Blown Mortgage

This post is from the Blown Mortgage Hall of Fame.  It caused quite a commotion when I originally posted it.  You can read the original comments here.  There are pros and cons to mortgage brokering vs. mortgage banking - I guess the question now is which one is going to last.  I’m a day away from my vacation - can’t wait to catch up with you all!

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Several people have asked me to comment on the differences between mortgage brokers and mortgage bankers and levy an opinion on which I believe to be the better business model. I am, of course, weighing in on what I believe the best model to deliver service and a solid loan to a consumer, and will ignore owner-related issues such as profit margins as they do not relate to the overall customer experience. This is not meant to be a deep introspection of the two models; rather, consider it a survey of some of the important differences between the two and their implications on customers interacting with each.
If you’re wondering why I may be able to speak to this argument with any rigor it is due to the fact that the company I own has operated under both the mortgage broker and mortgage banker business models. As the champion of our switch from brokering to banking, and the change agent involved in the transition, I have a first hand knowledge of all aspects of the differences between the two models. With this understanding I believe I can candidly discuss the pros and cons of both models; and what the implications of each are for the customer.

For those of you with limited time or attention, I’ll share my conclusion with you here. With anything complicated the answer is “it depends,” and here is the distillation of the below: if you are unconcerned about loan-product selection and you are a very vanilla-type borrower then I would suggest choosing the mortgage banker. If you are concerned about a wide selection or you have a difficult financial or credit history I would suggest choosing the mortgage broker. With one caveat, I would always suggest the mortgage broker over the small mortgage bank.

The Broker Argument
The broker argument is often surmised as follows. The broker has a wide range of bank partners and loan options, making it easy for brokers to find and place the best loan for a customer in terms of price, rate and terms of the loan. The argument continues, not incidentally, that people with difficult-to-document situations can be served by this wide network of lending partners. Brokers will also excitedly share with you the discount you receive by receiving “wholesale” rates that are below the market that banks offer. The reasoning is that because the broker is responsible for overhead they receive a reduced rate from the bank – which they are graciously passing on to you, the customer.

An Argument against Brokers
Often, you’ll hear someone who works for a bank or a mortgage banker tell you that working with a mortgage broker is bad news with the following pitch. A broker is an independent third party, with zero decision-making ability; they don’t approve your loan and have to wait in line with all other mortgage brokers while they wait for a decision from the underwriting department. Further, when you have a middleman you pay for that extra party involved. They have expenses that they need to cover by fees charged up front on a loan; which means higher upfront charges to you.

The Banker Argument
The banker argument sounds a bit like this. By working with a direct lender you have eliminated and expensive middleman who has zero decision-making ability. You have decided to come straight to the source; and because we lend our own money we are able to make underwriting decisions, gain special exceptions, and process your loan much faster at a much lower cost to you. Everything is done in-house, there is no waiting inline, no false promises – I can give you a fully underwritten approval from right down the hall. A mortgage broker can’t really tell you what you’re approved for until they hear back from the bank, which can be weeks. Why put yourself through that when I can tell you right now whether you’re approved or not? And remember, we are a financial institution, a direct lender, not just a fly-by-night broker who you are not sure is going to be there tomorrow.

An Argument against Bankers
Often, when a broker is competing against a banker they’ll use some derivative of the following argument. Mortgage bankers are exceptionally limited in the products that they are able to offer. They make their money by producing volume in limited product categories; in addition they don’t have the opportunity to shop for the true best deal for you. You only get to choose from what they offer, and depending on their specialty, those rates and programs could be far from the market value. You also don’t see how much money they truly make on your loan. They could be making thousands of dollars in additional hidden profit by giving you a higher interest rate than you deserve.Further, many small mortgage banks are nothing more than brokers on steroids. Since they sell your loan immediately they don’t always have ultimate control like they say they do. Finally, your loan will be sold immediately. This means that you may be confused about whom to make your payment to, and will have to deal with the headaches of your lender changing almost as soon as the ink dries on your loan documents.

Common Misconceptions about Brokers
With anything confusing people attempt to simplify the story to make it easier to understand. We are far better at remembering and making sense out of stories than we are at remembering and processing lists of facts and figures. That’s why people tell stories and don’t rattle off bulleted lists. The problem with the way we process information and remember stories however; is that we tend to over-simplify to make the story cleaner and easier to tell and remember. For most things the result is negligible, and the simplification suits us well; for others this tendency can be damaging. Such is the case in a complex comparison between brokers and bankers. By distilling to simple comparisons we fall victims to the lack of focus on key distinctions and facts.

Here are some common misconceptions about brokers, and a humble rebuttal.

