The Role of Mortgage Brokers in the Subprime Crisis

Antje Berndt∗ Burton Hollifield∗ Patrik Sand˚as∗∗

∗Carnegie Mellon University

∗∗University of Virginia

WatRISQ Seminar, University of Waterloo March 2010 New Century

70 retail broker 60 total

50

40

billions 30

20

10

0 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Loan Origination 1997-2006 Mortgage Brokers: Friends or Foes?

Friends Foes ...can help borrowers sort through the ...work neither for borrowers nor for lenders complexities of choosing a loan ...receive fees from borrowers and/or ...search far and wide for just the right through payments from lenders known as home loan at an attractively low price yield-spread premiums (YSP) ...that is, act as middlemen who lower costs ...often the broker’s incentives run counter of searching and matching for borrowers to the borrower’s interests. Lenders pay YSP to the broker when the borrower is paying a higher interest rate than the best he or she could qualify for ...may also be paid a bonus for loans with prepayment penalties

Mortgage Brokers: Friends or Foes?, Wall Street Journal, D1, 24 May, 2007, by James Hagerty Mortgage Broker Compensation

1. Fees paid directly by the borrower Origination fee, and (often) credit, document preparation, application, or processing fees...

2. Yield spread premium (YSP) paid by the lender

Lender’s wholesale rate sheet sets the base rate Example: a loan @ par+0.5% → YSP=1% of loan amount versus a loan @ par+1.25% → YSP=2% Disclosure: Good Faith Estimate (range), HUD1 Closing statement (actual) Research Questions

• How do brokers respond to New Century’s incentives?

• Do brokers earn profits on the loans? Size of profits?

• Are different loan types more or less profitable for brokers?

• Are brokers able to extract more profits from some types of borrowers?

• Do state laws regulating mortgage brokers and lending practices have any impact on broker profits? Positive, negative?

• Is there a link between the broker profits and the quality of the borrower/loan type “match”? Are more profitable loans riskier or less risky? Literature∗

Subprime lending: Demyanyak and Van Hemert (2009), Jian, Nelson, and Vytlacil (2009), DellAriccia, Igan, and Laeven (2008), Gerardi, Shapiro, and Willen (2008), Mian and Sufi (2008), Key, Mukherjee, Seru, and Vig (2008) Mortgage brokers, broker compensation: Anshasy, Ellihausen, and Shimazaki (2006), Jackson and Burlingame (2007), LaCour-Little (2008), Woodward and Hall (2009), Garmaise (2009) Related work on insurance brokers and mutual fund brokers: Gravelle (1994), Cummins and Doherty (2005), Bergstresser, Chalmers, and Tufano (2009), Inderst and Ottaviani (2009), Christoffersen, Evans, and Musto (2010), Regulation: Ho and Pennington-Cross (2006), Pahl (2007), Bostic et al. (2009), Inderst and Ottaviani (2009, WP), Kleiner and Todd (2009) Our Data

• New Century loan origination, servicing and broker data for 1997 – March 2007

• 1.35 million records of funded loans

• Substantial variation in loan, borrower and broker characteristics across states and time.

• Concentrated in California, Texas, and Florida, but active in virtually all states by end of sample

• Information on servicing Loan Origination Statistics (1999–2006)

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Number of loans (×1000) Funded 19 35 40 38 45 94 164 243 306 327 Origination channel (Percentage of funded loans) Retail 35 32 30 30 24 16 11 12 15 19 Corres 12 14 11 9 5 6 9 12 14 13 Broker 53 54 59 61 71 78 79 76 71 68 Number of brokers with loans originated for NCEN (×1000) 1.7 3.2 4.9 5.3 5.9 9.8 15.3 21.3 26.7 29.4 Loan Origination Statistics (cont’d)

