FTC Staff Comment Before the Department of Housing and Urban Development Concerning Proposals to Relax Section 8 With Regard to Home Mortgages

fDM¥l~~lDN AUTHORIZED
l 	l)'\c"c··lf -;
UNITED STATES OF AMERICA
DEPARTMENT OF HOUSING AND URBAN DEVELOPMENT
Proposals to Relax the Interpretation
of Section 8 with Regard to Home
Mortgages
July IS, 1988
Docket No. R-88-1256
STATEMENT OF THE STAFF OF THE BUREAU OF ECONOMICS OF THE UNITED STATES
FEDERAL TRADE COMMISSION

I. 	Introduction and Summary
Section 	8 	of 	the 	Real 	Estate 	Settlement 	Procedures 	Act 	of 	1974
(RESPA)l prohibits compensated referrals for "business incident to or part of
a 	real estate settlement service involving a federally 	related 	mortgage loan,"
Violations 	of 	Section 	8 	are 	subject 	to 	criminal 	and 	civil 	penalties. 	In 	a
Notice 	of 	Proposed 	Rulemaking 	(NPRM),2 	the 	Department 	of 	Housing 	and
Urban 	Development 	(HUD) 	announced 	that 	it 	is 	considering 	whether 	to
create exemptions to the application of Section 8. 	This analysis by the staff
of the Federal Trade Commissions suggests that these, and other exemptions,
may provide significant benefits to consumers.·
HUD 	is 	proposing 	to exempt 	from 	Section 	8 pa yments 	by 	a 	uorrower
(but 	not a 	lender) to mortgage 	brokers or other intermediaries, such as real
estate 	agents, 	who 	assist 	in 	bringing 	the 	borrower 	and 	lender 	together. s
HUD 	is 	also 	considering 	whether 	to 	exempt 	payments 	by 	a 	lender 	to 	a
mortgage 	broker or 	any 	other 	person 	who 	assists 	in 	bringing 	the 	borrower
1 Real 	Estate Settlement Procedures Act of 1974, Pub, L. 93-533 (1974)
(codified at 12 U.s.c. Section 260 I ~.).
2 	53 Federal Register 17424 (1988).
S These 	comments 	are 	the 	views 	of 	the 	staff 	of
Economics 	of 	the 	Federal 	Trade 	Commission, 	They 	are 	not
views of the Commission or of any individual Commissioner.
staff 	economist 	Carolyn 	A. 	Woj 	at 	(202) 	326-3434 	should
questions regarding our comments.
the 	Burea u 	of
necessJ.rily 	the
Please contact
you 	have 	an y
4 NPRM at 	17428,
loans 	in 	the definition
comment.
Leg:lI issues pertaInIng to the inclusion of mortgJge
of 	settlement services 	will 	not 	be 	addressed 	in 	this
S NPRM at 	17429; :4 CF,R. 	§ 3500,14 (g)(6). 	If adort~d. the proposed
regulation 	would 	formalize J 	legal opinion issued 	by HlJD's former GenerJI
CounseL 	This 	opinion 	Jppro\ed 	a 	mortg:1ge 	brokering 	progr:1m 	in\'ohing
voluntary 	payments 	by 	borrowers 	to 	persons 	who 	:1ssisted 	in 	bringing 	the
lender and borrower tog~t her 	'.; PRM :1 t 17429,

and 	lender 	together, 	as 	long 	as 	that 	person 	does 	not 	provide 	any 	other
settlement 	service 	in 	connection 	with 	the 	transaction 	and 	does 	not 	receive
any 	other compensation 	from 	the 	borrower, seller, or 	any 	other 	person 	for
services related to the transaction ("neutral intermediaries").6
The first 	proposal 	would formally authorize payments by 	borrowers to
persons who search for loans on their behalf, a practice that is now allowed
under an informal legal opinion by HUD's former General Counsel. We believe
that this practice may increase consumer welfare relative to an environment
where 	no such 	payments are 	permitted. 	Allowing 	borrowers 	to hire agents
or 	brokers 	to 	locate 	loans 	will. 	of course, create some 	risk 	that 	the 	agent
will 	not diligently seareh for the best loan available. 	Because the borrower
may not have sufficient information to assess the performance of the agent,
the 	agent 	may 	not 	seek 	the 	loan 	with 	the 	lowest 	interest 	rate, 	instead
settling for 	the first loan 	for which a buyer is qualified. 	Nevertheless, the
mere 	possibility 	of 	this 	harm 	does 	not 	necessarily 	warrant 	prohibiting
transactions between 	borrowers and mortgage brokers, for 	these transactions
may 	create 	substantial 	benefits 	by 	lowering 	consumers' 	search 	costs.
Moreover, 	since 	only 	the 	consumer 	pays 	for 	the 	services, 	there 	is 	no 	risk
that 	the 	consumer 	will 	be 	steered 	to 	only 	those 	lenders 	who 	pay 	referral
fees.
HUD 	is 	also 	considering 	whether 	to 	allow 	payments 	by 	lenders 	to
persons 	who 	bring 	borrowers 	and 	lender 	together, 	31though 	only 	under 	3
restrictive 	set 	of 	conditions. 	The 	person 	cannot 	provide 	any 	other
settlement 	services 	and 	cannot 	receive 	any 	other 	compensation 	from 	the
6 NPRM at 	\7429. 	ThiS exemption would not extend to the p3yment of
referral 	fees 	by 	lenders 	to 	re:lI 	est3te 	brokers, 	since 	these 	persons 	do
provide other settlement sen Ices related to the transaction .
..,

seller or buyer. 	Even under these restrictive conditions. however, permitting
the payment of fees 	by lenders to intermediaries could 	further 	increase the
available volume of truthful information about home mortgages, which would
benefit consumers. 	Other possible 	benefits include more 	rapid 	development
of 	innovative 	forms 	of 	service, 	such 	as 	computerized 	loan 	origination
services, and 	increased 	competition 	In 	the 	market 	for 	home 	mortgages. 	In
addition. 	we 	suggest 	that 	HUD 	consider 	expanding 	this 	option 	to 	allow
payment of referral fees to any persons, regardless of whether they meet the
restrictions. 	Such 	fees 	could 	encourage 	real 	estate 	brokers 	and 	others 	to
provide 	even 	more 	options 	to 	borrowers, 	and 	to 	adopt 	cost 	saving
innovations more rapidly.
Although 	permitting 	the payment of fees 	from 	lenders to all 	types of
intermediaries may generate consumer benefits, it also creates the possibility
of consumer losses. 	Under certain circumstances. this option 	may 	result 	in
non-neutral, or ~interested~ intermediaries steering consumers to loans whose
provisions 	are 	less fa vora ble 	than 	those offered 	by a 	lender 	who does 	not
pay 	a 	fee. 	These 	possible 	costs 	must 	be 	weighed 	against 	the 	possible
benefits from lender payments. 	Though we lack sufficient data to quantify
precisely 	these 	costs 	and 	benefits, 	our 	analysis 	suggests 	that 	any 	possible
concerns 	associated 	with 	the 	payment 	of 	referral 	fees 	can 	be 	adequately
addressed 	through 	some 	form 	of 	mandatory 	disclosure. 	whereby 	interested
intermediaries would 	be obligated to notify their clients of the existence of
referral fee arrangements with lenders.
The 	remainder 	of 	this 	submission 	is organized 	as 	follows. 	Section 	II
describes 	the 	interest 	3nd 	relevant 	experience 	of 	the 	Federal 	Trade
Commission staff. 	Section 	III 	rc\iews the rationale underlying enactment of

