If you haven’t heard, the mortgage broker community is buzzing right now due to recently introduced legislation (HR 3915) from Democratic Congressman Barney Frank that may outlaw a little known and understood compensation structure called yield spread premiums (YSP) for mortgage brokers. If YSP were outlawed or severely restricted it could mean the extinction of the mortgage broker industry ultimately raising the cost of obtaining a mortgage for consumers.

Despite the complex sounding name, YSP is nothing more than a fancy term for profits. Unfortunately, many consumer groups and politicians who do not fully understand financial markets or the mortgage industry have unfairly characterized YSP as insidious. Often times they will say that YSP is an incentive for putting borrowers in mortgage loans at rates higher than they qualify for. This is only partially true and not nearly as bad as it sounds.

How Yield Spread Premiums Work

Most people who have taken 9^th grade economics understand that wholesale plus profit equals retail price. The only people who seem to have difficulty with this math are politicians and nanny state consumer groups.

What is often left out of the YSP debate is that mortgage brokerages obtain mortgages on a WHOLESALE market. YSP is how the interest rate is marked up to offer retail interest rates. For example, a mortgage bank may be offering mortgage brokerages 30 year fixed rate loans at 6%. At this interest rate, there IS NO PROFIT in the mortgage loan for the brokerage. The only way you as a consumer would ever get that interest rate is if the broker charged you points.

But suppose you don’t want to pay points? That is where the YSP comes in. Instead of you paying points to the mortgage broker, the broker can raise your interest rate and earn a commission from the mortgage bank which is the YSP. See at 6.5% the loan is worth more to the mortgage bank, so they can pay the broker his 1% commission without him charging you points. So instead of you getting 6% with 1 point in closing costs, you get 6.5% with no points. You are happy because your closing costs are less and the broker is happy because he earned his commission. The bank is happy because they got a loan from the broker that they otherwise would not have received. The important fact to keep in mind that the 6.5% with the YSP built in is still a lower rate than you would have received had you gone to the mortgage bank directly and not through the mortgage broker.

The problem with YSP is that many consumer groups feel mortgage brokers have an incentive to try to raise your rate as high possible to make as much money as possible. Of course they do! That is called capitalism! EVERY business in this country has an incentive to try to make as much money as possible on the spread between their wholesale cost and what you are willing to pay in retail price! Duh!

As a consumer, you should only be concerned with the FINAL TERMS of the mortgage loan you are receiving, not what the brokerage is earning in profit. If you shop for a mortgage loan in earnest, there is absolutely NO WAY a mortgage broker can gouge you since it would be reflected in an interest rate that is significantly higher than their competition. If a mortgage broker is trying to make 3% in YSP off a loan that most would do for 1.5%, it will absolutely show up in the final interest rate you are offered.

In short, this bill is like telling Wal-Mart they cannot mark up a pair of socks from their wholesale cost to sell to you at their retail price. Unbelievable.