Anyone completing a course in microeconomics would find great difficulty applying what he or she learned about competition to the home mortgage market. The market meets the major requirement of a competitive market in having many buyers and many sellers, but the benefits associated with competitive markets are conspicuously lacking. Instead of the expected single price that barely covers the sellers’ costs and is available to all buyers, mortgage prices are all over the lot. Some borrowers pay competitive prices, but many pay more.

Why competition doesn’t work

The core reason that competition in the home mortgage market doesn’t generate the benefits that the textbooks lead us to expect is that most mortgage borrowers are required to select a lender before they know the price. No market will function well under that condition.

Some mortgage borrowers are not aware of this condition, and shop different lenders as if they could make a selection based on price. Most mortgage borrowers, however, don’t try to shop; they select or are selected by a single lender, to the dismay of many observers. But the nonshoppers may instinctively realize what many experts have not fully grasped, which is that shopping in this market is largely futile.

I confess that it took awhile before I realized this myself. Over the years, I wrote several articles on "how to shop for a mortgage," which I am now in the process of revising. The corrected title will be more like "how to minimize the loss from having to select a lender without knowing that lender’s price."

Why mortgage borrowers can’t shop price

Multiple prices: The microeconomics textbooks assume that there is only one price that covers the buyer’s payment obligation to the seller in full. In the case of mortgages, however, there are at least two prices: the interest rate and total lender fees. On adjustable-rate mortgages (ARMs) there are also rate caps, the rate index used, and the margin over the index. An interest rate all by itself means very little.

While multiple prices complicate shopping by borrowers, the difficulties would be surmountable if not for the additional problems noted below.

Changeable product: The textbook analysis of competition assumes that the product or service being sold can be precisely defined and doesn’t change. If you price a horse but deliver a mule, as in "Fiddler on the Roof," the price doesn’t mean anything.

In the case of mortgages, two critical factors affecting the price are not known with certainty until the borrower has selected the lender and applied for the mortgage. These are the credit score and loan-to-value (LTV) ratio, which are determined by the lender based on a credit report and property appraisal ordered by them.

While a preliminary price quote may be based on estimates provided by the borrower, that price is subject to change. Since the financial crisis, such changes have occurred with increasing frequency, and have been larger, in some cases leading to outright rejection.

Uncommitted price quotes: The textbook analysis of competition assumes that buyers can buy at the prices quoted by sellers. In the mortgage market, however, lenders have no obligation to lend at the price they quote until they lock, which may take days or even weeks. In the meantime, the quoted price is very likely to change with the market, which is very volatile. Quoted prices are reset every day and sometimes during the day.

Unsavory lender practices

The inability of borrowers to shop effectively is exploited by some lenders using a variety of unsavory practices.

Lowball scamming is the practice of quoting a price to a borrower below the price the lender is actually willing to accept. The purpose is to be selected by borrowers who believe they can shop price. Lowballing is endemic on Internet-based referral sites, which display price quotes by dozens or hundreds of lenders.

Market-volatility scamming exploits borrowers already onboard but not yet locked by taking advantage of changes in the market. If market prices increase, the borrower is charged the higher price, but if market prices decrease, the borrower is charged the price quoted earlier. In the second case, most borrowers are content to receive the price they were quoted earlier.

Property-valuation scamming exploits borrowers whose loans have been locked before their home appraisal has been received. If the appraisal comes in lower by enough to raise the loan-to-value ratio past a notch point where the price increases, the lender increases the price accordingly. But if the appraisal comes in higher by enough to reduce the loan-to-value ratio past a notch point where the price should decrease, the original lock price is retained.

Next week: Regulatory and market-based approaches to eliminating unsavory lender practices.

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