Brokers don’t have to be licensed
This is patently wrong (mostly, depending on the state). Brokers are governed by state licensing institutions and therefore require licenses to operate. Federally chartered banks are not subject to state licensing requirements and therefore do not need to have their employees licensed under the state regulations in the jurisdictions where they operate. The efficacy of licensing is a debate for another time; but suffice to say, according to (most) state laws brokers of residential home loans need a license.

Brokers have no decision making power
This is wrong as well. While this myth is most likely perpetuated from the past, brokers have many of the same tools as the mortgage banks in terms of underwriting and qualifying a borrower for a home loan, on the spot. Brokers have access to the same Automated Underwriting Systems (AUS) that most mortgage bankers do. This allows brokers to obtain instant approvals in-house with out needing to ship the file off to the bank for approval. Once an AUS approve is obtained, the bank simply verifies the documentation supports the information uploaded in to the AUS; they do not re-underwrite the loan, and they do not review the decision (except as noted).

This means that an approval from a broker is as solid as the one from the bank. In fact, the mortgage bank is going to do the exact same thing. Where this myth holds is in the offices of the “old school” brokers who refuse to run files through AUS prior to submitting files to the bank. By avoiding this recent technological advance the broker is putting you in line with others; and then truly has no decision making ability. Some times, if you are a subprime borrower or have a unique lending circumstance, brokers may not be able to issue an AUS approval, and then your file will need a complete underwrite at the bank your loan is destined.

Brokers are financially unstable
Bankers love to portray all mortgage brokers as fly-by-night operations that don’t have the capitalization or the stability to be a direct lender. This is certainly true in some cases. Some people who obtain a brokers license choose to practice their craft on a part-time basis, others are truly the fly-by-night variety, in the industry for a quick buck and then gone the moment things get tough; however, there are some brokers that are well established, have a longer track record of success than a mortgage banker, are better capitalized and have made a choice to stay a broker.

Brokers are a rip-off
There seems to be an American quality that drives us to “eliminate the middle man,” perhaps it’s been the successful marketing over the years of direct-to-consumer efforts of other industries. We love Costco, we love discount “wholesalers” we loathe paying markups and dealing with middlemen. In the case of mortgage brokers some are certainly rip-offs. The fact remains however that anyone issuing credit to you in the form of a home loan can rip you off. Bankers can certainly charge excessive fees with the best of under-handed brokers. Loan officers at banks and loan officers in a brokerage all have varying moral compasses and the institution they work for has little to do with their current direction.

Here are some common misconceptions about mortgage bankers; again with a rebuttal:

Bankers charge more on loans – you just don’t know it
Some brokers argue that because mortgage bankers are not required by law (like brokers are) to disclose the compensation paid to them for selling premium interest rates, bankers are able to dupe the customer in to a higher interest rate to reap additional hidden profit. While it is true that bankers do not need to disclose that hidden profit (known as yield spread premium, see link for in-depth explanation) most are unable to maximize that hidden profit because to do so would price them out of the competitive interest rate market. Hidden profit cannot be made unless there are higher interest rates charged to the customer. Unless the customer is blindly accepting the rate on good faith, they should be able to quickly surmise that the rate offered is way out of line with even a superficial comparison shopping effort.

This competitive environment often limits this ability to hide profit from customers from turning in to a “rip off.”

Bankers are limited to only one of two programs
I’ve heard the silly argument that bankers are bad for consumers because they only offer say, product A or B, and if product A or B isn’t ideal for the customer the mortgage banker still steers them in to one regardless better options “out there.” While bankers do customarily have fewer bank relationships than brokers, this does not necessarily mean they are more limited in the mortgage products they can offer. Take for instance a mortgage banker that sells to Countrywide. This banker may have in excess of 150 different loan products running the full spectrum of financing options.

Additionally, mortgage bankers may be allowed (based on the business rules established in the institution) to take loans that don’t “fit” their banking guidelines through the broker channel and act in a limited broker capacity; that is they can farm your loan out if it doesn’t fit internal guidelines. As I said, their ability to do that is really dependent upon the institution they work for.

Bankers have better rates
Some people mistakenly believe that bankers have lower rates than brokers. It probably stems from the “eliminate the middleman” pitch that we discussed above. This myth is just that, a myth. Rates are based upon the rate available to the bank for the particular loan program PLUS the markup charged by the banker to cover their expenses and add to the bottom line. This markup is hidden from you, the borrower, and often from the employees – definitely the sales team. Brokers must disclose all rate markups. This doesn’t imply that banker rates are higher than broker rates, but it does suggest that regardless of business model their will be fluctuations based on decisions made at each individual business.

