A few simple changes in financial regulation could pay huge dividends to home buyers and retirees. Better still, they could be implemented by executive orders that do not require funding by the government or the concurrence of Congress. I’ll be discussing them in this and following columns.
Today I’ll discuss title insurance, which every mortgage borrower has to purchase. A simple executive order from the president to the Federal Housing Finance Agency (FHFA), when fully implemented and digested, could save borrowers at least $7 billion a year.
The executive order would direct FHFA to instruct Fannie Mae and Freddie Mac to require lenders originating loans for sale to the agencies to pay for title insurance that protects themselves. This would end the practice of requiring borrowers to pay for the insurance that protects the lender. Borrowers would continue to have the option of buying insurance that protects themselves.
While the new rule would apply only to conforming loans, which are those eligible for sale to Fannie and Freddie, it would spread quickly to the smaller market for non-conforming loans.
Inanity of the current practice
To appreciate the inanity of having a buyer pay a seller’s cost, consider what would happen if that practice were used in a more familiar market — such as the automobile market. Suppose that industry adopted the practice of pricing cars without tires, requiring that tires had to be purchased by the buyer in a separate transaction, from a tire seller approved by the dealer. Then the cost of the tires, instead of being embedded in the price of the car, would be paid for separately by the car buyer. This would mirror exactly the way that title insurance is transacted.
If this were to happen, the existing highly competitive market for tires would be replaced by a dysfunctional market, and the price of tires would soar.
In the existing market, car manufacturers negotiate the lowest tire prices possible because tires are one of their costs. Further, they have the knowledge and bargaining power to obtain the best competitive prices. But if car buyers had to purchase tires separately, competitive pricing would disappear.
Tires sold separately would become a separate source of profits to car dealers, who would be positioned to refer car buyers to favored tire dealers. The price of tires would rise to accommodate the marketing costs incurred by tire sellers in soliciting the favor of dealers, which would come to include explicit or disguised kickbacks.
Since kickbacks are viewed as odious; left-wing legislators might attempt to make them illegal. If they succeeded, right-wing legislators might attempt to authorize legal ways to accomplish the same objective, including joint ventures between automobile dealers and tire distributors.
Fortunately, this is all hypothetical as it applies to automobile tires, but it accurately describes the dysfunctional title insurance market, including the federal government’s response to date.
The problem is not the absence of competition
When markets don’t work well, it is often attributed to lack of competition, but that is not the problem with title insurance. Competition in this market is fierce, but it is directed not at borrowers but at the lenders, Realtors and builders who have referral power. Competition directed at referrers tends to raise prices rather than reduce them because it raises marketing costs, and because many referrers expect to be compensated.
Existing federal government policies miss the point. There are two. One is to declare the payment of referral fees to be illegal. Enforcement of this rule by HUD is difficult because there are so many players, and because there are so many ways that one party can provide something of value to another.
The second policy is to provide a safe harbor, called an “affiliated business arrangement,” or ABA. To take advantage of this provision, the title agent forms a new agency owned jointly with a referring lender or realtor. Referrals to this new entity are legal, and the referrer can profit in proportion to its ownership share.
ABAs are a costly way to pay referral fees legally. To minimize the costs, the new agency may be only a facade, with the work actually done by another agency. These are deemed shams and unacceptable by HUD.
Title insurance costs to borrowers will not be lowered by trying to enforce rules against the payment of referral fees, or by forcing referrers to incur high costs in order to legalize these payments. The solution is to eliminate referral power by requiring the referrer to pay for the policy.