Were YSPs (Yield Spread Premiums) Ever Really Legal?

I cannot count the number of times over the last dozen years I’ve heard people in sales and company leadership say they wish originators were still able to charge Yield Spread Premiums (YSPs) on each transaction.

I don’t understand this, because if you applied YSPs as required under the law way back in the 1900s, it’s not too dissimilar from the compensation laws we currently have in place.

Am I nuts? Keep reading and see what you think.

What Are Yield Spread Premiums?

For those who did not earn their scars during the Mortgage Mad Max years of 2007 through 2013, let me explain what a Yield Spread Premium is, as described by HUD, which administered RESPA in those olden days.

YSP is indirect compensation paid by a lender to a mortgage broker based upon the difference between the interest rate and points of the loan entered into with the borrower and the par rate offered by the lender to the mortgage broker for that loan.

In simpler terms, if the lender’s par rate was 6.0% but the borrower accepted 6.5%, that higher rate could generate a YSP. The lender might then pay some of that additional value to the mortgage broker.

Since a loan with a rate higher than current market value will yield more value on the secondary market than a rate set at market, the lender can earn additional revenue from the sale of that loan. That value, while maybe not yet realized by the lender, can be funneled back into the transaction for the benefit of the parties involved.

But who should get that benefit? Hmmmm.

Of Course It’s RESPA’s Fault

The saga of YSP starts with the anti-kickback provision in RESPA Section 8. Basically, it says that no person shall give and no person shall accept a thing of value for the referral of a settlement service.

Sounds simple, but Section 8 can get complicated really fast. For our purposes, the important parts are:

• You cannot give or accept a thing of value for the referral of a settlement service.

• You cannot get paid for services that were unnecessary or not actually performed—the “money for nothing” problem.

  
  

Money for Nothing and Their BPS for Free

The fun started when borrowers—the Culpeppers—sued their lender, Inland Mortgage, for paying the mortgage broker a YSP, which they alleged was a money-for-nothing scheme. An illegal referral fee, if you will.

Inland Mortgage (later Irwin Mortgage) responded with “Nuh uh.”

Well, THAT started an eight-year legal drama.

At this point in the story, HUD felt left out, so it flexed its regulatory status and issued its famous Statement of Policy 1999-1, wherein it explained that a YSP is not illegal “per se.”

This just means that a YSP is legal unless it’s not. How does that work, you ask?

Well, HUD figured that if the YSP proceeds—which are realized by the borrower agreeing to a higher-than-market interest rate—were offsetting the borrower’s costs in the transaction, then it could be completely legitimate.

Inherently, this logic recognizes that the value of the YSP belongs to the borrower who is bearing the higher rate that generates it. When the earned YSP is applied dollar for dollar toward the borrower’s costs, it serves a legitimate purpose. It certainly should not be outlawed.

Smart, right?

The Culpepper case went through different iterations of appeals over several years. In the middle of all that, HUD, flexing once again, explained in Statement of Policy 2001-1 its position on YSPs:

It’s not illegal per se.

For fun, I’ll mention a derivative point for our purposes here, but one that was actually central to the Culpepper drama: HUD’s relentless position that the legality of any YSP could only be determined at the loan level.

That meant harm could not be determined without looking at the specific facts of each borrower’s loan transaction, which scuttled plaintiffs’ counsel’s hopes of making this a simple, easy-money class action suit against any dastardly lender who paid YSPs to brokers.

HUD’s position was pivotal in avoiding a figurative indictment of the whole mortgage industry based on a lazy legal application of the legality of YSPs.

In other words, winning. But I digress.

The “Not Illegal, Per Se” Line Exposed

Let’s work through an example to understand HUD’s meaning of “not illegal, per se.”

Let’s say the proper compensation for the broker in a transaction, as determined by industry standards, is $3,000. If the broker discloses that $3,000 origination fee, then collects $2,000 from the borrower and $1,000 from the YSP, that totals $3,000. You’re fine.

Now let’s say the broker discloses that $3,000 origination fee, then collects $3,000 from the borrower and $1,000 from the YSP, thereby collecting $4,000 for a $3,000 transaction. That $1,000 overage could be imputed as an illegal referral fee paid by the lender to the broker for the referral of that loan.

Hmmmm.

Now you have to ask yourself: Did loan brokers exercise good mathing skills to make sure everything balanced to the equivalent of the $3,000 example above?

