Compensation Structures in Mortgage Industry
Interesting piece on how mortgage workers were comped during the heyday by John Quigley, titled Compensation and Incentives in the Mortgage Business.
It goes a long way to explaining why so many people did such silly things during the boom: They were well paid to do so!
A quick excerpt:
The incentive structure that arose for firms in this specialized industry set the stage for
the collapse. The incomes and fees generated are all transactions-based, that is, payments are made at the time the transaction is recorded. The originator of the loan, typically a mortgage broker, is paid at the time the contract is signed. Brokerage fees have varied between 0.5 and 3.0 percent. The mortgage lender earns a fee, between 0.5 and 2.5 percent, upon sale of the mortgage. The bond issuer is paid a fee, typically between 0.2 and 1.5 percent, when the bond is issued. On top of this, the rating agency is paid its fee by the bond issuer at the time the security is issued. All these fees are earned and paid in full within six to eight months after the mortgage contract is signed by the borrower.Thus, no party to the mortgage transaction has any economic stake in the performance of
the underlying loan. In fact the mortgage broker is paid a larger percentage, termed a “yield spread premium,” if he convinces his clients to accept a higher and more default-prone interest rate. With this structure of incentives, it is not hard to understand why any risky loans were originated, financed, sold, and securitized, especially during the period of rapidly rising house prices from 1999 through 2006. With expectations of rising house prices, it is also not hard to understand why pools of these loans received the imprimatur of a credit rating agency when offered for sale.One does not need to invoke the menace of unscrupulous and imprudent lenders or of equally predatory borrowers to explain the rapid collapse of the mortgage market as house price increases slowed in 2006, before ultimately declining. There were certainly enough unscrupulous lenders and predatory borrowers in the market, but the incentives faced by decent people—mortgagors and mortgagees—made their behavior much less sensitive to the underlying risks. The only actor with a stake in the ultimate performance of the loan was the mortgagee. Everyone else had been paid in full—way before the homeowner had made more than a couple of payments on the loan.
The full list of foolishness is maintained at mortgage implode . . .
>
Source:
Compensation and Incentives in the Mortgage Business
John M. Quigley
The Economists' Voice: Vol. 5: Iss. 6, Article 2.
http://www.bepress.com/ev/vol5/iss6/art2
Friday, October 31, 2008 | 01:10 PM | Permalink
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Barry,
Let me give you a 20-something perspective on this whole lunacy. 4 years ago I bought my first house, mid-200k, put 20% down, which the mortgage company almost thought was unheard of, as they were willing to lend me, at the time a 23 year old with 1.5 years of work experience and a 60,000 annual income over 350k..
But the real insanity were the salaries people in this industry were making. I had one 23 year old female friend, a communications major(!!), that came out of school and made $150,000 in her first year selling model homes for one of the homebuilders. A ton of my friends, mostly average students, got into selling mortgages and were making 100,000 plus a year in - these were kids that, in any other period in the last 30 years, were destined for 30,000/year type jobs. And being such brilliant financiers, many of them used their newfound wealth to buy investment properties with no money down..
This whole thing is not nearly unwound yet.
Posted by: CF | Oct 31, 2008 1:48:37 PM
Of course, everybody in the business (as I was) was well aware of all this.
People behaved rationally to maximize their own welfare--like all people try to do at all times in all industries.
The central problem was too much money, both from the fed's negative real interest rates, and from the huge trade deficits that had to be financed somehow. Too much money drove the whole mortgage securitization trail of tears.
The rest, i.e., lax regulation, cock-eyed incentive structures, fraud, etc., were just by-products of the first failure of government, which was supplying more dollars than the world needed. There are no regulations in the world that could have overcome the flood of cash.
Posted by: Donkei | Oct 31, 2008 2:00:27 PM
yeah, when I was investigating Macquarie US's "mortgage accelerator" loan offerings I came across one of their pages written for their broker agents and not the general public.
It was touting "high YSPs", so I had to look that up, and what I found out about it did not please me in the slightest.
