Should Mortgage Brokers Play the Market?
June 19, 2000, revised November 14, 2006
"In a recent column, you said that many mortgage brokers lock the borrower's interest rate at their own risk rather than at the lender's risk. Since brokers have no special expertise in forecasting interest rates, this makes no sense to me."
Because of the way the market works, brokers can profit from playing the market, even though they have no ability to forecast the direction of market rates.
Lenders charge to lock a loan because their commitment is not matched by a comparable commitment by the borrower. If market rates increase during the lock period, the lender is committed to the lock price, but if market rates decline the borrower may walk away and negotiate a cheaper loan elsewhere. This makes locks costly to the lender, and the longer the lock period, the higher the cost.
Brokers play the market when they substitute their own lock for that of the lender. The broker tells the borrower the price is locked, but does not lock with the lender. Because the mortgage price declines as the lock period shortens, the broker profits if interest rates don't change between the lock date and the closing date, or if rates decline. Brokers only lose if rates increase appreciably during the lock period
Consider a borrower who wants rate protection for 60 days. His mortgage broker shops the market for the best wholesale prices. The price on a loan delivered within 5 days is 8% plus 1 point (each point is percent of the loan). The price on a loan delivered within 60 days (the 60-day lock price) is 8% plus 1.5 points. The broker adds a markup of, say, 1.5 points to the 60-day lock price, making the price quoted to the borrower 8% plus 3 points.
If the broker locks for 60 days with the lender, the broker earns 1.5 points on the deal. If he locks the borrower at his own risk, and if interest rates don't change during the 60 days, the loan will be delivered to the lender at the 5-day price, or 8% plus 1 point. The borrower pays 3 points, as before, but the broker makes 2 points instead of 1.5.
If interest rates increase during the 60-day period, the broker could lose the extra profit, and even the markup. If the float price after 60 days turns out to be 8% plus 3 points, for example, the broker will make nothing on the deal.
If interest rates decline, on the other hand, the broker will make more than 2 points, assuming the borrower stays with the deal. If the borrower threatens to walk, the broker will be forced to share some of the benefit of the rate decline with the borrower. For this reason, gains from rate declines don't fully offset losses from rate increases.
Nonetheless, the brokers who lock at their own risk believe that the profits they earn in stable markets will be greater than their losses from market fluctuations. Because market fluctuations have been small since the early 90s, the practice for the most part has been profitable.
I believe they are. Brokers who play the market rationalize it by saying that they assume the risk and will absorb the loss if the market goes against them. In fact, however, they only protect the borrower against small interest rate increases. What the borrower needs most is protection against an interest rate spike, and brokers cannot provide that.
For example, in the two-month period January-March, 1980, mortgage rates jumped from 12.88% to 15.28%. A broker who locked for 60 days at 12.88% would have to pay a lender about 15 points to accept a loan with that rate in a 15.28% market. The broker would either go out of business, or deny that a lock was given. (Broker locks are oral commitments.) The borrower would be left high and dry in either case.
The brokers who play the market would have a better case if they were upfront with borrowers about who is locking their loans. Their practice, however, is to tell the borrower that "the loan is locked", but not to disclose that they have not locked with the lender. To protect yourself, insist on receiving the rate lock commitment letter from the lender identifying you as the applicant.
"In a recent column, you said that many mortgage brokers lock the borrower's interest rate at their own risk rather than at the lender's risk. Since brokers have no special expertise in forecasting interest rates, this makes no sense to me."
Because of the way the market works, brokers can profit from playing the market, even though they have no ability to forecast the direction of market rates.
Why Lenders Charge For a Lock
Lenders charge to lock a loan because their commitment is not matched by a comparable commitment by the borrower. If market rates increase during the lock period, the lender is committed to the lock price, but if market rates decline the borrower may walk away and negotiate a cheaper loan elsewhere. This makes locks costly to the lender, and the longer the lock period, the higher the cost.
Why Brokers Play the Market
Brokers play the market when they substitute their own lock for that of the lender. The broker tells the borrower the price is locked, but does not lock with the lender. Because the mortgage price declines as the lock period shortens, the broker profits if interest rates don't change between the lock date and the closing date, or if rates decline. Brokers only lose if rates increase appreciably during the lock period
Consider a borrower who wants rate protection for 60 days. His mortgage broker shops the market for the best wholesale prices. The price on a loan delivered within 5 days is 8% plus 1 point (each point is percent of the loan). The price on a loan delivered within 60 days (the 60-day lock price) is 8% plus 1.5 points. The broker adds a markup of, say, 1.5 points to the 60-day lock price, making the price quoted to the borrower 8% plus 3 points.
If the broker locks for 60 days with the lender, the broker earns 1.5 points on the deal. If he locks the borrower at his own risk, and if interest rates don't change during the 60 days, the loan will be delivered to the lender at the 5-day price, or 8% plus 1 point. The borrower pays 3 points, as before, but the broker makes 2 points instead of 1.5.
If interest rates increase during the 60-day period, the broker could lose the extra profit, and even the markup. If the float price after 60 days turns out to be 8% plus 3 points, for example, the broker will make nothing on the deal.
If interest rates decline, on the other hand, the broker will make more than 2 points, assuming the borrower stays with the deal. If the borrower threatens to walk, the broker will be forced to share some of the benefit of the rate decline with the borrower. For this reason, gains from rate declines don't fully offset losses from rate increases.
Nonetheless, the brokers who lock at their own risk believe that the profits they earn in stable markets will be greater than their losses from market fluctuations. Because market fluctuations have been small since the early 90s, the practice for the most part has been profitable.
Are Brokers Who Play the Market Deceiving Borrowers?
I believe they are. Brokers who play the market rationalize it by saying that they assume the risk and will absorb the loss if the market goes against them. In fact, however, they only protect the borrower against small interest rate increases. What the borrower needs most is protection against an interest rate spike, and brokers cannot provide that.
For example, in the two-month period January-March, 1980, mortgage rates jumped from 12.88% to 15.28%. A broker who locked for 60 days at 12.88% would have to pay a lender about 15 points to accept a loan with that rate in a 15.28% market. The broker would either go out of business, or deny that a lock was given. (Broker locks are oral commitments.) The borrower would be left high and dry in either case.
The brokers who play the market would have a better case if they were upfront with borrowers about who is locking their loans. Their practice, however, is to tell the borrower that "the loan is locked", but not to disclose that they have not locked with the lender. To protect yourself, insist on receiving the rate lock commitment letter from the lender identifying you as the applicant.