There is plenty of blame to go around for the housing and credit crisis now menacing the U.S. economy. One culprit: Home buyers often mistake foes for friends.
Mortgage brokers, for example, may act like they are on the buyer's side, but they're not. They're working for themselves. When it comes down to it, they are economically motivated to pick profits over the buyer's best interests.
But new laws could change that equation.
As statehouses around the country look for ways to prevent future mortgage messes, one radical idea keeps cropping up: Can lawmakers force brokers to be your friend?
A law passed by Illinois legislators earlier this month and backed by state Attorney General Lisa Madigan attempts to do just that. It would extend what's called a "fiduciary duty" to mortgage brokers, making them legally bound to do the best thing for their clients.
Supporters think it's high time to institute such a consumer protection; but detractors say the law is folly, impossible to enforce and bound to make class-action lawyers rich.
The concept of fiduciary duty is essential in many business relationships. For example, a trustee who manages an estate for a beneficiary -- say a minor whose parents have died -- is bound to ignore his or her interests and do only what's best for the child. Lawyers must do what's best for their clients. Some personal financial advisors have a fiduciary responsibility to their clients – they can't recommend transactions simply because they'll profit from them. The implications of fiduciary responsibility are far-reaching. Financial advisers who put their own interests above those of their clients can be sued for negligence, even if their recommendations were ultimately profitable for the client.
As things stand today, mortgage brokers have no such duty to their home-buying clients. Brokers regularly recommend loans because the broker stands to gain financially. It's perfectly legal for a mortgage broker to talk a client into paying a higher interest rate for a loan so the broker can pocket the difference, or to convince a buyer to agree to a pre-payment penalty so the broker receives a bonus from the bank. In fact, according to some brokers, they have a greater legal duty to banks (to screen out applicants for fraud) than to home buyers.
'Redifine the relationship'
If Deborah Hagen has her way, all that will soon change.
"(We are) trying to redefine this relationship," said Hagan, who heads the consumer protection unit in the Illinois attorney general's office. She said many consumers go to a broker instead of a bank because they think the broker is on their side. "They go to a broker ...to have them figure this out for them, and think that they have a duty to do what's best for them. In fact they don't."
Similar battles have already unfolded in other states around the country. In Minnesota, legislators recently approved new rules defining mortgage brokers as "agents" of home buyers, requiring them to act in clients' best interest. But similar measures in Iowa and Colorado were defeated.
In Illinois, the legislation passed by both houses of the state legislature is awaiting action by Gov. Rod Blagojevich, who has yet to indicate whether or not he will sign it. The fiduciary duty provision is just one of several controversial measures in the law, which also would require financial counseling before borrowers take out certain kinds of mortgages, a provision opposed by lenders.
Criticized as 'vague'
The Illinois Association of Mortgage Brokers is vehemently opposed to the bill. Executive Director Marve Stockert said that while his group finds other provisions more objectionable, it is most opposed to the imposition of fiduciary responsibility. Essentially, he asks, how can laws be used to enforce fairness?
"The word that best describes this is vague," he said. "If someone else has better rates than you, are you in violation of the law?"
Mortgage brokers are not normally in a position to know what's best for each consumer, he said. A home refinance intended to cash out equity to pay down credit card balances could be a sound financial choice for some clients, but a poor one for others. It's not fair to place a legal burden for that determination on a mortgage broker, he said. He also rejected parallels between estate trustees and mortgage brokers.
"In a trust situation you have all the assets in front of you," he said. Mortgage brokers don't get that kind of detailed access to a client's financial picture, he said.
Stockert also said existing state laws can already be used to prosecute brokers who are deceptive.
But Kit Mueller, an Illinois-based broker, said he isn't afraid of the fiduciary responsibility.
"I would hope we could abide by the terms other financial advisers have to abide by," he said. He noted that for many consumers their home loan is a much larger part of their financial portfolio than their retirement or investment accounts, yet their mortgage broker has less legal responsibility than their financial adviser.
On his blog, "Mortgage Planner," Mueller has argued against many aspects of the Illinois mortgage law, but called the fiduciary responsibility element "embarrassingly necessary," and "a standard that we frankly should already be upholding."
Fair, but meaningless?
Jack Guttentag, a retired Wharton School professor who now goes by the moniker The Mortgage Professor, said he agrees conceptually with the idea of fiduciary responsibility. But practically, he said, it would be meaningless.
"There's not much point in having a law that required a broker to be an agent if you don't stipulate what that means in terms of operational behavior," he said. "Brokers are too small to be inviting to a class action lawsuit. No borrowers are in a position to sue individually. So there is no real enforcement mechanism."
He said a similar provision has existed in California law since the 1970s and it hasn't had any impact on mortgage brokers' behavior there.
Carolyn Warren, a former broker and author of the book "Mortgage Rip-Offs and Money Savers," had a similar perspective.
"I'm for the idea, but it's meaningless rhetoric," she said. "(Brokers) can't look at every person's financial situation, review their credit cards, their accounts. ... How can you regulate that?"
Guttentag favors rules requiring more specific and clear disclosure of broker compensation, which he says would expose unfair fees and other unsavory practices.
"If you agree on the fee up front then the broker is working for you," he said. "No longer can they slip something into the contract like a prepayment penalty."
Disclosure is not a guarantee of fairness, however. A recent study conducted at Carnegie Mellon University, and cited in M.P. Dunleavy's excellent New York Times column, warned about the ineffectiveness of disclosures. The study revealed that consumers tended to follow bad advice even more readily from "experts" who disclosed potential conflicts of interest, because the consumers mistook the disclosure as evidence the advice was good.
A fiduciary duty goes much farther than disclosure -- it requires that brokers get the best deal they can, a provision Hagan says is essential to reforming the industry.
"I've never fought so hard for a bill," she said.
RED TAPE WRESTLING ADVICE
• Discussion of fiduciary duty is a welcome addition to the realm of consumer protection. I hope it finds its way into other consumer/business relationships. Why should brokers -- or anyone -- shy away from a law that requires them to do the best they can for consumers? There are obvious questions about enforcement, but ultimately, redefining the relationship puts brokers on notice that they're playing with fire when misleading consumers, and adds a new consumer right to redress. Support similar efforts in your state.
• Two-thirds of home buyers now go to mortgage brokers, and they do so for one of two reasons: to have a guide through the mortgage process or to get a cheaper loan.
Let me eliminate reason No. 1. Unless you are the kind of person who enjoys making risky investments, playing the stock market and tinkering with your retirement funds, there's only one kind of loan for you: a traditional fixed-rate loan with 5, 10 or 20 percent down. You don't need a broker to explain those choices. If you understand financial risk, then go ahead and play with "exotic" loans, but be sure you're smart enough that you don't need a broker to explain them.
As for No. 2, brokers sometimes can get better rates. The only way to find out is the usual way: Shop around. Warren recommends getting good faith estimates from at least two brokers and one bank on the same day for the same kind of loan.
• Most of all, remember that the broker does not work for you. Think of your broker as you would a friendly commission-based electronics store salesman -- perhaps full of valuable expertise, but always to be kept at arm's length.
• Both Warren and Guttantag offer free advice on their Web sites and will answer simple consumer questions sent via e-mail. Visit them at AskCarolynWarren.com or MTGProfessor.com.