Section 8. 	Section JV examines the likely 	incentive effects of 	referral 	fees
and 	the reasons why 	their prohibition 	may sometimes be desirable. 	Section
V discusses the market for 	home mortgages and provides an analysis of the
proposals, including an examination of their potential costs and benefits. 	In
addition, 	we 	provide 	a 	framework 	within 	which 	to 	consider 	the 	costs and
benefits of a mandatory disclosure that a referral fee will be paid. 	Section
VI presents our conclusions.
II. 	Interest and Experience of the FTC
Under 	the 	Federal 	Trade Commission 	Act, 	15 	USc. 	§ 	41 	et sea., 	the
Commission 	is 	charged 	with 	preventing 	unfair 	methods 	of competition 	and
unfair 	or 	deceptive 	acts 	or 	practices. 	The 	staff 	of 	the 	Federal 	Trade
Commission, 	upon 	request 	by 	federal, 	state, and 	local 	governmental 	bodies,
regularly 	analyzes 	regulatory 	proposals 	to 	identify 	provisions 	that 	may
impede 	competition 	or 	increase 	costs 	without 	providing 	countcrvailing
benefits to consumers.
For several 	years, 	the 	Commission staff 	has examined 	the competiti\e
effects 	of 	various 	restrictions 	on 	state-licensed 	professionals, 	including
optometrists, 	dentists, 	and 	lawyers.7 	Among 	the 	restrictions 	that 	we 	h3.ve
examincd 	are 	ones 	thJt, 	like 	Section 	8, 	prohibit 	the 	payment 	of 	referral
7 See Liang and Ogur, Restrictions on Dent31 Au'(ili3ries (Fcdcral TrJde
Commission, 	1987); Imoro\l:1g Consumcr 	Access to LegJI Scn'iccs: 	Thc C:lse
for 	Removing 	Restrictl()~s 	on 	Truthful 	Advertising 	(FederJI 	Trade
Commission, 1984); Bond, K v. (jK3.. Phcl3.n, and Whittcn. Effects of Restrictions
on 	Advcrtising 	Jnd 	Comm,r::]1 	PrJcticc 	in 	thc 	Pnfessions: 	The 	C:lSC 	of
Optometrv, (FcdcrJl TrJdc Cvr.lnlISSIOn, 1980).

fees. 8 	In addition, the Commission staff has extensively studied 	the nature
of competition in the real estate industry.ll
8 Comments of the Federal Trade Commission's Bureaus of Competition,
Consumer 	Protection 	and 	Economics 	re 	the 	Development 	of 	Regulations
Pursuant 	to the Medicare and Medicaid 	Anti-Kickback Statute, Presented to
the 	Department of 	Health 	and 	Human Services (December 	18, 	1987); Letter
from 	Janet 	M. 	Grady, 	Regional 	Director, 	San 	Francisco 	Regional 	Office,
Federal Trade Commission to Hon. Chuck Hardwick, Speaker of the Assembly
of 	the 	State 	of 	New 	Jersey, 	re 	Assembly 	Bill 	2647, 	which 	would 	have
prevented 	a 	physician 	from 	referring 	patients 	for 	physical 	therapy 	to 	an
entity 	in 	which 	the 	physician's family 	had 	any 	financial 	interest (May 	21,
1987); 	Letter 	from 	Walter 	T. 	Winslow, 	Acting 	Director, 	Bureau 	of
Competition, Federal Trade Commission to H. Fred Yarn, Executive Director,
Florida 	Board 	of 	Dentistry 	(Nov. 6, 	1985); 	Letter 	from 	Walter T. 	Winslow,
Acting Director, Bureau of Competition, Federal Trade Commission to George
M. 	Sanchez, 	O.D., 	President, 	Arizona 	State 	Board 	of 	Optometry 	(Oct. 	17,
1985). 	Copies 	of 	these 	comments 	are 	available 	from 	the 	Federal 	Trade
Commission's Office of Public Reference.
9 The Residential Real Estate Brokerage Industrv (Los Angeles Regional
Office (LARO) of the Federal Trade Commission, 1983); Butters, Consumers'
Experiences with Real Estate Brokers: 	A Report on the Consumer Survey of
the 	Federal 	Trade 	Commission's 	Residential 	Real 	Estate 	Brokerage
Investigation 	(Federal 	Trade 	Commission, 	1983). 	Our 	law 	enforcement
initiatives have also developed expertise within the staff. 	Florence Multiple
Listing 	Service 	Inc. 	of 	Florence, 	S.c., 	No. 	C-3228 	(April 	20, 	1988) (consent
order 	settling 	charges 	that 	respondent 	had 	restrained 	competition 	by
restricting 	membership); 	Multiple 	Listing 	Service 	Mid 	County 	Inc. 	of
Brooklyn, N.Y., 	No. C-3227 	(April 	20, 	1988) (consent order ending 	practices
that allegedly restrained price and service competition among residential real
estate brokers); Multiple Listing Service of Greater Michigan City Area, Inc.,
106 F.T.C. 95 (1985) (consent order); Orange County Board of 	Re3ltors, 	Inc ..
106 F.T.C. 88 (1985) (consent order); Brief for the Federal Trade Commission
as Amicus Curiae Coldwell B3nker Residential Real Est:1te Ser\'ices of Illinois,
Inc. v, ClaYTOn, 105 Ill. 2d 289, .tiS N.E. 2d 536 (1985).
5

III. 	Stated Purpose or the RESPA Section 8 Prot'ision
In 	the 	late 	1960's, 	concerns 	arose 	that 	the 	cost 	of 	real 	estate
settlement services could 	be so substantial as to interfere 	with 	the national
goal 	of 	widespread 	home 	ownership.lO 	In 	1969, concerns 	over 	what 	were
considered 	to 	be 	unnecessary 	and 	inflated 	settlement 	costs 	led 	a
Congressional 	subcommittee 	to 	hold 	public 	hearings. 11 	In 	response 	to 	the
hearings 	and 	subsequent 	report 	(which 	expressed 	concern 	over 	the 	cost 	of
settlement 	services), 	Congress 	enacted 	section 	70 I 	of 	the 	Emergency 	Home
Fin3nce 	Act 	of 	1970. 12 	This 	provision 	directed 	HUD 	and 	the 	Veterans
Administration (VA) to study real estate settlement costs.1 s
One 	of 	the 	primary 	factors H 	identified 	in 	the 	HUDjV A 	Report 15 as
contributing to the allegedly high price of settlement services was a system
of 	rebates 	and 	referral 	fees 	then 	existing 	in 	the 	industry.16 	Given 	its
10 Whitman, Home Transfer Costs: 	An Economi: and Legal An:ll\'sis, 62
Georgetown Law Journal 1311 (1974).
11 The 	hearings 	were 	held 	on 	conditions 	then 	existing 	in 	Washington,
D.C.
12 Bar ro n, 	...F...>:e,-"d,-"e~r-"\a..:..I--,R~ebg",,,u~l,..a.!-'t i,-"o:..:.n,--",o..:..f_-,-,R....,e,-"ao..:,l_=E..=.s...,ta"-,t,.,,e,,-:_--,T:...;h:.:.e::::--....;R'->..:e-".a..:..1----'E::.s"-'t:.>:a....t..::::.e
Settlement Procedures Act 	11 (1975).
13 Emergency 	Home 	Finance 	Act 	of 	1970, 	§ 	701. 	USCA 	12 	§ 	1710.
This provision also directed 	HUD and the Veterans' Administration (V A) to
provide 	Congress 	with 	appropriate 	recommendations, 	and 	to 	set 	standards
governing settlement costs In connection with Federal Housing Administration
(FHA) and VA home loa ns
H 	Other factors cited in the report include excessive specialization and
excessive duplication in the land title record system.
IS Senate 	Committee 	on 	Banking, 	Housing 	and 	Urb3n 	Aff3irs, 	9:d
Congress, 	2d 	Session, 	Mortg3ge Settlement 	Costs: 	Report 	of 	Department 	of
Housing and Urban Devclopment and Veterans' Administr3tion (197:\.
16 The 	report
industry 	manifest
h.ickbacks, 	rebates.
concludcd 	th3t "[c]ompetitive forc,-s 	in 	the conveyancing
themscl\ cs 	In 	an 	elabor3te 	system 	of 	rcferr:l1 	fees,
commiSSions and 	the 	like 3S 	inducements 	to 	those 	firms
6

