Markets don’t work well when one party to a transaction knows much more than the other party, a condition economists call "information asymmetry." The home mortgage market is the classic case.
Sources of information asymmetry
Information asymmetry arises from three major sources:
- Mortgage borrowers transact very infrequently, and therefore don’t have opportunities to learn from their mistakes. In contrast, the loan officers and mortgage brokers ("LOs") with whom they deal will typically originate one loan after another.
- Mortgage loans are extremely complex, and the process of creating one is complex and convoluted.
- Mortgage borrowers must commit to an LO without knowing the price. The borrower commits by applying for the mortgage and providing the information the LO requires to process the application. The LO commits by locking the price, but this usually requires that the application be approved and critical information, including credit score and property value, be verified. This lag between the borrower’s commitment and the LO’s commitment provides ample opportunities for skulduggery.
Lender selection by borrowers is haphazard
Information asymmetry would not cause the problems it does if borrowers had good methods of selecting loan providers, but they don’t. Shopping price quotes is fruitless because lenders are not bound by the prices they quote. Price "lowballing" — in which lenders quote prices below anything they can deliver in order to snag customers — is a pervasive practice. Referrals from other borrowers are typically based on a single experience, which is often misjudged. Referrals from Realtors and builders are often biased by financial interest. Lead generation Internet sites direct borrowers to the lenders who offer the most for the lead.
Mandatory disclosure works poorly
Perhaps the most obvious way to correct information asymmetry in a loan market is to require that lenders share information with borrowers. The federal government has adopted this approach with Truth in Lending and other mandated requirements, as have most states.
But mandated disclosures apply only to lenders who have already been selected by borrowers and have begun the process of document generation. They don’t help borrowers shop for the best price or help them select lenders.
Right of rescission works poorly
An altogether different approach is to give borrowers a legal right to rescind a transaction and be reimbursed for all monies they have paid. Borrowers refinancing with lenders other than their existing lender have had a three-day right of rescission under federal law for some years, and it has accomplished very little. It takes too long for borrowers to overcome their emotional investment in the transaction and realize that they have been exploited. Many realize it when it’s too late to rescind.
A further limitation is that a right to rescind doesn’t apply to house purchasers because a loan rescission would require an unwinding of the purchase.
Private certification as an alternative
In my opinion, the failures of the private market to overcome the effects of information asymmetry will be fixed by … the private market! Call the firm that does it a "price integrity certifier," or PIC.
The principal mission of the PIC is to assure borrowers that the mortgage prices of certified lenders, including the prices quoted to borrowers who are in shopping mode and the prices locked for borrowers who have selected a lender, are valid and competitive. Valid prices are:
- the posted prices of lenders that come directly from their internal pricing systems, with no intermediation from LOs.
- fully adjusted for all loan features that affect the price, such as credit score, type of property, etc.
- complete, covering all lender charges, not just points, and all relevant features of adjustable-rate mortgages.
- current, meaning not made obsolete by recent market price changes, or by changes in loan transaction features.
The PIC will assure competitive prices by having multiple lenders bidding for each loan.
A second critical mission is to provide borrowers with various types of decision support that are seldom available from lenders but that nonetheless enhance the value of the loan prospects certified lenders receive from the PIC.
PICs as a business proposition
As a private business, PICs must create more revenue-generating value than they cost, which is a challenge because, while the PICs will provide significant value to consumers, the revenue must be paid by lenders. The value of the PIC to lenders is the high-quality loan prospects they provide, a large proportion of which will convert to closed loans, reflecting the decision support features of the PIC. This contrasts to the low-quality leads and low conversion rates characteristic of the lead generation sites that now dominate the Internet.
PICs would be encouraged by a minor rule change that would allow them to charge lenders on the basis of closed loans without having to be licensed as lenders or brokers. Given the persistent failures of government to protect mortgage borrowers in other ways, this is the least government can do.