Blog reader Chris Harris raises an interesting question in an email to us: Why do mortgage brokers get paid everything up front when they originate a deal?
This sort of contract gives brokers terrible incentives. They just want to get a deal done. It matters very little to them whether the borrower eventually defaults or not. (It is possible that if their clients always go into foreclosure, then the lenders with whom they work will steer clear of them; but since most loans are sold off by the originating banks anyway, this mechanism is likely to be a very weak form of discipline.) We’ve written in the past about my student Zahi (Itzhak) Ben-David‘s work on real estate fraud and the role that mortgage brokers played.
Chris Harris offers a simple solution to the problem: instead of paying mortgage brokers a lump sum when the deal closes, have them pay a small amount out of every mortgage payment. That way, the mortgage brokers will have a disincentive to initiate high-risk mortgages that are likely to default.
One has to be a little careful with this sort of solution, however, because if you pay the mortgage brokers a percentage of the mortgage payment, they will have an incentive to make the mortgage payment as high as possible, which is definitely not a good idea.
A simple alternative is to make the mortgage broker’s monthly payment a fixed percentage of the value of the loan. This isn’t perfect either, but it might be a step in the right direction.
and 
. You can also watch it on 
Only certain types of people can handle commission only jobs. They have to be compensated for their risk because not every mortgage broker is successful.
Is there any reason to think that mortgage brokers wouldn’t get together and securitize the income streams associated with the mortgages they sell, undoing the plan? Mortgage brokers don’t want 30-year income streams. Investors do.
Don’t blame bad decisions by investors on brokers.
When I buy a stock, I pay a transaction fee. I do not blame my broker if the stock goes down.
I have had this conversation with many mortgage bankers and brokers… this questions should include bankers as well who are often paid bonuses for originating loans… the basic question is should they be paid for the origination of the loan and the terms originated or the performance of the loan… they could be paid out over time or given a lump sum payment at a later date (not necessarily the life of the loan which would usually be 30 yrs, but some later date). Might be tough to recruit the best talent under this plan, but if the bank plans on holding the loan on their books – this makes a lot more sense.
Just imagine the transaction cost to pay mortgage brokers once a month or even once a year for the life of the loan, which is typically not 30 years but only until the borrower refinances (7 years).
A broker may be paid $10 a month for 30 years, or $120 a year, and may risk losing the 23 years left of the typical borrower refinances. Just the transaction cost of this paying and keeping track whether the loan is still alive (through resale of the loan?) would eat up the $10/month. Imagine how many loans a broker must generate to have a livable income, say $4k/month.
The unintended consequence of this idea would be to introduce a high administration cost to the broker fees and increase fees for all borrowers.
Next idea? How about a mandatory test for borrowers or a class in lieu of a test. Let’s equip every borrower the tools to keep their brokers honest. If a broker cheats by providing answers, it is grounds for license revocation/penalties/rescission of the loan.
How about a standard base payment with an escalator based on the size of the loan/payment? What if the base is categorized based on the size of the loan? ($1mm) If the pay structure is dominated by the base pay, the broker will only have an incentive to increase the loan size on loans on the border.
There are a couple of problems with this is it would take too long to build enough clients up as a broker to make enough income for the job to be sustainable and how do you handle early pay offs?
Maybe you need some sort of fixed finders fee with a payback that increases over time (increases motivation to make sure client will have ability to pay over the life of the loan). The loan you’re creating becomes more valuable to you the longer the payments remain in good standing.
“they will have an incentive to make the mortgage payment as high as possible, which is definitely not a good idea.”
Aren’t mortgage brokers in the business of selling loans to borrowers? Why shouldn’t they want to make the payment as high as possible? Isn’t competition among brokders an effective downward force on the price of the mortgage?
As a real estate broker and a mortgage broker who has never had a client go into foreclosure, I find all this bashing a bit much. Yes, there are a few bad apples in the industry, but I believe most of the loans that have gone bad did actually follow the incredibly lax lenders’ guidelines at the time. And most of the homes I show that are short sales often have big LCD screens in every room and $50k pimped-out SUVs in the driveway. So, I think everyone was living a bit too large, not just the brokers.
As far as the delayed compensation plan goes, I am not too interested unless provisions exist for early payoffs due to refinancing or sales.