1999 2000 2001 2002 2003 2004 2005 2006 Loan program (Percentage of funded broker loans) FRM 35 27 20 29 36 42 41 31 Hybrid 65 73 80 71 64 58 57 62 Purchase 24 23 22 21 30 46 53 53 Refinancing (cash out) 58 60 60 62 59 49 38 37 Refinancing (no cash) 17 17 18 17 11 5 8 9 Full docs 65 66 60 61 60 52 55 58 Stated docs 35 29 32 34 36 44 43 41 Average characteristics for funded broker loans Loan amt (×1000) 108 115 147 156 169 175 184 191 FICO 596 584 582 592 608 627 633 630 LTV (%) 72 70 76 77 76 70 66 67 Prepay penalty (%) 76 83 83 80 79 76 69 64 APR (%) 12.0 12.7 10.6 9.2 8.2 8.3 9.3 10.6 Mortgage rate (%) 10.3 11.1 9.7 8.5 7.7 7.6 8.0 8.9 Broker revenuesBreakdown of Broker Revenues Density Density

0 5000 10000 15000 20000 25000 0 5000 10000 15000 20000 Total broker fees in dollars Yield Spread in dollars Broker Fees Yield Spread Density

0 5000 10000 15000 20000 25000 Total broker revenue in dollars Total Revenues Broker Compensation by Vintage (% of Loan Amt)

1999 2000 2001 2002 2003 2004 2005 2006 All funded broker loans YSP 1.6 1.6 1.4 1.3 1.3 1.3 1.1 1.1 Total fees 2.9 2.7 2.4 2.2 1.9 1.7 1.4 1.4 Broker revenue 4.5 4.3 3.8 3.5 3.2 3.0 2.5 2.5 # brokers (× 1000) 4.9 5.3 5.9 9.8 15.3 21.3 26.7 29.4

In general, between product variation is smaller than variation across time. Loan Performance

Adjusted Delinquency Rate 40 1999 2000 35 2001 2002 30 2003 2004 2005 25

20 percent

15

10

5

0 0 6 12 18 24 months since origination Framework

• Interaction between broker and borrower, and broker and lender

• Broker and borrower bargain over terms of mortgage, subject to lender’s approval

• Lender sets yield spread and decides on loan funding

• Implemented as a stochastic frontier model as in Green, Hollifield, and Schuerhoff (2006), and Hall and Woodward (2009) Nash bargaining between borrower and broker determines loan terms

ρ 1−ρ maxl,r,f (f + y(P, l, r) − C) (ν(P, l, r) − f ) subject to • Funding by lender: (P, l, r) ∈ F • Borrower participation: ν(P, l, r) − f ≥ 0, • Broker participation: f + y(P, l, r) − C ≥ 0

ρ = 0 → The borrower has all the bargaining power ρ = 1 → The broker has all the bargaining power

Loan only made if the gains from trade are nonnegative: ν(P, l, r) + y(P, l, r) − C ≥ 0 Outcomes

Splitting the gains from trade:

(1 − ρ)(f + y(P, l, r) − C) = ρ (ν(P, l, r) − f )

Fees: f = ρν(P, l, r) + (1 − ρ)(C − y(P, l, r))

We observe the brokers’ revenues (fees+YSP):

f + y(P, l, r) = C + ρ(ν(P, l, r) + y(P, l, r) − C)

= C + Profits, Profits ≥ 0 Empirical Specification: f+y(P,l,r) = C+Profits

• Cost function (ij refers to broker and borrower pair):

0 2 Cij = γ Zij + ij , ij symmetric, N(0, σc )

• Profit function:

Profitij = ξij ∼ exponential with mean 1/λ(Xij ), where

Y βk Xij,k 1/λ(Xij ) = β0 e

• Stochastic frontier model: one sided error represents broker’s profits

0 fij + y(P, l, r)ij = γ Zij + ij + ξij

• Parameters identified from shape of broker revenue distributions Sample: Stand-alone first lien broker-orig loans