Posted by: Troy | Oct 31, 2008 2:03:19 PM
Everyone was in it for a quick buck from top to bottom. Mass hysteria in 03-04 in San Diego followed by the same thing in AZ as those flippers came here to get better value and bid up all the crappy houses in PHX. I have not a single ounce of sympathy for anyone who got involved. Save us the sob stories about predatory lenders.. The buyers didnt care, they figured it was a sure thing so the terms of the loan were not a concern.
Posted by: whaaa? | Oct 31, 2008 2:19:32 PM
Folks,
All this 'fees' business comports with my experience. As an a fee advisor, I had two mortage borkers as FP clients. Well the incomes were pretty helecious between the two of them mid six figures with no scruples what so ever. And, financial savvy near nil! The fees drove this thing up and down line. Glad they were too smart for me and moved on.
Greed only controlled by some scintilla of conscience. Long greed and short conscience is a bad option
George
Posted by: george | Oct 31, 2008 2:26:20 PM
A few notes. Banks have YPS's. They don't have to disclose them as brokers do. Believe me, you are being screwed just as hard by your bank as you would have been by a broker. If disclosures were equally required, banks would never be able to lend.
I'm a broker, and admit freely this industry poked itself in the eye (some of us that is...)It's pretty hard though to hear of "I didn't know what kind of loan I was getting" or "at the last moment I had the loan switched and had to sign". Sure, there are a boatload of bad actors in the mortgage business, but everyone - and I mean EVERYONE knew exactly what they were doing in Real Estate lending and buying from 2003 to 2006. One cannot say with a straight face that a $14,000 per year farmworker had absolutely no idea he could not afford a $700k priced home with no money down. HoookoodaKnown? Please.
Finally, if you research any bank or broker rate sheets from 2003 to 2006 you'll find extraordinary YSP "encouragement's" to fund absolutely junk loans including the Option ARM. That kind of financial heroin, combined with a knowing public driven to keep up with the Jones's at all cost fed this maelstrom.
Posted by: JWMTG | Oct 31, 2008 2:28:13 PM
I hope this is not considered shocking to many on this board. I have been assuming all along everyone knew about this already and have been making decisions based off of it..
I hope I am not wrong...
Posted by: bill | Oct 31, 2008 2:48:02 PM
actually JWMTG, consumers were very understanding of the previous status quo: everyone knew someone who had made a lot of money on their house and just assumed the party would continue for another two to five years.
The plan was to live in the house for the teaser period and "refi" before the rate resets or the loan was recast. I'm taking Real Estate Principles at my local CC and the instructor just said this week that that was a viable purchasing strategy.
Doing the math on how a refi results in long-term continued ownership is the thing; Jose's $700,000 house had a $1750 interest payment at 3% net rate . . . his household (he was living with another family) could cover that and at any case paying $1750/mo for a very nice house was better than renting two crappy apartments in Watsonville for that money.
Assuming the party played on, Jose could, in 2 years time, take his $300,000 in new-found appreciation, re-borrow $1M against the house, and be able to pay the IO mortgage for 10 years with that cash-out. Sure beats renting!
And if the party ended, well, his credit already probably sucked so no biggie.
Posted by: Troy | Oct 31, 2008 2:55:57 PM
Troy, it is the thinking in your post that got us into the problem we are in today: fantasy appreciation, stated income fraud, an a "who cares" attitude like "and if the party ended, well, his credit already probably sucked so no biggie".
You are your brothers keeper. You do not give a hand gun to a suicidal person. The Realtor who sold "appreciation, like trees, grow to they sky", the mortgage lender who said the payment would be 1% of the loan and not to worry, aided a homedebtor who was not ignorant, but simply stupidly led forward into the morass thinking he could keep up with everyone else.
Do us a huge favor and quit taking Real Estate Principles class. Instead enroll in an ethics class - and not one taught by anyone associated with Real Estate. Find your moral compass. It will guide you well into the future.
Posted by: JWMTG | Oct 31, 2008 3:32:31 PM
"The only actor with a stake in the ultimate performance of the loan was the mortgagee."
Obviously not true. Both the mortgagor and the mortgagee have an interest in the ultimate performance of the mortgage. The middlemen do not necessarily have an inherent interest in the ultimate performance, but the investor (and to a lesser extent the prospective homebuyer) is theoretically in a position to demand quality work from the fee-based parties all the way down the line. The system as implemented over the past decade did a poor job of handling the information problems involved, but that failure is not necessarily an intrinsic quality of the process.