authority 	under Section 	701 	of 	the 	Emergency 	Home 	Finance 	Act of 	1970,
HUD established proposed maximum fees for certain settlement costs in 1972.
Because of Congressional opposition 	to, and criticism of, 	the 	maximum 	fee
schedules, 	the 	schedules 	were 	not 	published 	in 	final 	form. l1 	RESPA,
however, was enacted in 	1974, and contained a provision that prohibited the
payment 	or 	receipt 	of 	referral 	fees 	for 	business 	incident 	to 	settlement
services 	involving a federally 	related 	mortgage 	loan. 18 	It 	was thought 	that
a prohibition of referral fees would decrease the cost of providing settlement
services and benefit consumers by lowering prices.
and 	individuals 	who direct 	the placement of business. 	These 	practices are
widely 	employed, 	rarely 	inure 	to 	the 	benefit 	of 	the 	home 	buyers, 	and
generally increase total settlement costs." 	HUDjV A Report at 3.
All 	of 	the 	study's participants did 	not concur 	in 	the study's findings.
John 	C. 	Payne 	of 	the 	University 	of 	Alabama 	Law 	School 	acted 	as 	a
consultant to 	the study. 	He observed 	that "[t]he basic data collected 	relates
only to FHA and V A insured mortgages, no effort has been made to classify
rationally 	the 	information 	obtained, and 	all 	elements of 	transactions 	other
than 	monetary 	outlay 	have 	been 	ignored. 	It 	is 	impossible 	to 	begin 	a
consideration of the legitimacy of costs until we know exactly who performs
what 	services, 	for 	whom, 	under 	what 	conditions, 	and 	at 	what 	cost."
Hearings 	before 	the 	Subcommittee 	on 	Housing 	and 	Urban 	Affairs 	of 	the
Committee on Banking, Housing and Urban Affairs, United States Senate 92d
Congress 	Second 	Session 	on 	Mortgage 	Settlement 	Costs 	March 	I, 	2, 	and 	3,
1972,p.219.
Esta te	The	Esta tc:	Real	of	Regulation
18 (1975).
17 Barron, 	Federal	~":::"":"'-"--'---'--'-"::":>-"'-'-=-'-''''''-'-=---'''''-'--~='':'_=='';'-''-'---~'::'-~~-'----=:'''-'-=~
Settlement Proced u res Act
18 Federally 	related 	mortgage 	loans 	include any 	loan 	that 	is "made 	in
whole 	or 	in 	part 	by 	any 	lender 	the 	deposits 	or 	accounts 	of 	which 	are
insured by any agency of the Federal Government, or is made in whole or in
part 	by 	any 	lender 	which 	is 	regulated 	by 	any 	agency 	of 	the 	Federal
Government." 	RESPA 	Sectlon 	3500.2 	(b) 	(2) 	(i). 	Most 	home 	mortgage 	loans
are covered by RESPA.
7

IV. 	The Use of Referral Fees Between Intermediaries and Protiders
Referral fees provide intermediaries with an incentive to recommend the
use of a particular professional or firm to consumers. 	In essence, they are,
like advertising, a means for a business to attract customers. 	In a world of
perfect 	informa tion 	and 	perfect 	competition, advertising, 	referral 	fees, 	and
recommendations would not be needed. 19 	Since any consumer could evaluate
the available combinations of price and quality offered costlessly, advertising
or a 	recommendation 	from 	a 	third 	party 	would 	be of 	no additional 	value.
Firms would 	appeal to consumers directly, rather than 	by advertising or by
paying third 	parties to recommend 	them. 	Firms could 	attract customers by
simply lowering prices and/or increasing quality.
Advertising 	and 	referral 	fees 	are 	used 	when 	information 	is 	costly 	to
obtain. 	Both 	theoretical 20 	and 	empirical 	studies 21 	indicate 	that 	by
increasing 	the 	amount 	of 	information 	on 	price 	and 	quality 	available 	to
consum:::-s, 	advertising 	actually 	decreases 	prices. 	Similarly, 	commissions 	or
referral fees, by increasing the amount of information available, may increase
competition and decrease prices.
19 See 	Pauly, 	The 	Ethics 	and 	Econorr,ics 	of 	Fee-Splitting, 	10 	Bell
Journal of Economics 344 (1979).
20 See 	Stigler, 	The 	Economics 	of 	Information, 	69 	Journal 	of 	Political
Economy 213 (1961).
21 Improving 	Consumer 	A.ccess 	to 	Legal 	Services: 	The 	Case 	for
Removing 	Restrictions 	on 	Truthful 	Advertising (Federal 	Trade 	Commission.
1984); Effects of Restrictions on Advertising and Commercial Practice in the
Professions: 	The 	Case 	of 	Optometry 	(Federal 	Trade 	Commission, 	1980);
Benham and 	Benham, RegulJting ThrouQh the Professions: 	A. Persrective on
Information Control, 	18 Journal 	of Law and 	Economics ..1:1 	(1975); Benham.
The 	Effects 	of 	Advertising 	nn 	the 	Price 	of 	Eveglasses. 	15 	Journal 	of 	Law
and Economics 337 (1972).
8

Through advertising, firms attempt to convey information on price and
quality to consumers directly. 	In many real-world situations, they 	may also
find 	it 	advantageous 	to 	provide 	other 	parties 	with 	an 	incentive 	to 	mark-et
their products for 	them. 	Such agreements between producers and marketers
are 	a 	form 	of 	a 	"vertical" 	relationship. 	The 	term 	"vertical" 	refers 	to 	a
relationship that 	involves some financial 	agreement between a 	producer and
an 	intermediary 	(~.&., 	a 	dealer, 	distributor, 	or 	broker). 	A 	vertical
relationship might take the form of a sales commission paid to a dealer, i.~.,
the 	dealer 	receives 	a 	percentage 	of 	the 	sales 	price 	when 	the 	good 	is sold.
This percentage can 	be adjusted by the producer to increase or decrease the
dealer's 	incentive 	to 	market 	the 	product. 	Alternatively, 	a 	vertical
relationship 	might 	take 	the 	form 	of 	a 	referral 	fee, 	whereby 	the 	producer
pays 	a 	referral 	fee 	to 	the 	dealer 	(or, 	more 	likely, 	the 	"broker") 	for
promoting 	the 	producer's 	goods 	or 	services. 	The 	difference 	betwe.en 	a
"commission" and a "referral fee" is thus more semantic than 	economic. 	As
the following ex.amples show, both commissions and referral fees are found in
a multitude of settings, and both often provide benefits to producers and the
ultimate consumers.
A good example of an efficient vertical relationship can be found in the
markets for 	fire, auto, and 	homeowners insurance. 	Many 	insurers sell 	thcir
policies 	through 	independent 	agents and 	brokers, 	while 	others employ 	their
own sales force. 	An 	independent agent typically sells policies for 	numerous
insurance 	companies. 	Consumers 	can 	choose 	between 	contacting 	the
representatives of different 	direct 	writers, each 	of 	whom 	will 	try 	to sell a
policy of its parent compan\, or they can contact an independent agent. who
will search and 	evaluate 	the 	offerings of a 	number of different companies.
9

