If you read the article – Fair Lending Landscape 2021 – The Top 5 Potholes, this is Pothole #3 – Relying on the Fair Lending Knowledge of Your Secondary Marketing Team
I get it; mortgage pricing is complex and challenging to understand unless you work in that area every day. Yet, the biggest fair lending challenge that mortgage bankers face is pricing disparity. Our old school methods for making a profit do not work in today’s world, and here is why!
Secondary Marketing is a Profit Center
Your secondary marketing department is the department that takes the loans driven in by the originators and turns a profit for the company. Their goal is to make money for the company so that the company can pay everyone.
Their decisions and why they do what they do are all based on profit, not compliance…..unless compliance and secondary work on strategies together to accomplish both profit and fair lending compliance! When these two departments are not on the same page, decisions can be made that are detrimental to that lender’s Fair Lending risk profile.
Here Is Why?
I talked about the expansion of the HMDA data in my last post, The HMDA Data Evolution – Why You Need to Evolve Monitoring Practices! In that post, I reviewed how the new lender required data gives the examiner the ability to dig deeper, and this new treasure trove of data is affecting our monitoring practices. I also spoke about how each company needs to evolve its practices to avoid issues that the expanded data will likely uncover.
Some companies pay attention to this issue by implementing strategies to change the “old school” secondary strategies to a more modern method that creates profit without creating fair lending risk. Sadly, many are sticking to their old school ways because they do not understand or believe that a change is essential.
The Biggest Myth Told to Compliance
Due to the complexity of pricing and profit models, many compliance folks rely on their secondary team to provide them with the answers as to why their fair lending scoping software shows higher interest rates to minority borrowers. You may recognize this conversation which goes something like this:
Compliance: “Our data is showing that we charge higher rates to minority borrowers. Can you help me understand why this is happening?”
Secondary: “We charge everyone the same rate/price, so the differences are likely coming from risk adjustments for credit profile differences.”
That sounds reasonable, and everyone goes on about their day. The reality is that secondary may not fully understand the implications of their pricing stacks for fair lending purposes. The compliance person is the one who needs to connect the dots and demonstrate to both the secondary and the executive team how they affect one another.
Getting Comfortable with the Pricing Stack
First, compliance must understand the pricing stack. What is a pricing stack? A pricing stack looks at how the pricing engine technology is configured to produce a consumer rate. In a stack, we start with the raw pricing from the market. Next in the stack is corporate margin, followed by regional, branch margins, originator compensation, fees, and product margins. Any variations at any of the stack levels can cause pricing disparity that has nothing to do with risk adjustments.
The reason for these differences may be risk adjustments. However, the more likely explanations are the following:
- Product Margin Variations – These are variations in the margin added to the pricing based on the loan product type. They are not investor required; the secondary team adds them to adjust for profit on a loan type. The additional margin could be due to a perceived risk or merely a profit strategy. Example: Conventional product margins are 150 basis points. Government margins are 350 basis points. That is a 200 basis points differential or approximately .50% in rate difference. No matter how good a salesperson you are, that amount of pricing variance will be hard to formulate a business justification for an examiner. Remember, business justifications must be backed by empirical data, not just a reason as to why you think you need to charge more.
- Originator Compensation Built into the Pricing Stack – This is when originators have their negotiated commission rate built into the secondary pricing stack. When origination compensation is in the pricing stack, the consumer’s outcome varies based on compensation variations. So, you could have a branch with 3 originators earning different commissions and 3 different rates to the exact same client.
- Fees in the Pricing Stack – If your pricing engine considers fees in the pricing stack and your company allows originator or branch variation in those fees, your output to the consumer will vary.
- Origination Fees in the Pricing Stack – Some branches/originators are permitted to add origination fees to their pricing stack, while others do not, resulting in variation. I find the most egregious practice is charging an origination fee on a VA loan to compensate for not charging traditional fees such as processing or underwriting. Here is an example: Let’s say the loan amount for the Veteran is $300,000. VA does not allow processing or underwriting fees, so your company policy charges a 1% origination fee only on VA loans to compensate for the lost fees. Let us further assume that on a conventional or FHA loan, your standard processing or underwriting fees are $1000. Charging a fixed origination fee means you charge a Veteran $3000 [1% origination] vs. the $1000, a differential of $2000 more. Does that seem right?
- Pricing Exceptions – In the most recent quarterly call with regulators, the CFPB mentioned a focus on Pricing Exceptions. Pricing exceptions are any deviation from the pricing output, even if that deviation is only $1. There is no regulatory standard on the percentage of pricing exceptions allowed, but it is reasonable to assume they should not be high. I think if most of you look at the percentage of pricing exceptions at the originator or branch level, you will see numbers much higher than what would be reasonable. Exceptions create pricing variation and discretion issues because the originator or company uses discretion to determine what consumers may receive an exception. If your exceptions are high, then you are likely not pricing to market and reaping the profits of those consumers who do not negotiate with you. If those consumers happen to fall within a prohibited basis, you have pricing disparity risk.
Before the new HMDA data, regulators could not pick up on these variations because they did not have the data. Now, they have the data, knowledge, and AI to help them scope for these issues!
This message bears repeating. There are pricing strategies that a company can put into place that will accomplish the profit goals, keep your sales staff, reduce the fair lending risk and flatten the disparity in pricing between consumers. It is beyond the time to make that happen before you end up on the wrong side of a fair lending exam!
Those of you who are not comfortable with pricing can take two of our classes on pricing, which will help you tremendously. Or I’m just an email away if you want to talk one-on-one. Our company has helped many lenders re-formulate their profit strategies, and we can help you too!
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Fair Lending Diversity specializes in uncovering and fixing the highest risk issues to the lender. Our clients range from small banks to top mortgage lenders. Our mission for all our clients is simple – “Maintain Profitability & Reduce Risk.” If you would like to discuss our services, please contact me at firstname.lastname@example.org