Referral fees arise from competition by title companies for the favor of the builders, brokers and lenders who can refer clients to them, combined with the willingness of many referrers to be paid off. Referrals have value and they want a piece of it.

Under the Real Estate Settlements and Procedures Act (RESPA), referral fees are illegal unless they constitute payment for services rendered, and the payments must not exceed the value of the services. However, the Department of Housing and Urban Development (HUD), which has responsibility for enforcing RESPA, does not have the army of examiners it would need to do the job effectively.

Violations of the antikickback provision of RESPA are widespread. Small players do it with many different varieties of under-the-table payments. Large players generally search for legal ways to comply with the letter of the law while violating its spirit. Title companies in Colorado viewed the reinsurance affiliate as such a device.

Some large lenders have used this device to extract referral fees legally from mortgage insurance companies. The lenders have reinsurance affiliates that receive part of the mortgage insurance premiums paid by borrowers who have been referred to the mortgage insurers by the lenders. In exchange for the premiums, the affiliate shares the risk with the insurer. This is the legal cover for RESPA compliance.

The title companies in Colorado used the same device, reinsurance affiliates owned by builders, to pay off the builders. It boomeranged, however, because of the major difference between mortgage insurance risk and title insurance risk.

Losses from defaults are a major part of the costs of mortgage insurers. And while they can go for many years with no problems, losses will balloon when real estate prices collapse. Since one can never be sure when this will happen, nor how large the losses will be when it does, it would be very difficult for HUD or anyone else to establish beyond reasonable doubt that the reinsurance affiliates are being overpaid for the risks they assume.

Most title insurance costs, in contrast, stem from their risk prevention functions rather than from insurance losses. Title insurance losses account for a small part of the premium dollar, and are much less vulnerable to conditions in real estate markets than mortgage insurance losses. The finding in Colorado, that the builders' reinsurance affiliates have had zero losses, is thus powerful evidence that the premiums paid to them were only thinly-disguised referral fees.

Why do the title companies get all the heat for paying referral fees? RESPA states very clearly that those who receive kickbacks are as guilty as those who pay them. Indeed, their demands drive the referral process. But the title industry has some large players, who make the best targets for district attorneys and class-action lawyers.

The failure of the title companies has been their inability to resist the pressures to pay. It is difficult because they must compete for the patronage of builders and others in a position to refer customers to them, who can play one title company off against another. It would be easier for them to say no if the recipients of referral fees had as much to lose from exposure as the payers.

Why are referral fees such a problem in this industry? This question, along with possible remedies, will be discussed next week.