases of consumer-benefitting services associated with the home purchase; and (4) moral hazard issues which may reduce the quality of some settlement services that primarily benefit consumers but which are included in lender-provided packages.

If we consider which types of consumers are most likely to lose out from packaging these include both savvy buyers (who would prefer to shop around for best deal on all services, and who will be disadvantaged without itemization and freedom of provider selection) and unsophisticated purchasers (who may be unable to evaluate the choice between competing packages and who may ignore the non-packaged components of settlement services).

An additional information-related cost of packaging is that it may lead to reduced purchases of consumer-benefitting services. That is, if customers think that a package is complete (as it may be from a lender’s perspective) they may be unaware of the advantages they might receive from settlement services which could supplement the package. They may, for example, be unwilling to purchase an owner’s title insurance policy, or to retain their own attorney to represent their interests in the transaction, or to pay (extra perhaps) for an independent home and pest inspection, etc.

Related to the last point is that the potential for conflicts of interest associated with packaging is enormous. There is clearly an asymmetry in the nature of information held by a lender and a home buyer, both in terms of the types of settlement services which may be desirable for the buyer to obtain, and in the quality of services provided. For some of these services, quality has little effect on the lender but potentially major impacts on the buyer ? examples are home inspection, appraisals, pest inspections. As long as the providers of these services are able to detect and prevent major problems which would reduce the value of the property below the loan value, the lender would be satisfied; buyers however, would like more assurance of likely future maintenance problems and the costs which these will require. Given both different needs and different ability to judge quality, we would expect a sub-optimal level of service (from consumer perspectives) to result from packaged provision.

While better information and greater certainty about rates and points would be desirable, the current system has generally served consumers well. Furthermore, a limited amount of packaging is occurring even without a regulatory mandate. Some vertical integration is occurring and leading to internal company packages; however, without mandate, changes occurring are market-driven and still leave room for non-integrated firms, small businesses, and consumer choice among settlement providers.

Matthew J. Cholewa is Branch Counsel with Lawyers Title Insurance Corporation in its Cromwell, Connecticut office, having joined Lawyers Title in April, 1998. Mr. Cholewa was previously an attorney with Robinson & Cole LLP in Hartford, Connecticut. He received his Juris Doctor degree from the University of Virginia School of Law in 1992, where he was a member of the Virginia Law Review. Mr. Cholewa can be reached at 860-635-5566 or by Email at  .

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