Why mortgage lenders charge overages, and why they may stop

Bank of America earlier this year delivered the following message to its loan officers: "Policy Change: Effective with initial locks on or after Jan. 21, 2010, overages will not be allowed on either purchase or refinance transactions."

Some years ago, I had occasion to compare the marketing of home mortgages by lenders in the United States 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 for their innocence of the rules. In contrast, a large proportion of mortgage borrowers did not understand that they were in a mortgage bazaar and that 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 charges the borrower. If the posted price is 5 percent and zero points, for example, and the loan officer charges the borrower 5 percent and half of a point, the half-point is the overage. Typically, the loan officer will get half of the overage. 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 II. Secondary markets made it possible to go into the loan-origination business without becoming a regulated financial institution. Because you could sell loans to the secondary market as fast as you made them, all you needed was a little capital and a line of credit. These firms are known as "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 culture that were very different from those of depository institutions. The companies invested very little in physical facilities designed to attract walk-in traffic during business hours. Instead, they retained loan officers to pursue clients, as opposed to sitting behind a desk waiting for clients to appear.

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

Because loan officers did most of their work out of the office and with little supervision, they were compensated largely or entirely on a commission basis. While they were legally employees of the mortgage bank, loan officers 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 loan officers wanted to be free to charge what the traffic would bear and to profit from it. The lender who wouldn't tolerate overages would lose loan officers, and the most successful among them would be the first to leave.

This mortgage origination system made the depository institution 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 choice because it avoided a 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 loan officers who had not yet been moved into a separate affiliate.

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 has come. Not the least of the reasons is that, under revisions to Truth in Lending rules recently proposed by the Federal Reserve, lenders will not be able to share overages with loan officers. This will eliminate the financial incentive for loan officers 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 loan officers writes to me, which is how I discovered the news about Bank of America. No lender is going to put out a press release announcing that it will no longer overcharge its customers.