(This is Part 2 of a three-part series. See Part 1 and Part 3.)

Last week, I advised against becoming a mortgage lead. That means ignoring the too-good-to-be-true mortgage promises that bombard every computer user today.

The promises are either not true or extremely misleading. Their sole function is to hook you into filling out an information form, which makes you a lead. Leads are solicited by the loan providers who buy them. If you made one mistake by becoming a lead, don’t make a second one by responding to a solicitation.

This article compares leads with referrals. Selling leads is legal, while selling referrals is not. Is there a good rationale for this?

The Economics of Leads and Referrals

The basic economics of leads and referrals are virtually identical. For example, assume I place an ad on my Web site that entices readers to enter information about themselves, information that I sell to a loan provider (LP) for $10 per lead. Assume further that 10 percent of the leads result in a closed loan. This means that in obtaining loans through me, LP has a marketing cost of $100 per closed loan.

Now suppose that instead of doing it this way, my deal with LP is that he pays me $100 for every lead that results in a closed loan, otherwise nothing. Instead of 10 payments of $10 each, I now receive one payment of $100, but over time the same amounts change hands.

Differences Under the Law

Although the economics is much the same, the law sees the two approaches very differently. The $100 payment contingent upon a loan being closed would be an illegal referral fee under the Real Estate Settlement Procedures Act (RESPA). In contrast, the sale of a lead is not directly related to a real estate transaction, and is not therefore subject to RESPA. Given that the purpose of the RESPA restriction is to protect borrowers from being overcharged, is there any reason for treating referrals and leads differently?

Other Differences Between Leads and Referrals

Some differences between leads and referrals have no bearing on borrower protection. These include the greater uncertainty in pricing leads, and the need for a referrer, but not a lead generator, to obtain accurate information about the number of closed loans.

But there is another difference between leads and referrals that is very relevant to borrower protection. Lead generators–the ones who entice you with promises of fantastic mortgages at rock-bottom rates–accept zero responsibility for the actions of the loan providers who are supposed to redeem the promises. Those who refer borrowers to loan providers for a fee, in contrast, may accept some responsibility to the borrower.

The lack of responsibility of lead generators reflects the largely impersonal nature of this market. Lead generators typically sell to any loan provider willing to pay their price. Leads are often sold to more than one loan provider, and increasingly there is an intermediary between the lead generators and the loan providers. If a loan turns out badly for the borrower, there are no recriminations for the lead generator, who is remembered by the borrower, if at all, as a glitzy Web site with no face.

In contrast, those who refer a borrower to a loan provider will typically have a relationship with the loan provider. If the loan sours, the borrower will know and most likely blame the person who directed him/her to that loan provider. Disgruntled borrowers will not refer their friends to real estate agents or others who refer them to bad loan providers. As a result, referrers often have a long-term business interest in having their referrals vindicated by the favorable experience of borrowers.

This doesn’t mean that a referrals system works well in protecting borrowers–it doesn’t–but it does offer some protections where existing leads systems offer none. Discouraging referrals by outlawing referral fees while leaving the leads market free is perverse. I am not arguing that the leads market be regulated, heaven forbid, but restrictions on referral fees should be removed.

Most borrowers follow someone else’s suggestion about where to go for a mortgage loan. The market will work much better for borrowers when those who get paid for directing them to specific loan providers explicitly guarantee the performance of those loan providers. If that requires that the guarantor be paid for loans closed, why not?

Next week: Emergence of the monitored loan provider.

The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at http://mtgprofessor.com.

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