97-00 2001 2002 2003 2004 2005 2006 Loan program FRM 0.23 0.14 0.23 0.26 0.23 0.26 0.24 Hybrid 0.77 0.86 0.77 0.74 0.77 0.74 0.76 Loan purpose Purchase 0.30 0.24 0.22 0.28 0.32 0.30 0.39 Refi (cash out) 0.52 0.59 0.62 0.61 0.62 0.62 0.53 Refi (no cash out) 0.18 0.17 0.16 0.11 0.06 0.08 0.08 Documentation type Full 0.65 0.60 0.60 0.60 0.54 0.61 0.62 Limited 0.02 0.08 0.05 0.04 0.04 0.02 0.01 Stated 0.34 0.32 0.34 0.36 0.42 0.37 0.37 Average loan characteristics Loan amt (×1000) 106 141 154 173 183 183 161 FICO 588 578 586 600 609 603 599 CLTV (%) 77 78 79 82 82 80 83 D/I ratio (%) 27 28 28 28 29 28 28 Prepay penalty 0.75 0.83 0.81 0.81 0.75 0.70 0.64 APR (%) 12.3 10.8 9.3 8.2 8.1 9.1 10.8 Mortgage rate (%) 10.7 10.0 8.7 7.8 7.5 7.9 9.1 Conditioning Variables

Location Indicators: CA; Fl; TX; Midwest; Northeast West w/o CA; South w/o FL & TX

Year dummies for loans originated in 1998—2006 with 1997 as the baseline

Loan Characteristics: Loan amt ($); Interest Rate; CLTV +indicators for Hybrid; Limited Doc; Stated Doc; Prepay Penalty; Refi; Refi w/ cash-out

Borrower Characteristics: FICO; Age +indicators for FICO ≥ 620; One Borrower (vs. couple)

State Regulation: Anti-Predatory Laws: (i) Coverage, (ii) Restrictions Mortgage Broker Laws: (i) Index, (ii) Min. Financial Req.

Regional/zip-code Characteristics: House Price Appreciation over last 3 years from FHA index by census division Race, % White population by zip-code

Broker Experience: Indicator for 6+ months w/ NCEN Baseline Estimation Results

Cost Profit estimate std. err. estimate std. err. 2 log(σc ) 13.88 (0.006) Constant 3647.0 (38.22) 195.391 (11.333) FL -1077.0 (13.25) 0.416 ( 0.013) TX -1477.0 (13.15) 0.406 ( 0.013) West w/o CA -958.8 (12.53) 0.157 ( 0.010) South w/o FL, TX -1388.0 (11.89) 0.362 ( 0.011) MidWest -1300.0 (10.50) 0.215 ( 0.010) NorthEast -947.7 (12.28) 0.360 ( 0.010) 1998 -197.0 (41.47) -0.092 ( 0.033) 1999 -83.1 (40.83) -0.175 ( 0.032) 2000 79.0 (41.08) -0.290 ( 0.032) 2001 264.0 (39.71) -0.318 ( 0.031) 2002 425.5 (38.23) -0.285 ( 0.030) 2003 468.4 (37.85) -0.317 ( 0.030) 2004 594.6 (37.83) -0.334 ( 0.030) 2005 429.4 (37.95) -0.350 ( 0.030) 2006 290.8 (38.30) -0.450 ( 0.031) Baseline Estimation Results (cont’d)

Loan amount 0.889 ( 0.004) Rate 0.072 (0.002) Hybrid 0.283 (0.005) Limited doc 0.357 (0.024) Stated doc 0.192 (0.009) Prepay penalty dummy 0.264 (0.006) Refi 0.166 (0.008) Refi w/ cash out 0.140 (0.007) CLTV 0.002 (0.000) FICO -0.001 (0.000) FICO > 620 -0.001 (0.007) Borrower age 0.005 (0.000) One Borrower -0.033 (0.004) Regulation (coverage) -0.015 (0.001) Regulation (restrictions) -0.015 (0.001) Regulation (brokers, Pahl) -0.025 (0.002) Regulation (brokers, KT) 0.008 (0.001) Racial composition (% white in zip) -0.301 (0.008) Home price appreciation 0.217 (0.051) Broker experience 0.052 (0.004) Observations 381,333 381,333 Broker Revenue and Estimated Profits

Broker revenue 0.02

0.015

0.01

0.005

0 0 5 10 15 20 25 1000 US dollars

Broker profits 0.1

0.08

0.06

0.04

0.02

0 0 5 10 15 20 25 1000 US dollars Estimated Broker Profits: California

Mean Std. Dev. 5% 25% Median 75% 95%

All Mortgages

Revenue 7228.86 3400.15 2895.80 4832.00 6613.40 8950.00 13702.50 Profits 3152.17 3097.56 355.19 824.07 2070.44 4513.90 9457.39

