Origination Fees Cause Bad Lender Behavior

Check your lender's incentives.

The New York Times has an article today with the headline, "Justice Department Fights Bias In Lending." Without thinking too deeply about it, I assumed that this meant certain groups of Americans weren't being given as many loans as others or worse terms. That led to my worrying that "bias" here could just be better termed "underwriting standards." And, indeed, if the article did criticize lenders for not giving loans to individuals with lower incomes and/or worse credit records, then I would have been right.

But it actually involves the opposite situation: too many loans being given to people with low income and poor credit histories. The solution there, however, would probably more effectively addressed by additional regulation than the Justice Department.To be sure, this is a counterintuitive concept. Why would lenders want to give more loans to people who would be less likely to pay them? Of course, you only need to look back to subprime mortgage fiasco during the housing boom to find an answer. Yet, then it was assumed that those loans actually would perform well, since the housing market was booming. Now that's changed, but lenders are still giving out loans to borrowers who can't afford them. Why?

The New York Times explains:

While past lending discrimination cases primarily focused on "redlining" -- a bank's refusal to lend to qualified borrowers in minority areas -- the new push will instead center on a more recent phenomenon critics have called "reverse redlining."

In reverse redlining, a mortgage brokerage or bank systematically singles out minority neighborhoods for loans with inferior terms like high up-front fees, high interest rates and lax underwriting practices. Because the original lender would typically resell such a loan after collecting its fees, it did not care about the risk of foreclosure.

What we've got here is an incentives problem. Many lenders ultimately sell the mortgages or other loans they originate to others, and along with them goes the default risk. One solution often mentioned is to force lenders to keep some skin in the game and retain a portion of the risk for the loans they originate. The problem with that idea, however, is that it will make credit more expensive, since lenders will have to hold additional capital against that risk.

But if we lived in a world where lenders weren't able to collect up-front fees, then they wouldn't originate as many bad loans -- even if sold. Imagine the following scenarios where a mortgage broker originates a $100,000 loan to a borrower with poor credit:

Scenario 1 (with fees, subprime borrower):

The broker also gets a $5,000 fee for originating the loan. He then sells it to a bank that pays him $96,000 for the loan, the present value of the loan to the bank based on its internal cost of capital and default risk assumption. But that's okay with the broker, because he still makes $1,000 on it, thanks to the fees.

Scenario 2 (without fees, subprime borrower):

The broker gets no fee for originating the loan. He then attempts to sell it to a bank. But the bank will only pay him $96,000 for the loan, given the inherent risk. Uh oh. The broker realizes that this isn't a good business and immediately becomes a mailman instead -- a good, clean living.

Sounds great right? Not necessarily. We may want a world in which you could still have honest mortgage brokers to originate good mortgages. Luckily, they probably won't all opt to be mailmen, as I joked. Instead, imagine yet another scenario -- the one we want!

Scenario 3 (without fees, prime borrower):

The broker gets no fee for originating the loan. He then sells it to a bank. That bank will pay him $101,000 for the loan, because it has good credit quality and, consequently, a much lower risk profile. That lower likelihood of default means the bank will profit on the loan through the interest payments that will continue for the life of the loan.

A framework without origination fees would result in the loan's risk being taken better into account because the original broker could only profit by selling loans with present values that exceed their principal values. With fees, you have the bizarre situation where loans are sometimes originated with negative net present values. That makes no sense. Eliminating origination fees would get rid of the ridiculous incentive to originate as many loans as possible, no matter their quality.