Many consumers apparently prefer to use 	independent agents. 	These agents
know about different insurers, so they can search at a lower cost than can a
person 	who 	is searching for 	the 	first 	time. 	By providing consumers access
to 	information 	regarding 	numerous 	insurers 	at 	one 	location, 	independent
agents substantially reduce consumers' search costs.
Independent 	insurance 	agents 	are 	compensated 	by 	commissions 	and
bonuses 	when 	they 	sell 	the 	policy 	of 	a 	particular 	company. 	These
commissions 	are 	the 	equivalent 	of 	"referral 	fees: 	and 	they 	can 	serve 	a
competitive 	purpose. 22 	Independent 	agents 	can 	provide 	insurers 	access 	to
markets 	that 	they 	might 	not 	have 	entered 	because 	of 	the 	high 	costs 	of
opening individual 	insurers' offices in 	those markets. 	By making entry less
costly, independent agents increase competition among insurers.
As 	an 	alternative 	to 	the 	payment 	of 	referral 	fees 	or 	commissions, 	a
firm 	that 	is 	attempting 	to 	attract 	customers 	could 	merge, 	or 	vertically
integrate, with the referring party. 	In doing so, the firm could assure itself
that 	its 	own 	representatives 	will 	refer 	customers 	to 	it. 	Like 	referral 	fees,
these 	sorts 	of 	arrangements 	are 	widespread 	and, 	like 	referral 	fees, 	can
provide competitive 	benefits. 	In 	the 	real 	estate 	market, 	for 	example, some
firms 	offer 	"in 	house" 	financing 	with 	the 	home 	purchase.:: 3 	Rather 	than
referring 	customers 	to 	outside 	lenders, 	the 	firm 	"refers" 	customers 	to 	its
22 Another 	market 	in 	which 	the 	use 	of 	commissions, or 	referral 	fees.
serves to increase competition is the market for job placement services. 	The
employer 	typically 	pays 	the 	placement 	firm 	a 	referral 	fee 	when 	the
placement firm 	locates a suitable employee. 	This arrangement. by 	reducing
the search costs of both job hunters and employers, benefits consumers.
23 Firms that offer financing 	with the home purchase include Coldwell
Banker, 	Ryan 	Homes, 	Haddon 	Group, 	Winchester 	Homes, 	Pulte. 	U.S. 	Home.
Christopher, and Richm:lr. 	According to Chuck Recker of Ryan Homes. it is
relatively common for builders to offer financing.
10

own 	financing division. 	Consumers are offered the choice of obtaining the
home 	and 	the 	mortgage 	from 	a 	single source, or 	obtaining 	the 	home 	from
one firm and 	the mortgage from another. 	This practice presents consumers
with a "one-stop" shopping option that they may often find convenient.
If 	referral 	fees 	are 	permitted, 	independent 	agents 	and 	lenders 	are
encouraged 	to 	set 	up 	a 	close 	working 	relationship, 	realizing 	many 	of 	the
same 	benefits as 	vertically 	intcgrated 	firms. 24 	However, a 	prohibition 	on
referral fees can prevcnt indcpendcnt firms from realizing these benefits and
place 	non-integratcd 	firms 	at 	a 	compctitive 	disadvantage. 	For 	example, 	a
financial 	institution could vertically 	intcgrate with a real estate broker and
thereby assure itself of a flow of refcrrals without explicitly paying referral
24 The 	"prcferred 	provider 	organization" 	found 	in 	the 	health 	care
industry 	represents 	another 	procompetitive 	referral 	fee 	system. 	Although
they exist in many forms, all PPO programs involve an arrangement between
"preferred" 	health 	care 	providers 	(e.g., 	a 	set 	of 	hospitals) 	and 	an
intermediary, 	such 	as 	an 	insurer 	or 	sclf-insured 	employcr. 	The 	preferred
provider 	typically 	charges 	the 	PPO 	a 	price 	below 	what 	it 	charges 	other
insurers to induce the PPO to encourage its subscribers to use the provider.
This is the economic equivalent of a rcferral fee. 	In turn, enrollees in PPOs
usually 	are 	given 	financial 	incentives 	(e.g., 	waivers 	of 	copayments 	and
dcductibles) to induce them to use the lower-priced providers.
These 	PPO 	arrangements 	have 	many 	procompetitive 	aspects 	and 	arc
widely credited with introducing elements of price competition into hospital
markcts 	where 	little 	was 	formerly 	prescnt. 	See Dranove, ~. The 	Effect
of 	In jecting 	Price 	Competition 	into 	the 	Hospital 	M:lrket: 	The 	C3se 	of
Preferred Provider Qrganiz3tions, 23 Inquiry 419 (1986).
In 	addition, 	other 	Jreas 	of 	re,tail 	distribution 	offet 	examples 	of 	the
joint provision of sales services and financing services that are equivalent to
firms 	using 	unrelated 	intermediarics 	who 	bring 	the 	firm 	and 	the consumcr
together. 	Retail 	dealers 	of 	consumer 	products 	such 	as 	autos, 	home
appliances, and furniture commonly offcr fin:lncing as an additional service,
as do department stores. 	1'-13ny, if not 	most, auto dealers offer a financing
option 	along 	with 	their 	prImary 	product, 	automobiles. 	Consumers 	are
typically 	offered 	the 	choice 	of 	purchasing 	a 	car 	and 	the 	103n 	from 	one
dealer, 	or 	Obtaining 	the 	loan 	from 	a 	different 	source. 	Appliance 	and
furniture 	dealers 	frequentl, 	offer 	their 	customers similar opportunities 	for
Obtaining 	credit. 	These 	arr3ngcments 	do 	not 	apPC:lT 	to 	differ 	in 	any
meaningful reSi)Cct from 3 5\stem of rcferral fce payments, yct quite clearly
can benefit consumers by redUCIng search and transaction costs.
II

fees. 	Such vertical relationships can circumvent any prohibition on referral
fees. 	Although vertical integration may benefit consumers, it may do so at a
higher cost 	than 	if 	the 	firms 	were able 	to attract 	business 	through 	the 	use
of referral fees.
Referral 	fee 	arrangements 	between 	unrelated 	entities 	and 	transfer
payments 	within 	an 	integrated 	company 	are 	distinguishable 	in 	that 	the
existence of a financial relationship between the affiliated components of the
integrated 	company 	is 	self-evident, 	whereas 	when 	a 	lender 	pays 	a 	referral
fee to an 	unrelated 	agent 	the 	relationship need 	not be publicly known. 	To
the 	extent 	that 	consumer 	awareness 	of 	this 	relationship 	may 	be 	important
(~.g., when 	interested 	persons 	are 	allowed 	to 	payor 	receive 	referral 	fees),
some sort of 	mandatory 	disclosure of the arrangement 	may 	be 	merited. 	In
section 	V.c. 	below, 	we 	discuss 	the 	costs 	and 	benefits 	of 	a 	mandatory
disclosure requirement.
Consumers may not always benefit from referr:il fees (or the integration
of 	the 	referring 	party 	and 	the 	service 	provider). 	For 	some 	goods 	or
services, it may be difficult for consumers to determine the benefits that are
generated 	by 	the good 	or service, even after 	it 	has been consumed. 	In 	the
most 	extreme 	case, 	consumers 	may 	be 	completely 	unable 	to 	evaluate 	the
contribution of the purchased good to the satisfaction of their demands. 	In
such 	instances, 	the 	existence 	of 	financial 	arrangements 	between
intermediaries and service providers can create an opportunity for defrauding
consumers. 	Essentially, the intermediary and the provider can increase their
Incomes by 	inducing a customer to purchase a greater Quantity of the good,
1::