Posted by: JBL | Oct 31, 2008 4:22:07 PM
I had to talk my pediatrician wife through the Countrywide pitch a couple years ago. She assumed, that other "professions" were like hers, and that the expert we were dealing with knew more about what was right for us than we did. She didn't believe my explanation about coin operated "professionals" aka car salesmen, life insurance salesmen, vinyl siding salesmen, mortgage brokers, stock brokers etc. My dad taught me to be skeptical. Hers didn't. Lesson learned - teach your kids how to navigate life. It's a concrete jungle out there!
Posted by: Gordo | Oct 31, 2008 4:32:17 PM
Remember that in states like New York with a Mortgage Tax, there was no incentive for state regulators to rock the boat while collecting all that higher tax revenue from bigger and bigger mortgages.
Posted by: John Greene | Oct 31, 2008 5:43:19 PM
The same flaws in the incentive scheme are still the norm in most financial deals. The transactional, point in time revenue model is what has driven most of the financial mania for many years. The mortgage business simply borrowed it from the more traditional sources like bond and equity salesmen, Private Equity etc. The goal is to have as little skin in the game for the shortest period of time as possible.
Posted by: Fred S. | Oct 31, 2008 6:17:38 PM
Humans are a 'social species' and highly prone to 'herd behavior. The real estate bubble caught up all manner of people...which is why the asset price deflation is an 'equal-opportunity' offender sparing no one who is over-leveraged.
Still, the CNBC talking head act as if credit will return en-masse to the 50% of US households (50% of 116 HH = 58M HH) who are 'sub-prime families' and walking junkbonds. It aint gonna happen.
And of the remaining 50%of HH who are not drowning in debt, a good chunk are too frugal & skeptical to use credit foolishly to lift the economy.
So the recession deepens and Debt Unwind continues.
Posted by: Avl Dao | Oct 31, 2008 7:30:54 PM
And notice that fed interest rates are almost back to zero..AGAIN.
Yes, yes, "it's different this time...yada yada"
Soon, there will also be 'reasons' & 'excuses' to re-inflate credit bubbles and re-animate dead markets...and the 'herd' will be off again to repeat mistakes and create brand new mistakes.
How human.
Posted by: Avl Dao | Oct 31, 2008 7:36:20 PM
Just one thing to add. The out of work mortgage broker I know also cites "commission only" payment structures as a contributing factor. Brokers who were compensated on a commission only basis pushed weaker and weaker borrowers through the system as things slowed down in order to keep their income levels up (and, in some cases, to support the shaky deals they'd gotten themselves into as noted in other comments).
Posted by: JayMach | Nov 1, 2008 2:32:16 AM
I'll cross-post this from the new site:
November 1st, 2008 at 4:25 am
ya know, with all the ink spilled, and pixels fluoresced, over this “Mortgage Crisis”, isn’t it time for a post on the actual Mechanics of a Mortgage?
towit: What, exactly, is being lent? Who funds the transaction? Where does the ‘bank’ get the ‘money’? and so forth..
to those, at the minimum, that are excited about Yield Spread Premiums (YSPs), you should wonder about the answers to those Q: s ..
Posted by: Mark E Hoffer | Nov 1, 2008 8:51:19 AM
to the YSP exciteds, here are a few starting points:
http://www.scribd.com/doc/6444589/Modern-Money-Mechanics
and, note, the point out, in the link above, is to, merely, Modern Money Mechanics, Federal Reserve Bank of Chicago.
http://www.google.com/search?hl=en&fkt=2781&fsdt=8437&q=I+Bet+You+Thought+Federal+Reserve+Bank+of+New+York&btnG=Google+Search&aq=f&oq=
or a GOOG search of : I Bet You Thought Federal Reserve Bank of New York
Posted by: Mark E Hoffer | Nov 1, 2008 3:41:07 PM
Hard to imagine if there are commissions to be made, there will be people who worry about ethical problems.
In the last days of the housing party, whatever remaining ethics were washed away as the players knew their game is almost over and wanted to squeeze the last drop of fat.
Posted by: jeflin | Nov 2, 2008 3:29:42 AM
