The Federal Reserve recently imposed an $85 million fine on Wells Fargo related to subprime loan origination.
Fines and legal actions against banks by regulators have become routine, but the Wells Fargo case is unique for several reasons.
- The Federal Reserve noted that this was the first time that regulators have imposed a penalty for practices related to subprime lending. In addition, the fine on Wells Fargo is the largest ever issued related to consumer protection enforcement.
- Wells Fargo engaged in subprime lending during the mortgage bubble, but was never a major presence in the subprime marketplace.
- Well Fargo emerged from the financial crisis relatively unscathed due to the fact that they are one of the best run banks in America. Legendary investor Warren Buffet has held a major position in Wells for many years based on the bank’s sound lending practices and highly regarded executive team.
The allegations against Wells Fargo by the Fed related to subprime loan origination at Wells Fargo Financial that occurred from 2004 to 2008. The Fed alleges that loan originators steered customers into high cost subprime mortgages who were actually qualified for lower rate conforming loans. In addition, loan originators falsified income on some loan applications for borrowers who were not qualified based on their actual income.
The abusive and fraudulent activity of the loan officers was encouraged by Wells Fargo’s compensation arrangements. According to the Federal Reserve, “These practices were allegedly fostered by Wells Fargo Financial’s incentive compensation and sales quota programs and the lack of adequate controls to manage the risks resulting from these programs.” Wells Fargo’s Chief Executive John Stumpf, said that “The alleged actions committed by a relatively small group of team members are not what we stand for at Wells Fargo. Fair and responsible lending practices have been at the core of our culture.”
The problems at Wells highlights one of the major reasons why subprime lending was promoted so vigorously by loan originators – it paid extremely well. Despite Wells Fargo’s claims of innocence, by making subprime lending extremely profitable for loan originators, Wells actively provided huge incentives to sell subprime products.
If financial incentives to push subprime mortgages were occurring at Wells Fargo, it is not hard to imagine how much more aggressive they were at non bank mortgage companies that specialized in subprime lending.
The vast majority of loan originators working for mortgage companies are 100% commissioned employees. In addition, commissions on subprime loans increased dramatically if the loan originator could steer customers into a higher rate.
It was not uncommon for brokers and loan originators to charge commissions of 6% or higher on subprime mortgages. A loan originator closing seven $250,000 mortgages per month could easily generate commissions of $105,000 of which the originator typically received 50%. A potential paycheck of $50,000 per month was a powerful incentive to steer customers into high priced subprime loans.
Although the Federal Reserve recently imposed limitations on fees that can be charged by commissioned loan originators, mortgage lending remains commission driven which continues to encourage abusive lending practices.
Should mortgages be sold like used cars, with loan originators receiving higher compensation based on higher rates and origination fees? With the government guaranteeing and providing the bulk of mortgage financing, there should be much greater uniformity in the fees and rates that similar mortgage applicants pay. Although subprime lending has been eradicated, ironically the most profitable mortgages today for loan originators are FHA mortgage loans on which fees of 4% or higher are common.
Perhaps the new Consumer Financial Protection Bureau (CFPB) will examine the matter of commissioned mortgage sales in greater detail in order to strengthen consumer protection and curb excessive fees.