and/or pay a 	higher 	price for 	the 	good, than 	the customer 	would 	if 	he or
she were perfectly informed. 25
A 	similar 	phenomenon 	might 	occur 	In 	the 	provision 	of 	auto 	repair
services. 26 	A person 	might 	wish 	to buy services from 	a 	mechanic 	in order
to 	produce 	a "reliably operating 	car: 	The 	mechanic (who 	jointly provides
both 	a 	diagnosis 	and 	a 	set of "recommended" 	repair 	services) could 	exploit
this 	person's 	ignorance 	of automobiles 	by 	providing 	a 	misleading 	diagnosis
requiring 	significant 	repairs, 	and 	then 	by 	installing 	unneeded 	replacement
parts. 	The customer cannot tell if he was defrauded, since the car runs well
after 	the 	unnecessary 	repairs 	are 	conducted; 	hence, 	he 	cannot 	deter 	such
behavior by threatening to withhold future business. 	This sort of fraudulent
beha vior 	can 	persist 	even 	when 	there 	is 	a 	competitive 	market 	for 	repair
services.
The opportunities for this sort of fraud increase as the consumer's cost
of 	evaluating 	a 	product 	or 	service 	increase. 	A 	customer 	can 	secure
protection 	from 	this 	sort 	of 	fraud 	by 	using 	an 	intermediary 	that 	is
financially 	unrelated 	to 	the 	provider 27 	(or 	by 	acquiring 	the 	requisite
expertise himself), but the costs of doing so may be quite high. 	Even under
these circumstances, however, it 	may 	be difficult to justify 	the 	banning of
2S See Darby and 	Karni, Free Competition and the Optim:lI Amount of
Fraud, 16 Journal of Law and Economics 67 (1973).
26 Another 	example 	may 	be 	found 	in 	the 	market 	for 	physicians'
services. 	Physicians 	tYPically 	diagnose 	a 	malady, 	and 	then 	prcscribe 	and
supply 	a 	course 	of 	therapy. 	Consumer 	ignorance 	makes 	it 	possible 	for
physicians 	to 	prescribe 	unneeded 	treatments. 	This 	behavior 	can 	be
constrained (~.g., by soliciting second opinions), but only at a cost.
27 To provide the intermediary that does not receive refcrral fees with
the incentive to produce an 	honest diagnosis, thc customer can make it clear
to 	the 	intermediary 	that 	another 	PJrty 	will 	provide 	whatever 	scrvice 	is
rccommended; otherwise. jnccnll~es for fraudulent diagnoses will rcm:lin.
13

arrangements 	between 	intermediaries 	and 	providers, 	since 	there 	may 	be
substantial 	savings 	associated 	with 	referral 	fees 	or 	with 	purchasing 	the
recommendation 	and 	the service 	from 	the same source. 	These savings 	may
offset the expected costs of fraud. 28
Whether a 	ban on the payment of referral fees in the context of home
mortgages 	is, 	on 	balance, 	efficient 	will 	be 	determined 	by 	(I) 	the 	cost 	to
borrowers of evaluating 	the "Quality" of the services referred 	(i.~., assessing
the 	terms 	offered 	by 	the 	referred 	lender 	relative 	to 	alternatives), 	and 	(2)
the 	benefits 	in 	terms 	of 	efficiencies 	generated 	by 	these 	arrangements
between 	intermediaries and 	lenders. 	If the cost to 	borrowers of evaluating
the Quality of the 	referral 	is sufficiently low, and the benefits of referrals
are 	sufficiently 	high, 	imposing 	restrictions 	on 	the 	creation 	of 	these
arrangements may produce a net harm for consumers. 	Therefore, we would
like 	to offer some observations that may be useful 	in HUD's evaluation of
this issue.
28 Using 	the 	car 	repair 	example, 	Darby 	and 	Karni 	(Free 	Competition
and the Optim31 Amount of Fraud, 1,6 Journal of Law and 'Economics 70 n. 6
(1973» 	cite 	the situation 	where 	it 	is 	necessary 	to disassemble 	an 	engine 	to
diagnose a problem. 	It may be much cheaper to incur the risk of fraud. and
have 	the repair made when 	the engine is taken apart, 	than 	to 	reassemble it
for repair elsewhere.
Other good examples can 	be found 	in the market 	for 	medic31 services.
Be:ause 	physicians 	typically 	provide 	both 	diagnosis 	and 	therapy. 	the
opportunity 	for 	fraud 	(~g.. 	"unnecessary 	surgery") 	exists. 	For 	expensive
procedures (~.g.. coronary 	bvpass), 	it 	may 	pay 	to seek 	advice 	from 	another
physician. 	For 	many 	procedures. 	however, 	the 	costs 	of 	soliciting 	a second
opinion will outweigh the C\pccted 	benefits. and the patient (or his insur~r)
will 	find that the best altcrn:ltlve is to purchase both diagnosis and therapy
from the same source.
14

V. 	Possible ECficiencies From the Use or Brokers
A. Proposal One - AI/owing Borrowers 10 Hire Brokers
Consumers do not have perfect information in the market for financial
services. 	Information on mortgage loan rates, although available, is not free.
The time and 	effort expended searching for the 	best loan 	represents a cost
to 	the consumer. 	Because search 	involves costs, consumers search 	until 	the
expected 	benefits 	of 	additional 	search 	are 	equal 	to 	the 	expected 	costs 	of
additional search. 29 	Consumers appear to engage in relatively little detailed
comparison shopping for credit. 	A 1977 Consumer Credit Survey found that
only approximately one-quarter of the respor.dents tried to obtain additional
information 	about 	other 	creditors 	or 	credit 	terms 	prior 	to 	engaging 	in 	a
recent 	credit 	transaction. 3o 	In 	addition, 	a 	1978 	home 	bu yer 	survey
conducted 	in 	Rochester, 	New 	York 	revealed 	that "[mlost of the 	people 	who
have a 	mortgage from a lending institution contacted 	but one institution to
secure it, 84.4 percent in 	the central city and 89.9 percent in 	the suburb.'<H
29 See 	Stigler, 	The 	Economics 	of 	Information, 	69 	Journal 	of 	Political
Economy 213 (1961).
30 Durkin and Elliehausen. 1977 Consumer Credit Survev. :: (Board of
Governors 	of 	the 	Federal 	Reserve 	System, 	1978). 	Responses 	were 	elicited
from 	persons 	using credit of at 	least $200 from 	institutional sources. 	This
study 	did 	not 	examine 	consumer 	search 	for 	home 	mortgages 	as 	a 	separa te
category. 	Mortgages were, however, one of the 	items included 	in the broad
definition of credit.
31 Benston, 	Horsky 	and 	Weing3ftner. 	"The 	Demand 	for 	Real 	Estate
Loans 	in 	Rochester 	--- 	Central 	City 	vs. Suburb" 	in 	An 	Emrirical 	Stud\' 	of
Mortgage 	Redlining 	(New 	York 	University 	Graduate 	School 	of 	Business
Administration's 	Monograph 	Series 	in 	Finance 	and 	Economics, 	Monograph
1978-5).
15

Gains 	from 	search, 	however, 	do appear 	to exist. 	In 	early 	1986, a 	30-year
fixed rate mortgage in New York City, for example, ranged from 11.5 percent
with 	3 	origination 	points, 	to 	9.88 	percent 	with 	2.5 	origination 	points. 32
Other studies have found 	that "no single lender· not even 	the very largest
- had the best loan offering on any single day more than 	30 percent of the
time."33
Since 	search 	involves 	some 	costs, 	but 	benefits 	from 	search 	exist,
consumers rna y prefer to designate an agent to undertake this task for them.
A 	large 	number of consumers rely on 	their 	real estate agent. 	A 	FTC staff
report 306 on 	the 	residential 	real 	estate 	brokerage 	industry 	revealed 	that 	67
percent of home buyers surveyed thought that the real estate agent's ability
to 	help 	obtain 	financing 	was 	an 	important service 	characteristic. 35 	About
half 	(50.8 	percent) 	of 	those 	surveyed 	said 	that 	their 	agent 	provided 	this
service. 36
Real 	estate 	agents 	are 	not 	the 	only 	persons 	on 	whom 	consumers 	can
rely 	to 	obtain 	information 	on 	mortgage 	loans. 	Mortgage 	brokers, 	for 	a
fee,37 	search 	for 	the 	best 	loan 	for 	a 	particular consumer. 	The 	ability 	of
32 Securitising the American Dream, 299 Economist 70 (1986).
33 Anderman, Ta\.;e the Bvte Out of Computerized Loan Origination, 18
Real Estate Today 39 (1985).
306 The 	Residential 	Real 	Estate 	Brokerage 	Industrv 	(Los 	Angeles
Regional Office of the Federal Trade Commission, 1983).
35 The Residential Real Estate Brokerage Industrv, Buyer Survey, p. 15.
36 ] d. at 17.
37 Mortgage 	brokers 	can 	simply 	refer consumers to a 	particulJr 	lender
or 	refer 	consumers 	and 	hJndle 	the 	paperwork 	associated 	with 	the 	loan
application 	process. 	If the 	broker simply refers a lender and the consumer
chooses to use that lender. 	the consumer typically pays $100. 	If 	the 	broker
performs 	the 	loan 	applicJtlc)n 	process, 	a 	fee 	approximJtely 	equal 	to 	1.5
16