Some pros and cons of working with a broker

Pros

• Low overhead can lead to lower rates
• Wide range of products from diverse lending sources
• Can source many different financing options
• Must disclose all compensation associated with loan

Cons

• Necessary middleman
• Sometimes limited decision making ability
• Can be ephemeral, lower barrier to entry for business owners

Some pros and cons of working with a mortgage banker

Pros

• On-site decision making ability, more control over the process
• Better rates for larger banks (volume discounting)

Cons

• Don’t disclose yield spread premium profit
• May charge additional fees to support overhead (underwriting, etc.)
• May not have true decision making ability

Why I don’t like small mortgage banks
I said earlier that if you had to choose between a broker and a small mortgage banker to always go with the broker. Here’s why I believe that.

Decision Making Ability
To make a decision on a loan you need an underwriter to sign off on the loan and a funder to coordinate the funding by ensuring the final documents are in place that make the loan “sellable.” When those two positions are properly performing their job functions you have in-house decision making ability on loan approval and funding. The problem with small mortgage banks is that they may not have underwriting and funding in-house. This takes the decision making ability right back out of the hands of the small mortgage bank; making them no better than a mortgage broker on steroids.

Small mortgage banks may not have underwriting and funding in-house due to the high expense associated with the positions. Underwriters are not cheap, and while funders are relatively inexpensive it is a fixed cost that some smaller operations choose to not incur. So if you are working with a small mortgage bank they may have a contract underwriter or a part-time underwriter or use an underwriting service to approve the loans they plan on writing. This invalidates their argument of having centrally-based decision making ability because they are sending their loan files off to another source outside of their organization for someone else to underwrite and make the decision. This is exactly what brokers do.

To exacerbate that problem, smaller mortgage banks often require prior approval from either their warehouse line or end investor (the bank ultimately buying the loan) or both. This means that not only does the small mortgage bank have to underwrite the loan (by sending it out?) but they also need to receive approval from their warehouse credit facility to lend the money and they may even need the investor’s prior approval to buy the loan before they are willing or able to fund the loan.

So hopefully you can see the added complexity that can bog down your loan when you use a small mortgage bank. Instead of one approval, they may need up to 3 approvals before your loan is truly approved and ready to go. Most of these problems are alleviated when you use a larger mortgage banker who has in-house, delegated underwriting authority. The question to ask when someone tells you they are a direct lender is “Do you have in-house underwriting?” and “Do you have delegated approval authority from your investor?” If the answers are yes to both of these questions then you are in pretty good shape; if not the service provider is going through extra hoops to approve your loan for funding.

Costs
As I mentioned above underwriters and funders are not cheap, and they are fixed costs for a mortgage bank; costs that aren’t there for mortgage brokers. There are other costs for mortgage bankers that are not associated with brokers – warehouse interest fees, document preparation fees, fees associated with the loan sale and transfer, and of course the added salaries of the people involved in the process.

These costs need to be recouped by small mortgage banks, and they often do it either by adding hidden profit in to the loans in the form of inflated interest rates, or by charging additional fees on the closing statement to recoup the costs of mortgage banking business. For a smaller mortgage bank that doesn’t do a lot of volume the need to recoup costs may be much higher on a per loan basis than a larger mortgage bank. Again these costs are non-existent for a mortgage broker.

You can see that a large mortgage banker, who operates on volume and therefore only needs to recoup a small portion of expenses on each funded loan; and a mortgage broker who doesn’t have the associated costs with their business model, may be less expensive than the smaller mortgage bank.

Higher Interest Rates
Continuing with the above, the need to recoup costs while profiting in a higher-overhead environment can often times manifest itself in interest rate mark ups. That is, the mortgage banker is not required to disclose yield spread premium profit on each loan. They therefore are able to mark up the rates offered to them by investors in secret, before delivering them to the sales staff so that there is a fixed profit margin on each interest rate quoted. This is often profit for the house and not known by the sales staff. In order to achieve this profit though there needs to be a spread between the interest rate offered by the investor and the interest rate charged to the customer by the mortgage banker. This can be anywhere from a few percentage points to a quarter or half-again higher interest rate.

This is exacerbated in smaller institutions because of the pressure to increase margins on each unit funded because of the overhead expense associated with banking. Larger institutions can make smaller profit on each individual unit; relying on volume to make up the difference.

In Conclusion
The banker/broker argument is a bit overblown. It is often used as a sales tool and the benefits of each are usually espoused the strongest based on the company’s current business model. Bankers push banking and brokers push brokering. As both a banker and a broker (a small banker, btw) I think that both models are efficient and have pros and cons that offset one another and are often overblown. I think that consumers, real estate professionals and other interacting with the lending community should not base their decisions on the business model chosen by the financing source (broker or banker) but rather on the individual merits of the people and institution. Regardless of model, I would look for people that tell the full story and look out for the best interests of the borrower as tantamount to any of the concerns above. Bankers and brokers both can be excellent sources of financing and lousy sources of financing. It’s up to the borrower to and business partner to choose their financing source based on service, honesty, integrity and follow through; more so than rate, cost or business model.

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