(This is Part 1 of a two-part series. Read Part 2, "Seattle mortgage broker adopts U.K. model.")
To gain perspective on institutional practices, nothing beats seeing how the practices differ somewhere else. Recently I looked at how mortgage brokers and the lenders they deal with operate in the United Kingdom. I have had invaluable help from Richard Hobson, a broker in the U.K. for many years who is now a broker in the United States.
The basic economics of the industry are essentially the same on both sides of the Atlantic. Assuming that the lender is satisfied that the broker is properly licensed or certified, the arrangement between them is very simple. In effect, the lender says to the broker: "Here are my prices and eligibility requirements; you bring me an eligible customer and I’ll make the loan."
Lenders find it advantageous to work through brokers because it gives them nationwide distribution capacity without branches or loan officer employees. Even a single-office lender can offer loans wherever there are brokers with whom it can do business. Lending through brokers is flexible; the lender who wants to cut its loan volume simply prices a little higher so the loans stop coming. It isn’t necessary to fire anyone or close offices.
On the broker side, mortgage brokerage is an attractive occupation for energetic self-starters who like to be their own bosses and reap the full rewards of their own efforts. They must be capable of meeting the legal requirements, which are generally low in the U.S. and higher in the U.K., as I’ll discuss next week. If the opportunities are provided by lenders, there is never a shortage of brokers.
Yet mortgage brokerage practices in the U.K. evolved differently than in the U.S. Perhaps the most important difference is that the pricing of broker services is much more transparent in the U.K. This greater transparency is closely related to differences in the way that lenders price mortgages.
The prices quoted by lenders in the U.K. are the retail prices available to borrowers through brokers. These prices are viewed as public information, and some lenders advertise them in various media and/or on their Web sites. An eligible borrower who seeks out such a price knows that he can obtain that price from any broker dealing with that lender.
In the U.S., in contrast, lenders deliver wholesale prices, and only to the brokers with which they deal. Brokers then add their markups before quoting retail prices to borrowers. Lenders never publicly disclose their wholesale prices. With the exception of Upfront Mortgage Brokers, brokers don’t disclose them either, since that would be tantamount to disclosing their markups, which brokers view as nobody’s business but theirs.
In both countries, brokers are most often paid by the lender rather than the borrower, because borrowers generally prefer it that way, but there is a major difference in the way this works. In the U.K., payments to brokers are set by lenders. While there are some differences, most lenders pay a fee of 0.35 percent of the loan amount on standard products to borrowers with good credit. On loans for investment rather than occupancy, the fee is about 0.55 percent. On subprime loans, the fee is 0.75 percent to 1 percent. These lender-paid fees do not vary with the interest rate on the loan.
In the U.S., in contrast, lender payments to the broker are determined by the interest rate the broker delivers to the lender on the individual loan. Some brokers standardize the charge, referred to as the "yield spread premium," but many don’t, charging what the traffic will bear.
In both countries, the broker may or may not charge an additional fee directly to the borrower. Where there is such a fee, the broker in the U.K. is legally obliged to inform the borrower of it at their first meeting. In the U.S., the borrower may not be informed of the broker’s fee until he receives a Good Faith Estimate of disclosure, which is not due until after the borrower submits an application.
A major consequence of the difference in transparency is that many brokers in the U.S. engage in opportunistic pricing, adjusting their markups to what they believe they can induce the borrower to pay. There is no opportunity for this in the U.K. The average markup in the U.S. is more than 2 percent, which is at least twice as large as in the U.K.
U.K. brokers perform the same functions as U.S. brokers, and they are burdened with regulatory duties that U.S. brokers don’t have, which I will discuss next week. U.S. brokers may work as hard per dollar of income, however, because they spend so much time on transactions that never close, and therefore don’t generate any income. Lack of transparency generates distrust, and distrust causes many borrowers to try to protect themselves by flitting from one broker to another, or by trying to play one broker off against another.
Next week: Differences in the way brokers are regulated in the two countries.
The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.
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