Or did they collect the $4,000, with the extra $1,000 considered a nice, undisclosed spiff to the loan originator?

Ponder that.

No Disclosure Required

It should be noted that there was no express requirement specifically requiring the YSP to be disclosed to the borrower.

We can debate whether this was a “paid outside closing” indirect fee that maybe should have been disclosed under then-existing rules, but there was no direct disclosure requirement applied specifically to YSPs…per se.

HUD Proposed Rule, 2002

So what happened next? Well, a few things.

While the Culpeppers kept claiming “uh-huh” to the courts while Inland retorted with “nuh-uh,” HUD in 2002 proposed a new RESPA rule that, among other things, would require not only that the YSP be disclosed, but that the disclosure show how it was offsetting the borrower’s costs in the transaction.

That’s right.

It was forced mathing that would show how the borrower—the one bearing the expense of the higher rate—was realizing the value of the YSP by applying it toward the costs of the transaction. That proposed rule went nowhere.

Died on the vine despite this compliance attorney’s sleepless nights and multiple flights and hotels to accommodate multiple meetings in multiple states while missing family birthday celebrations just to facilitate getting the right version of the rule finalized on behalf of a trade association.

But that’s another story.

Leverage by Meltdown

Then a thing happened starting in 2007: The collapse of the subprime market.

That was the leverage needed to reform—and, in some cases, OVER-reform—the mortgage regulatory requirements. HUD’s overhaul of Regulation X gave us RESPA 2010, which required disclosure of the YSP.

More importantly, the first iteration of the Loan Originator Compensation Rule appeared in 2010. The Federal Reserve Board, then the agency administering Regulation Z, established that a “loan originator may not receive compensation that is based on the interest rate or other loan terms.”

Well, that pulled the rug out from under YSP. But that sounds familiar, right?

In our current iteration, the Loan Originator Compensation Rule prohibits a loan originator from receiving compensation based on the terms of the transaction—or a proxy for the terms of the transaction.

If you’re wondering, that last part was put in there to avoid clever gamification of compensation plans or loan product pricing by loan originators attempting to achieve higher compensation without actually stating that the compensation variation was based on the terms of the transaction.

A Quick YSP Timeline

• 1999: HUD says YSPs are not illegal per se.

• 2001: HUD reinforces that position.

• 2002: HUD proposes additional YSP disclosure requirements.

• 2010: RESPA changes require YSP disclosure, and the Loan Originator Compensation Rule changes the compensation landscape.

So, YSP Windfall Comp Was Never Legal?

If you know of loan originators who collected YSP as additional compensation without using it, dollar for dollar, to offset the borrower’s transaction costs, well, I think HUD would have said they were doing it wrong.

And that’s the part I think gets lost when people look back nostalgically at YSPs.

The idea that an originator could simply generate additional compensation by putting the borrower into a higher-than-par rate was already constrained by the requirement that total broker compensation be reasonably related to the goods, facilities, and services actually provided.

Today’s rules get there differently and much more explicitly by prohibiting compensation based on transaction terms or their proxies.

Different regulatory framework. Very similar underlying concern: the borrower’s loan terms should not become a mechanism for creating a compensation windfall for the originator.

A Lender Doing It Right, Way Ahead of Its Time

All that said, here is an interesting story.

There was a large wholesale subprime lender out there that thought a YSP was such a bad deal for the borrower that it forbade them in its transactions. Instead, it disclosed the YSP in all borrower-facing disclosures in the form of a “borrower credit.”

That’s right. It applied the YSP funds—now get this—to the borrower’s actual transaction costs. The predecessor to the lender credit we now see in TRID.

Now here’s a weird twist.

This company eventually, and very reluctantly, went back to using YSPs in transactions. Was this because brokers rallied and forced the change? Nope.

It was because state regulators didn’t understand it and thought the lender was cheating borrowers out of something. Crazy, right?

After years of successful “borrower credits” that completely favored the borrowers, the company had to change its policy under threat of administrative action by regulators. You cannot make this stuff up.

And that may be the larger lesson here. Mortgage compliance rules change, terminology changes, and sometimes the industry forgets why a rule existed in the first place. Looking back at YSPs is a good reminder that the details matter—and that the way a rule is applied can be just as important as the rule itself.

If you have a compensation practice, pricing structure, or other compliance issue that makes you stop and think, “Are we sure this is right?” that’s a pretty good time to call Loan Risk Advisors.

Book a free discovery call with Loan Risk Advisors today.