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 . . .


Compensation and Incentives in the Mortgage Business
John M. Quigley
The Economists’ Voice: Vol. 5: Iss. 6, Article 2.

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