these intermediaries, including real estate agents, to provide consumers with
information 	on 	the 	loan 	terms 	of 	a 	variety 	of 	lenders 	may 	substantially
benefit 	consumers. 38 	HUD's 	proposal 	to 	allow 	voluntary 	payments 	by 	a
consumer 	to 	persons 	who 	perform 	these 	brokerage services 	therefore 	could
benefit 	consumers. 	The 	proposal 	would 	permit 	consumers 	the 	options 	of
undertaking the search process themselves, paying an agent to research 	loan
availability and make a recommendation, or doing both.
This 	proposal 	would 	not 	only 	permit 	consumers 	to 	choose 	between
searching 	for 	loans 	themselves 	or 	hiring 	someone 	else 	to 	do 	so, 	but 	also
encourage 	the diffusion 	of more efficient 	technologies. 	For example, there
have 	been dramatic changes in the technology with 	which agents undertake
the search process. 	The use of computerized loan origination networks, first
started 	in 	1982, 	is 	significantly 	affecting 	the 	competitive 	nature 	of 	the
industry. 	These 	networks assume a 	variety of forms, 	but 	the 	basic feature
of 	the 	typical 	system 	is 	that 	it 	provides 	information 	on 	the 	loan 	terms
offered 	by 	a 	variety 	of 	lenders. 39 	The 	principal 	benefit of 	this system 	is
percent 	of 	the 	loan 	value 	is 	paid 	if 	the 	borrower 	uses 	that 	lender.
Telephone 	conversation 	with 	Mr. 	Hogendike, 	National 	Association 	of
Mortgage Brokers, June, 1988.
38 It 	is 	estimated 	that 	there 	are 	approximatcly 	7.500 	to 	10,000
operating 	mortgage 	brokers 	today 	in 	the 	United 	States. 	Telephone
conversation with Mr. Hogendike, National Association of Mortgage Brokers,
June, 1988.
39 Another 	important 	feature 	of 	some 	of 	these 	networks 	is 	that 	the
loan application process can be performed by the individu:l1 using the system.
Absent 	computer 	networks, 	the 	loan 	application 	process 	was 	typically
performed 	by 	the lender at a site that was physically close to 	the property
and the borrower. This arrangcment tended to keep markets local. 	With the
computerized 	systems, 	however, 	an 	individual 	located 	in 	Baltimore. 	for
example, 	could 	apply 	for 	a 	loan 	offered 	by 	a 	lender 	in 	California.
Gultentag, 	Recent 	Chanec~ 	in 	the 	Primarv 	Home 	Mortg:lge 	tv1:lrket. 	3(3)
Housing Finance Review :.J.J (198~).
17

that it permits lenders to reach markets that otherwise would have been too
costly 	to 	enter. 40 	For 	example, 	,when 	one 	real 	estate 	broker 	In 	the
Philadelphia 	area 	joined 	the 	"Shelternet" 	system!l 	a 	number 	of 	lenders
outside the Philadelphia area gained access to that geographic markct. 42 	By
facilitating 	entry 	and 	improving 	information. 	the 	computerized 	networks
increased consumer choice. and may have enhanced the competitive nature of
credit 	markets,4S 	Since 	real 	estate 	agents 	or 	mortgage 	brokers 	using 	the
system 	can 	provide 	consumers 	with 	access 	to 	information 	on 	loan 	rates
nationwide. 	these systems increase the 	likelihood that consumers will obtain
a desirable loan package,"
Although computerized loan services are capable of providing substantial
benefits 	to 	consumers, 	their 	use 	among 	real 	estate 	agents 	is 	not 	yet
40 See 	Kane. Change and 	Progress 	in Contemporary Mortgage Markets.
3(3) Housing Finance Review 	257 (1984); Guttentag. Recent Changes 	in 	the
Primary Home Mortgage Market. 3(3) Housing Finance Review 221 (1984),
41 The 	Shelternet 	system. 	founded 	in 	1982, 	provides 	up-to-da te
information 	on 	the 	rates 	of a 	number 	of lenders. 	As of 	1986, 	the 	system
linked 	100 real estate offices and 20 lenders. 	The borrower is automatically
offered a rate which is the best among the packages offered by participating
lenders. 	Securitising the American Dream, 299 Economist 71 (1986).
42 Guttentag, 	Recent 	Changes 	in 	the 	Primary 	Home 	Mortgage 	t\13rket,
3(3) Housing Finance Review 245 (1984).
43 Citicorp's 	computerized 	network, 	for 	example. 	has 	enabled 	it 	to
compete vigorously with 	local lenders in New Jersey. 	By offering discounts
on 	loan origination 	fees and 	providing other service amenitics (e.g .. a 	10-15
day 	guaranteed 	loan 	commitment), 	Citicorp 	has 	expanded 	its 	share 	of 	the
market. "Citicorp Arouses \1ortgage Bankers' Ire." Barrons, June :7. 	1988. at
81.
.. Perhaps 	not 	surprisingly, 	some 	local 	lenders. 	who 	were 	otherwise
more 	insulated 	from 	competition. 	are 	opposed 	to 	the 	use 	of 	such
arrangements. 	Others. 	however. 	welcome 	the 	changes 	taking 	place. 	Len
Druger. 	Vice 	Chairm:ln 	of 	Citicorp. 	states. 	"[t)he 	issue 	here 	is 	f:lir
competition - competition 	th:ll'S ultimately good for 	the consumer bec:luse it
cuts 	prices." 	"Citicorp 	Arouses 	Mortgage 	B:lnkers' 	Ire," 	B:lrrons, 	June 	:7,
1988,at81.
18

widespread. 	Typically, agents are charged a 	monthly 	fee 	for access to the
loan information service,46 	but if they cannot be compensated for providing
this service to customers, 	they 	have a reduced 	incentive 	to offer it. 	Thus,
this proposal, which would make clear that compensation may be paid, should
preserve the 	incentive for agents to adopt this technology. 	Allowing agents
to 	sell 	this 	service 	at 	a 	market-determined 	price 	may 	create 	benefits 	for
both buyer and seller.
Allowing 	borrowers 	to 	hire 	intermediaries 	is 	not 	completely 	riskless.
The 	borrower cannot 	perfectly 	monitor the 	broker's efforts, so there 	is the
possibility 	that 	the 	intermediary 	will 	take 	advantage 	of 	the 	lack 	of
information 	on 	the 	part 	of 	the 	consumer. 	Whether 	this 	would 	occur 	with
sufficient frequency and magnitude to outweigh the likely benefits of the use
of 	intermediaries 	is 	unknown. 	However, 	both 	market 	forces 	(~.&., the
development 	of 	poor 	reputations 	and 	the 	attendant 	loss 	of 	business)46 and
state and 	federal 	law enforcement presence 47 are likely to place constraints
on 	such 	behavior. 	Furthermore, 	the 	incentive 	to 	provide 	misleading
information 	or 	to "shirk" one's duty 	would 	be 	no greater 	than 	it currently
is, 	and 	probably 	less 	due 	to 	competitive 	forces. 	If 	so, 	the 	potential 	net
45 Anderman, Take the Bvte Out of Computerized Loan Origin:ltion, 18
Real Estate Today 38 (1985).
46 	Substandard 	brokers 	will 	actually 	develop 	bad 	reputations 	only 	if
borrowers discover 	at 	some 	point 	that 	they 	have 	been 	ill-served. 	Whether
borrowers are 	likely 	to determine 	this is a 	point that 	we discuss 	in greater
detail below.
47 For example, the 	FTC issued a complaint against Donald 	A. Schw:lb
and 	Associates 	Mortgage 	Co., 	a 	mortgage 	broker, 	for 	allegedly
misrepresenting 	the 	availability 	of 	credit 	at 	low 	interest 	rates. 	The
Commission approved a consent decree with the respondent on July 	18, 1986.
In 	the 	U.S. 	District Court 	for 	the 	Southern 	District of Ohio an 	action 	was
brought 	for 	injunctive 	and 	other 	relief; 	a 	final 	order 	was 	accepted 	on
September 19, 1986 (C·I·86·96~)'
19

