Brokers' Fees and Borrowers' Needs

By Jack Guttentag
Saturday, August 4, 2007

Q: According to the National Mortgage News of July 9, "Several Democratic senators want to impose a fiduciary duty on mortgage brokers so they are obliged to serve the best interests of the borrower and can be held accountable for violations of that trust." I assume you support this effort.

A: I do. Brokers operating as independent contractors earn as much on transactions as they can induce borrowers to pay. They have no obligation to deliver the mortgages best suited to borrowers' needs. As agents of the borrower, in contrast, brokers would have to set reasonable fees, and the mortgages they offer would have to meet borrowers' needs.

At least that's the theory. In practice, agency obligations defined as such are not enforceable and would accomplish nothing. California has had such an agency law for years; it has never been enforced, and California brokers ignore it.

The critical challenge is formulating agency rules that can be enforced at a reasonable cost. No federal agency has the capacity to enforce laws applicable to more than 50,000 mortgage brokers if each enforcement action requires extensive investigation and time-consuming legal processes. Private suits by aggrieved borrowers usually cost more in legal fees than the contested damages, and brokers are too small to attract class-action suits.

Enforceability requires that the borrower be the principal enforcement agent. That is possible only if the rules are so specific that the borrower will know whether they have been violated and will have the evidence to document it.

Fortunately, there are agency obligations that meet this requirement. The most important would require that brokers operate like other service providers by disclosing in advance how much they are charging. The rule would read something like this: "The broker will establish a price for services upfront, which includes any payment to the broker from the lender or other parties, and which the borrower must acknowledge in writing."

This rule would work because borrowers would be able to document any violation. A violation occurs if a) the borrower has not acknowledged a written statement of price or b) the price on the statement is lower than the broker's total compensation shown on the HUD-1 settlement statement that the borrower receives at closing.

This simplicity is a critical requirement. Rules that say that broker charges must be "reasonable" or that loans must be "suitable" for the borrower would be dead on arrival.

Broker charges today 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, and a reason for low productivity is distrust, which leads borrowers to flit from broker to broker and submit multiple applications. Such actions raise broker costs, which puts pressure on brokers to make more per transaction, which generates more distrust.

Forcing brokers to disclose fees in advance would break this cycle. Broker prices would drop, and productivity would rise. But there is a caveat, having to do with exactly who would be affected by the rule.

Assume that X and Y are both loan providers who deal with wholesale lender Z. They both receive price sheets from Z, then add their markup. The markup is the price they are charging the borrower for their services. X brings the loan package to Z, who closes and funds the loan. Y closes and funds the loan itself, then delivers the completed loan to Z.

Under existing rules, X is a broker and Y is a lender. X has to report its markup in closing documents, but Y does not. To avoid this, thousands of brokers have joined "net branches," which close loans for them so that they can legally be classified as lenders.

If an agency rule requires only brokers to disclose their fees upfront, the stream into net branches would become a flood. To be effective, therefore, an agency law must cover all loan providers except those who lend at their own risk and therefore have no markup to disclose.

Jack Guttentag is professor of finance emeritus at the Wharton School of the University of Pennsylvania. He can be contacted through his Web site,

Copyright 2007, Jack Guttentag

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