On Mortgage Brokering

I'm still trying to understand fully how this market works, and I've got some outstanding questions about which I'd be interested in getting some more information.

1) Many commentators contend banks charge more for their retail rates than mortgage brokers are able to procure for buyers (and still make a comfortable profit margin for the broker to boot).  This was certainly my experience when I tried using a broker and phoning some banks directly.  But I don't understand how that business model is economically tenable.  If this is pervasive, why wouldn't banks drop their rates and squeeze out the middleman?  Something doesn't add up here, but maybe it's just a market failure.

2) If part of the added value the broker brings to the table is fostering competition among originating banks, does the rise of the internet and the easier dissemination of information mean the days of brokers are numbered?  I am reminded of how the garden-variety travel agency business basically vanished when airlines started going online and price shopping became easy for consumers.

3) What is the profit incentive of the mortgage broker?  If she is an agent of the buyer (which the buyer would surely be reasonable in believing if the broker refers to the buyer as her "customer" or even her "client"), then I would expect, for an alignment of principal-agent interests, that the broker's profit would be incentivized to reduce the buyer's loan cost (i.e., interest rate).  That is, if the broker gets a 5% mortgage for the buyer, she gets paid X, but if she gets 4.9% mortgage, she gets paid something > X (which hopefully is less than 0.1%!).  Yet as I understand it, the broker gets more if she convinces the buyer to take a higher priced mortgage  (i.e., earns something > X if she gets buyer to take mortgage at 5.1%).  Have I got that right?  (Note that I am, for purposes of this question, agnostic as to the structuring of that compensation, be it a flat fee paid at closing or a deferred fee achieved through a YSP.)  Similarly, does the broker have an incentive to get the buyer to take out more debt rather than less debt (that is, does the greater face amount of the mortgage increase the broker's profit)?  If so, I again worry about a potential disalignment of incentives.

Now, a comment (or at least semi-rhetorical question):

I understand some defenders of the YSP pricing structure to be making the argument that if we assume the mortgage broker has to be paid (which seems a reasonable assumption), then compensating him through a YSP is just spreading out what would otherwise be a flat fee up front.  If so, it has the potential advantage of providing further financing for buyers who would otherwise be unable to afford mortgage brokers.  That seems to make sense.  My concern, however, is that if I make a further assumption -- that the mortgage broker's fee is a small outlay in relation to the overall mortgage debt -- then we are talking about putative buyers who are so close to the margin that they cannot afford to secure the financing if forced to pay a small portion of it (the brokerage cost) as an upfront fee.  Pursuing that assumption, I have misgivings whether it is socially beneficial to put these people into home mortgages.  Perhaps they'd be better off renting a bit longer until becoming more financially secure, as surely they are the marginal consumers who will take the first hits when the market sours.  I worry there's something regressive lurking here.

Comments

[gm]

sorry, but i couldn't resist. the recent article in "The Boston Globe" has irked a few brokers, so they may be coming here to complain. i was trying to tell them to watch the documentary (no 25 in netflix top 50 instant movies: "Maxed Out"), but they didn't listen. so, the early preview of the brokers' wrath can be found here:
http://www.brokeroutpost.com/loans/brokers/forum/topic.asp?TOPIC_ID=174274

[Felix]

Hi John --

I think your first two points are very salient and very good.

Your third point I'm not so sure about. Think of buyers' brokers in the real estate (not mortgage) market -- incentives work much the same way. Or art consultants, or just about anybody who works on commission and whose job is to help people buy something big (art, houses, financial products such as mortgages, whatever). I don't see the broker model as being particularly out of line with accepted norms.

As for your final comment, I think you're over-egging the pudding when you talk about "buyers who would otherwise be unable to afford mortgage brokers". You don't need to get to the "unable to afford" point to make the argument here that for someone buying a house it might well be very welcome for them to be able to pay their broker's fee over many years rather than up-front.

[Russ]

John:

The questions you are asking are common and the economics of the mortgage business are often misunderstood.

1) Consumers often think that by cutting the middleman out you are able to save money. In some businesses this is true, others it is not. Mortgages just happens to be one of the ones where cutting out middlemen does not save you money. Mortgage brokers simply do not have the same overhead as large banks, so our cost of originating (getting clients) is much lower.

Banks know this as well which is why nearly every major bank has a WHOLESALE lending channel. It is easier and cheaper for the bank to offer brokers their loan products on a wholesale basis rather than trying to staff, train, and employ their own workforce. The best way to think about it is that brokers in some sense are an outsourced sales force for mortgage banks.

A bank may be offering a broker a loan that pays hime 1% YSP that is .25% lower than you would get if you just went to that bank directly. The broker's overhead is low enough that that 1% YSP more than compensates him for his time and overhead.

2) The internet certainly helps with shopping, but the problem is that you are not purchasing a television but a complex financial product. Every person's deal is unique and different lenders have varying underwriting requirements. As a consumer, there is no way for you to effectively do this on your own and really know if you are asking the right questions or getting the right loan product unless you are the most plain vanilla type of loan (99% of consumers are not).

Put another way, one can easily find all sorts of legal documents and contracts on the net. However, unless you really know what you are doing, it would probably not be wise to represent yourself in your own divorce or other legal matters.

3) The incentive for most brokers is a satisfied client. Most professionals in this business depend on referrals.

The way you describe the broker incentive, shows you don't fully understand how ysp works. Yes, our compensation will increase as the rate increases, but in order for the broker to remain competitive, there is only so much YSP they can make without pricing themselves out of the market. Brokers try to find a balance between a fair profit margin and a competitive rate that usually is lower than banks.

Remember, WHOLESALE plus YSP equals RETAIL. It is not the YSP that matters, but what the final rate is on the loan.

Paying points does not always make sense financially which is why most brokers just take the YSP. Consumers generally rather not pay points as well. Often times, paying points won't save you money because you will not have the loan long enough to recoup the upfront cost. Makes no sense to pay $3000 to save $50/mo. It will take you 5 years just to break even.

I agree that if some buyers can't afford the upfront costs, they shouldn't be buying homes.

[lmclark]

There's nothing like the input from a player to help shed light on things -- which is what makes Russ's comments so helpful.

But I agree with Prof. Pottow on at least one point -- I can envision a time when mortgages will be warehoused through the internet, rather than through a broker. 10 years ago, travel agents told us that the internet couldn't replace them because it couldn't possible give consumers the added value that the travel agent's experience and ability to tailor to fit need could offer. They were wrong. I suspect the same will happen to mortgage brokerage.

There's another thought here as well. Mortgage brokerage was a popular and profitable business when it was "feeding the monster" -- the investment industry's insatiable need for more product to turn into CDO's. That, at least for now, has dried up. Brokers will of course have a lot to offer in a down market to consumers looking for a product, but what really drove their business over the last five years wasn't the buyers of mortgages. It was the sellers of mortgages.

Incidentally, my own experience with mortgages recently is that the broker gained the more we borrowed. Our broker didn't get an advantage by pitching a higher rate.