benefits 	from 	adopting 	HUO's 	proposal 	to 	permit 	borrowers 	to 	hire
intermediaries could be substantial.
B, Permil/lng Lenders to Pay Referral Fees
HUO has also requested comment on 	whether to add 	an 	exemption 	to
Section 	8 	that 	would 	allow 	referral 	payments 	by 	a 	lender 	to 	"neutral
intermediaries," 	Economic 	analysis 	suggests 	that 	HUO 	should 	consider
expanding this proposal to allow lenders to pay referral fees to any persons
who 	bring 	together 	the 	borrower and 	the 	lender, 	rather 	than 	limit 	referral
fees to neutral 	intermediaries. 	We discuss below the 	potential 	benefits and
costs of referral fees in this context.
1. Potentiat Benefits From the Payment of Referral Fees
Permitting 	lenders 	to 	pay 	referral 	fees 	to 	intermediaries 	may 	benefit
consumers 	in 	a 	number 	of 	ways. 	First, 	referral 	fees 	may 	be 	an 	efficient
means 	of 	conveying 	information 	to 	customers. 	They 	may 	represent 	an
attractive 	substitute 	for, 	or 	complement 	to, 	other 	forms 	of 	information
dissemination, 	such 	as 	mass 	media 	advertising. 	In 	a 	competitive 	market,
innovations 	1n 	the 	methods 	of 	transmitting 	information 	benefit 	both
customers and 	producers. 	The 	FTC and 	others have 	found 	that 	innovative
advertising can 	benefit 	consumers 	and 	that 	advertising 	bans, 	by 	increasing
consumer search 	costs, can 	result 	in 	higher 	prices. 	Empirical 	studies 	have
shown, for example, that prices for professional goods and services are lower
where advertising exists than where it is restricted or prohibited by law. 48
48 Improving 	Consumer 	.\ccess 	to 	Legal 	Services: 	The 	C3se 	for
RemoyinQ 	Restrictions on 	Truthful 	.\dvenising (Federal 	Trade Commission.
:0

Further, 	payment 	of 	referral 	fees 	may 	also 	provide 	lenders 	access 	to
certain geographic markets that 	they otherwise 	might 	not 	have entered. 	A
lender 	in 	California, 	for 	instance, 	may 	find 	it 	too 	costly 	to 	appeal 	to
consumers in New York via mass media advertising or other means. 	Paying
referral 	fees 	to 	an 	agent 	in 	New 	York 	may 	be 	a 	low-cost 	substitute 	for
direct 	advertising; 	by 	doing so, 	the 	lender 	may 	be 	able 	to 	encourage 	New
York 	agents 	to 	inform 	consumers of 	its 	rates. 49 	In addition, a 	New 	York
agent, who might not have otherwise adopted 	the computerized loan service,
may 	now have an additional incentive to do so. 	These services often allow
individuals 	to 	apply 	for 	the 	loan 	of 	a 	consumer's 	choice 	through 	the
computer. 	Since consumers may be unlikely to favor an out-of-town lender
without 	the 	convenience 	of 	this 	service 	(and 	agents 	receive 	fees 	from 	a
lender only if the 	borrower chooses that 	lender), referral 	fees 	may provide
the 	agent 	with 	an 	incentive 	to 	adopt 	this 	technology. 	Referral 	fees, 	by
facilitating 	entry 	and 	increasing 	the 	amount 	of 	information 	on 	loan 	rates
that 	agents 	possess, 	may 	increase 	the 	range 	of 	financing 	opportunities
a vaila ble 	to 	consumers. 	Discouraging 	this 	method 	of 	disseminating
informa tion could harm consumers.
1984); Effects of Restrictions on Advertising and Commercial Practice in the
Professions: 	The 	Case 	of 	Ootometrv 	(Federal 	Trade 	Commission, 	1980);
Benham and 	Benham, Regulating Through the Professions: 	A Persoective on
Information 	Control, 	18 Journal of Law and 	Economics 421 	(1975); Benham.
The 	Effects 	of 	Advertising 	on 	the 	Price 	of 	Eveglasses, 	15 	Journal 	of 	Law
and Economics 337 (1972).
49 Both advertising 	and 	referral 	fees are costs that 	must 	be 	passed on
to 	consumers, 	but 	as 	the 	studies 	discussed 	in 	the 	previous 	footnote
demonstrate, 	these 	costs 	are 	more 	than 	offset 	by 	the 	benefits 	of 	the
increased 	competition 	that 	results 	from 	advertising. 	The 	costs 	of 	referral
fees may be lower than the costs of direct advertising, while achieving equal
or superior results. 	For example. referral 	fees are only paid 	when an agent
recommends 	a 	lender; 	ad\crtising, 	by 	contrast, 	bl:lnkets 	all 	potential
customcrs, and so could be more costly.

Referral fees !!lay provide agents with an incentive to recommend low-
cost 	lenders. 	A 	lender 	with 	lower costs 60 (hence 	larger 	price-cost 	margins)
than 	its rivals can 	induce an 	agent 	to 	recommend 	its 	loans. 	Such 	lenders
could 	use 	part 	of 	their 	higher 	margin 	to 	pay 	an 	agent 	a 	larger 	bonus 	or
commission, and 	remit some or all of the remaining margin 	to the borrower
in the form of more attractive credit terms. 	This arrangement increases the
likelihood 	that 	a 	recommendation 	will 	be 	made 	that 	benefits 	the 	borrower,
while preserving the benefits of professional search.
2. Potential Harm From the Payment of Referral Fees
Previously, 	we 	discussed 	the 	general 	circumstances 	under 	which
relationships 	between 	related 	intermediaries 	and 	producers 	could 	harm
consumers. Sl 	When it is difficult for consumers to evaluate the attributes of
a 	product or service before (or even after) it is purchased, and 	when 	it 	IS
costly to hire an independent source of expertise to assist in the purchasing
decision, then opportunities for fraud may arise even in competitive markets.
To what extent are 	mortgage loans characterized 	by 	these properties?
Although 	the difference 	is one of degree, not of 	kind, 	it 	would seem 	that
mortgage 	loans 	are 	dissimilar 	from 	the 	types 	of 	services 	(£..g., 	car 	repair)
that may be 	most amenable to fraud. 	Although 	mortgage contracts may 	be
more 	complicated 	than 	other 	types 	of 	credit 	agreements, 	there 	nonetheless
exists 	a 	set 	of 	observable 	criteria 	(~.g., 	interest 	rates, 	points, 	term 	of
so 	Lenders' costs 	mJy 	differ 	for 	a 	variety 	of 	reJsons. 	For example.
some 	lenders 	may 	be 	more 	proficient 	at 	evaluating 	creditworthiness 	than
others.
51 	See Section IV. PD. 1:-14
........

