Q: “I want to be an Upfront Mortgage Broker because I already do business the UMB way.

Q: “I want to be an Upfront Mortgage Broker because I already do business the UMB way. I am concerned, however, with the part of the UMB ‘Commitment’ that states that ‘the broker will be the customer’s representative or agent.’ The model broker disclosure form of the National Association of Mortgage Brokers states that ‘in connection with this mortgage loan we are acting as an independent contractor and not as your agent.’ What does this mean?”

A: The mortgage broker trade associations have always promoted the independent contractor model and warned against the agency model, because the agency opens the broker to claims of violation of fiduciary duty. If you want to be a UMB, however, you must accept the agency model and the obligations that come with it.

Independent Contractor Versus Agency: The issue is a legal one but it has major financial ramifications. The independent contractor model views brokers as similar to merchants who buy at one price and sell at another. They can earn as much on transactions as they can induce borrowers to pay, need not disclose what they make except where required by law, and have no obligation to deliver the mortgages best suited to borrowers’ needs.

The agency model, in contrast, accepts that brokers are service providers, not merchants, and they negotiate fees with clients upfront. Their services include finding mortgages that best meet borrowers’ needs.

The agency model is in its infancy. The independent contractor model dominates the industry, and prevailing industry practices reflect that dominance.

The Independent Contractor Model and Industry Practices: Most brokers charge what the market will bear. This means that unsophisticated borrowers who accept what they are told and visit a single broker will pay more than knowledgeable borrowers who challenge the broker and shop alternative sources. There is very little relationship, therefore, between broker charges and the amount of work the broker does for the borrower.

Broker charges average more than 2 percent of loan amounts, which is about twice as high as they should be. A major reason for high fees is low productivity. Brokers spend an inordinate amount of time looking for clients, pay heavily for leads from an industry of lead generators, and also waste time with potential clients who don’t close. Low productivity generates pressure to earn more on the deals that close.

A major reason for low productivity is distrust, which pervades the letters I receive from borrowers concerning brokers. A broker who is an independent contractor has the right to make as much money as possible from a complex transaction that the broker understands and the borrower doesn’t. How can that not breed distrust?

Brokers detest borrowers who flit from broker to broker, submit multiple applications, or pump brokers for information and then deal elsewhere. Yet these practices are how borrowers try to protect themselves against brokers they don’t trust. Borrower reactions to distrust raise broker costs, which pressures brokers to make more per transaction, which generates more distrust in a vicious circle.

The Agency Approach of Upfront Mortgage Brokers: UMBs operate according to a different set of rules than the remainder of the industry. UMBs view themselves as the agent of the borrower, to whom they owe a fiduciary responsibility. A UMB agrees with the borrower on total broker compensation from the transaction, and passes through the best price from the broker’s lenders.

The agency approach recognizes that shopping mortgages is difficult for borrowers, but brokers are experts at it. The optimal arrangement for many borrowers, therefore, is to purchase the shopping expertise of brokers for a fixed fee.

The advantage of the UMB approach is that it breeds confidence, which lowers costs and increases productivity. I know UMBs who charge half the industry average per transaction but close three to four times as many loans. Their secret is a continuous stream of referrals from previous clients — and from me.

Implementation of the Agency Approach: The way to break the circle of distrust is to change the operating model, from independent contractor to agency. Government should mandate the agency approach, but probably won’t because it would be opposed not only by the broker associations, but also by the wholesale lenders, who are as shortsighted as the brokers. They support the independent contractor model in order to limit their own liability for broker misdeeds.

The agency approach will have to win the battle in the marketplace, which will take time. When this was written, there were 135 UMBs. Growth will accelerate, however, with the activation of Upfront Mortgage Brokers Association, a non-profit organization dedicated to promotion of the agency approach to brokering.

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

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