Beginning of the End of the Mortgage Bazaar?

March 8, 2010, Reviewed January 14, 2011

“Policy Change: Effective with initial locks on or after January 21, 2010, overages will not be allowed on either purchase or refinance transactions.” [Message delivered by Bank of America to its loan officers]

The Mortgage Bazaar is Based on Overages

Some years ago, I had occasion to compare the marketing of home mortgages by lenders in the US with the marketing of carpets in middle eastern bazaars. The comparison favored the carpet merchants, who didn’t pretend their prices were fixed. Virtually all carpet buyers know that in the bazaar, bargaining is the rule. While less-competent bargainers may pay a little more, they are paying for their incompetence, not their innocence of the rules. In contrast, a large proportion of mortgage borrowers did not understand that they were in a mortgage bazaar -- they paid for their innocence.

The price of innocence is called an “overage”. It is the difference between the price a lender posts with its loan officers – which is the price the lender expects to receive -- and the price the loan officer (LO) charges the borrower. If the posted price is 5% and zero points, for example, and the LO charges the borrower 5% and .5 points, the .5 points is the overage. Typically, the LO will get half. Interested readers will find a full discussion of how overages work at What Is a Mortgage "Overage?"  

How Overages Evolved

We have not always had overages. In the 1920s before there were secondary markets, consumers who wanted mortgages visited the offices of commercial banks, savings banks, or savings and loan associations, and dealt with salaried employees who had no discretion or incentive to adjust prices. 

Overages arose following the development of secondary mortgage markets after World War 2. Secondary markets made it possible to go into the loan origination business without becoming a regulated financial institution. Because you could sell loans as fast as you made them, all you needed was a little capital and a line of credit. These firms are “mortgage companies”, or (as they much prefer) “mortgage banks”. I sometimes refer to them as “temporary lenders” as distinguished from “portfolio lenders” who hold the loans they originate in their portfolios.

Mortgage banking developed its own operating methods and a culture to match that were very different from those of depository institutions. They invested very little in physical facilities designed to attract walk-in traffic during business hours. Instead, they retained loan officers (LOs) to actively pursue clients, as opposed to sitting behind a desk waiting for clients to appear.

To develop purchase loan business, LOs courted real estate sales agents, making themselves available to the agents wherever and whenever they were needed to take a loan application, which might be on the hood of an automobile on a Sunday morning. To develop refinance business, LOs might camp out in the office of a public agency that maintains records of deeds and liens, developing lists of borrowers who might profit from a refinance.

Because LOs did most of their work out of the office subject to little supervision, they were compensated largely or entirely on a commission basis. While legally employees of the mortgage bank, LOs operated largely as if they were independent contractors. And the more loans they brought in, the more independent they were.

Overages were part of the package. Most LOs wanted to be free to charge what the traffic would bear, and profit from it. The lender who wouldn’t tolerate overages would lose LOs, and the most successful LOs would be the first to leave.

The LO-based mortgage origination system made the depository office obsolete as a source of mortgage loans. Depository institutions that wanted to be major players in the home loan market, had to hire their own loan officers – or acquire an entire mortgage banking firm as an affiliate. The affiliate approach was the more popular because it avoided clash between very different cultures.

I recall my shock when I joined the board of a large savings and loan association some years ago and found that the CEO was the third most highly compensated employee of the association. The two who earned more were LOs, who had not yet been moved into a separate affiliate.

Overages as a Necessary Evil

The general attitude of most depository institutions has been that overages were a necessary evil that they would like to eliminate if they could do it without losing their best loan producers. Bank of America has evidently decided that that time had come. Not the least of the reasons is that under revisions to Truth in Lending recently proposed by the Federal Reserve, lenders will not be able to share overages with LOs. This will eliminate the financial incentive for LOs to charge overages.

My guess is that other major lenders will soon follow suit, if they haven’t done so already. I won’t find out about it until one of their LOs writes me, which is how I discovered the news about Bank of America. No lender is going to put out a press release announcing that they will no longer over-charge their customers.

The ending of the mortgage bazaar is not the beginning of the end for LOs. They will remain the dominant mortgage delivery system, and while  borrowers will no longer be in a bazaar, they will be in a lottery in which those with winning tickets work with an excellent LO and those with losing tickets deal with clueless LOs.

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