mortgage, 	etc.) 	to 	facilitate 	comparisons. 52 	Consumer 	evaluations 	are
facilitated by the affirmative disclosure requirements contained in regulations
such 	as 	the 	Truth 	in 	Lending 	Act, 	which 	compels 	the 	disclosure 	of
information 	about 	credit 	terms 	and 	costs. 5! 	This 	is 	not 	to 	say 	that
information 	is so readily available 	that consumers cannot 	benefit from 	the
services of an 	informed 	and 	competent agent; 	what 	it 	does suggest 	is 	that
the information available to consumers may be sufficient to place constraints
on the ability of lenders and brokers to take advantage of consumers.
Arrangements that are economically equivalent to referral fees exist in
this, 	as 	well 	as 	other 	industries. 	Earlier 	we 	described 	how 	many 	home
builders and real estate agencies have diversified into consumer finance, thus
offering 	consumers 	a 	potentially 	valuable 	financing 	option. 	Automobile
dealers have for years offered similar types of services. 	These arrangements
generate consumer benefits with no apparent adverse consequences. 	One of
the 	differences 	between 	these 	sorts 	of 	arrangements 	and 	that 	in 	which
lenders 	pay 	real 	estate 	brokers 	referral 	fees 	pertains 	to 	the 	lack 	of
disclosure of the referral fees paid to the brokers. 	In the home builder and
automobile 	dealer 	examples, 	the 	existence 	of 	the 	arrangement 	between 	the
service provider and its financing arm is self-evident. 	Similarly, if lenders
52 At 	minimUm, 	consumers can 	compare 	the 	referred 	lender's 	rates 	to
rates 	of 	other 	lenders 	in 	the 	area 	by 	consulting 	the 	real 	estate 	section 	of
the local paper. 	Information on the terms and conditions for a large number
of 	loans 	appears 	to 	be 	available 	in 	newspapers 	across 	the 	country. 	An
informal phone survey revealed 	that the Washington 	Post, Arkansas Gazette.
Boston Globe, Los Angeles Times, Detroit Free Press, Cleveland Plain Dealer,
Tampa 	Tribune, 	and 	Denver 	Post, 	for 	example, 	contain 	such 	information.
Only 	one 	paper 	out 	of 	those 	contacted 	in 	the 	survey, 	the 	Des 	Moines
Register, 	indicated 	that 	it 	did 	not 	publish 	information 	on 	mortgage 	loan
ra tes.
53 Regulation Z (Truth ,n Lending) 1:2 CFR § :2:26.

are allowed to pay referral fees to neutral intermediaries, the existence of a
relationship between the lender and intermediary ought to be apparent.
We have suggested, however, that HUn consider expanding its proposed
lender 	exemption 	to 	include 	interested 	intermediaries, 	such 	as 	real 	estate
agents. 	In 	most 	cases, 	if 	there 	are 	sufficient 	reasons 	to 	believe 	that
referral 	fees 	are 	appropriate 	when 	paid 	to 	certain 	persons 	(~.&.., neutral
intermediaries), then it is not clear why it IS not also appropriate to 	permit
the 	payment 	of 	referral 	fees 	to 	real 	estate 	agents. 	If 	it 	appears 	that 	the
expected 	benefits of lender payments are likely to exceed the corresponding
costs, 	it 	would 	seem 	reasonable 	to 	permit 	these 	payments 	without 	placing
restrictions on who may receive them.
In 	the case of lender 	referral 	fees paid to real estate agents, however,
the arrangement between the lender and agent may not be apparent. 	If the
only 	difference 	between 	interested 	and 	neutral 	party 	referral 	fee
arrangements 	is 	the 	consumer's 	knowledge 	that 	a 	payment 	is 	being 	made,
then 	the appropriate 	policy 	measure 	may consist of a 	mandatory disclosure
requirement at the time of the referral for interested parties.
C. 	The Costs r:nd Benefits of Mandatory Disclosure
A 	disclosure 	requirement 	could 	only 	be 	warranted 	if 	the 	fact 	to 	be
disclosed would not be apparent absent the forced disclosure. 	If HUn limits
its lender exemption to neutral 	intermediaries, there would be no need for a
disclosure 	requirement. 	If. 	however, HUn expands 	its 	lender 	exemption 	to
allow referral fees to interested intermediaries, HUD may wish to consider a
disclosure requirement appli-::3ble solely to these intermediaries.

Disclosure 	would 	inform 	consumers 	that 	referring 	parties 	have
incentives 	to 	recommend 	a 	particular 	lender. 	Since 	consumers 	retain 	the
option of choosing another lender when referral fees are used, disclosure 	is
likely 	to 	allow 	consumers 	to 	enjoy 	the 	benefits 	of 	referral 	fees 	while
insuring 	that 	they 	are 	informed 	about 	intermediaries' 	incentives, 	and
mitigating the types of concerns discussed above. 	Accordingly, disclosure is
likely to be preferable to a prohibition of referral fees.
Disclosure 	may induce consumers to search for a 	loan package against
which they can compare the terms offered by the referred lender. 	If, as we
discussed 	earlier, 	referral 	fees 	provide 	brokers 	and 	agents 	incentives 	to
recommend 	appropriate 	loan 	packages 	to 	the 	borrow<.:r, 	the 	benefit 	of
disclosures rna y 	be small. 	If, 	however, 	the 	fees sometimes 	lead 	brokers 	to
recommend 	lende·rs 	whose 	packages 	would 	not 	serve 	the 	consumer's 	best
interest, 	then 	disclosure 	may 	induce 	the 	consumer 	to 	obtain 	additional
information on the loans of the referred lenders and loans offered by other
lenders. 	This additional 	information 	may 	result 	in 	the consumer seeking a
more 	favorable 	loan 	package. 	Thus, 	if 	policy 	makers 	conclude 	that 	the
potential 	for 	harm caused by referral fees is present, then disclosure at the
time of referral might significantly reduce or eliminate these potential costs.
In 	weighing 	the 	desirability 	of disclosure, 	however, 	it 	is 	necessary 	to
compare 	the 	benefits 	of 	disclosure' to 	its 	costs. 	The 	potential 	costs 	are
twofold. 	First, 	there 	is 	the 	obvious 	direct 	cost 	of 	simply 	conveying 	the
information. 	Second, 	there 	IS 	the 	potential "chilling" effect 	on 	the 	usc 	of
referral 	fees 	caused 	by 	the 	stigma 	that 	may 	attach 	to 	disclosure.
Compulsory disclosure may suggest that accepting (or paying) referral fees is
somehow improper, which would discourage the practice. 	Consumers m3Y be
~5

induced to engage in unproductive search because of a mistaken belief that a
better loan package is available.
The timing and form of disclosure IS also important. 	Disclosure should
be made early enough in the loan application process so that consumers can
consider other loans. 	If the information is disclosed the day before the loan
is 	to 	be 	signed, 	for 	example, 	it 	is 	likely 	to 	be 	too 	late 	for 	consumers 	to
search 	for 	an 	alternative 	source 	of 	credit. 	Also, 	disclosure 	via 	a 	written
form 	is 	likely 	to 	ensure 	that 	consumers actually 	are 	put 	on 	notice 	of 	the
possible 	incentives 	facing 	the 	real 	estate 	agent 	rccommcnding 	particular
lenders.
VI. 	Concluding Remarks
Allowing 	the 	payment 	of 	referral 	fees 	may 	benefit 	consumers
significantly. 	Benefits may include lower search costs, increased information,
the 	increased 	use 	of 	innovative 	technologies, 	and 	lower 	prices 	for 	loan
packages. 	Some of these benefits may be foregone 	if HUD adopts only the
mortgage broker exemption. 	Real estate agents and other intermediaries may
be 	less 	inclined 	to 	offer 	potentially 	valuable 	services 	if 	referral 	fees 	are
proscr i bed.
HUD 	rna y 	wish 	10 determine 	whether 	the 	characteristics 	of 	mortgage
markets 	are 	such 	that 	referral 	fees 	pose 	a 	significant 	risk 	of 	harm. 	As
discussed above, we do not 	believe that the3e 	markets are 	likely to prod uce
adverse effects for consumers if referral fees are allowed. 	If HLTD decides
that 	referral 	fees 	genera Ie 	both 	benefits 	and 	significant 	costs, 	however. 	it
may 	wish 	to 	consider 	whether 	alternativcs 	to 	a 	referral 	fee 	ban, 	such 	as
mand:ltory 	disclosure 	of 	a 	referral 	arrangement 	between 	lenders 	and

\.
interested 	intermediaries, 	would 	eliminate 	these 	costs 	while 	preserving 	the
benefits.
:7