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.
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Mortgage brokers are paid when a loan closes as compensation for their time and effort spent in securing financing (or sometimes re-financing) for people’s real estate purchases. The job they are paid for is completed when a loan successfully closes. The professional mortgage broker deserves payment once the job is completed.
Other professionals are paid when services are rendered, so why would you have a mortgage broker wait to get paid based on what the client does in the future? To make sure that mortgage brokers become mortgage insurers? To make sure that people with bad credit never get financing because no mortgage broker would work with them for fear of not getting paid? If a bank decides that someone is credit worthy, why make the mortgage broker the guarantor of the bank’s decision? Mortgage brokers don’t decide if a person gets a loan, they just help the person apply for a loan.
Yes, some unscrupulous mortgage brokers put clients into loan programs that were not appropriate or didn’t follow the rules. Aren’t there unscrupulous people in all professions? Rather than make it harder for a professional mortgage broker to get paid for doing their job, why not institute some sort of licensing requirement that makes it harder for bad mortgage brokers to exist in the first place?
This would apply to then to almost any agent or broker transaction – should a broker who represents a client in a transaction vouch for the client’s future actions? This could apply to lawyers, agents, or brokers (sports, movie, or even job placement firms). The duty to perform proper due diligence lies with the recipient not the broker.
For example a broker represents a tenant (i.e. Bennigans) to lease a 5,000 sf retail location for 10 years. The commission is paid upon tenant’s initial occupancy and payment of the first months rent. The broker here acted as a conduit in procuring a tenant to the Landlord – it is the Landlord’s responsibility to perform due diligence on the tenant (Bennigans) to ensure the tenant is not about to go into bankruptcy.
Why stop at mortgage brokers? This mismatched incentive structure exists all over the finance industry. Look at what happened to CEOs of Citi and other big banks. One year they have a great year and get huge bonuses. The next year they give up all their gains and then some and don’t give any of the bonus back from the prior year.
The solution to the mortgage broker problem is greater scrutiny of the loans by the entity assuming the loan that the broker originates. If I’m buying loans, I need to know the qualification standards that were applied to make lending decision (and hopefully something other than an meaningless AAA rating from S&P). If the broker can’t quantify the standards, that should be a huge warning sign.
Why not regulate the amount of time required before any mortgage broker can sell a loan? It provides an incentive to sign up only those mortgagees who can pay, lest a broker later need to try to sell a loan at a loss.
ARM’s in particular should be regulated in this fashion – the sudden increase in amount of a mortgage payment has caused many of the defaults of late.
Before asking, “How should mortgage brokers be paid?” we should ask, “Why should mortgage brokers be paid?”
In this day and age, there should be very little need for a broker in any industry, and particularly in the mortgage industry, where the product being offered is pretty simple to compare.
Granted, the mortgage companies try to make it as difficult as possible to make comparisons, but when it comes down to it, mortgages are commodities.
The other point is that, at least until recently, loans were sold many times over. The mortgage broker got his fee upfront and so did the first bank, then the second, etc. Everyone got a piece until it landed on the final bank.
A true broker is not long for this world. Soon it will be a handful of banks holding the keys and they will pay their loan originators little.
Since December 2006 about 262 banks have been bought or went under. The big banks have not been playing with mortgage brokers lately and their options have dwindled.
Maybe you could pay the brokers over the first five or ten years of the loan. Statistically, when is someone most likely to default on a mortgage? I bet it’s early in the loan’s life. If you’re ten years into a 30 year note, you probably have enough equity to avoid defaulting. Besides, many people sell or refinance within ten years anyway.
To all the brokers out there – I definitely see the value in making it a bit graduated to provide a way for new brokers to make a living. That’s almost surely required. Similarly, 30 years is a long time, I’m all for hearing an argument about 5 or 10 years out. Anything better than paid in full on closing is an improvement IMHO.
Arguing that it’s impossible under this paid-over-time scenario isn’t being fair though – insurance brokers do it every day. They effectively generate a monthly subscription business which provides a lot of nice stability once you’ve built it up. Mortgage brokers could do the same thing.
Cory – I agree 100% with you. In fact, there are studies which show that paying CEO’s on a moving average over 5 years or more is much more “aligning” than these large single year payouts.