Fixed Rate

Revenue 6385.03 3003.22 2520.00 4300.00 5850.00 7888.75 11979.50 Profits 2370.18 2580.25 289.88 584.22 1341.79 3300.43 7642.95

Hybrid Rate

Revenue 7481.43 3470.60 3055.00 5022.00 6860.00 9256.25 14120.00 Profits 3386.22 3199.42 389.01 941.70 2344.40 4853.85 9881.73 Documentation and Broker Profits: California

Mean Std. Dev. 5% 25% Median 75% 95%

Full Doc

Revenue 7030.38 3272.90 2860.00 4725.95 6425.00 8677.21 13250.00 Profits 2967.55 2961.58 344.19 776.23 1892.14 4224.10 8994.19

Limited Documentation

Revenue 7430.10 3511.13 2945.00 4951.00 6819.75 9221.50 14109.00 Profits 3338.83 3215.37 367.19 887.37 2274.59 4799.66 9851.77

Stated Documentation

Revenue 7750.56 3677.64 3007.50 5089.50 7147.50 9678.00 14907.75 Profits 3641.22 3406.43 401.63 977.80 2627.68 5259.93 10541.82 Prepayment Penalties and Broker Profits: California

Mean Std. Dev. 5% 25% Median 75% 95%

No Prepayment Penalty

Revenue 6806.25 3639.60 2307.50 4222.75 6062.50 8592.21 13711.50 Profit 2958.68 3218.92 301.92 652.80 1675.48 4215.34 9541.55

Prepayment Penalty

Revenue 7244.70 3389.85 2928.00 4850.00 6630.00 8960.00 13702.50 Profit 3159.42 3092.70 357.54 832.66 2084.20 4525.66 9457.05 Robustness

Estimation results for profit function are robust when cost function is allowed to depend on location and time dummies, as well as:

• the type of rates: fixed or hybrid (+),

• the documentation type,

• if the loan has a prepayment penalty (+), and

• if the loan is a refinance (+), or not. Broker Profits and Loan Performance

CA/Hybrid/FullDoc: Low broker profits CA/Hybrid/FullDoc: High broker profits 25 25 2003 2003 20 2004 20 2004 2005 2005 15 15

percent 10 percent 10

5 5

0 0 0 6 12 18 24 0 6 12 18 24 months since origination months since origination

CA/Hybrid/StatedDoc: Low broker profits CA/Hybrid/StatedDoc: High broker profits 25 25 2003 2003 20 2004 20 2004 2005 2005 15 15

percent 10 percent 10

5 5

0 0 0 6 12 18 24 0 6 12 18 24 months since origination months since origination Cox PPH Model w/ Mortgage Rates

Cox Proportional Hazard Model for 60-day Delinquency h(t|X ) = h(t) × exp(X β)

Variable Estimate Std. err. Variable Estimate Std. err. FL -0.200 (0.048) Prepay penalty 0.107 (0.019) TX -0.046 (0.045) Refi -0.035 (0.026) West 0.036 (0.040) Refi cash-out -0.080 (0.024 South 0.117 (0.041) CLTV 0.014 (0.001) Midwest 0.210 (0.039) FICO -0.006 (0.000) Northeast 0.093 (0.037) FICO geq 620 -0.144 (0.028) 2000 -0.179 (0.036) Borrower Age -0.011 (0.001) 2001 0.307 (0.041) One Borrower 0.176 (0.015) 2002 0.260 (0.041) % White Pop. -0.213 (0.028) 2003 0.312 (0.039) Brk Experience -0.006 (0.019) 2004 0.529 (0.037) Regs: coverg -0.043 (0.005) 2005 0.713 (0.035) Regs: restr 0.041 (0.004) 2006 0.690 (0.039) Regs: Pahl -0.018 (0.006) Log loan amt 0.009 (0.027) Regs: KT 0.009 (0.004) Hybrid 0.320 (0.021) HP Apprec. -0.153 (0.188) Limited doc -0.015 (0.046) Log brk profit 0.123 (0.014) Stated doc 0.136 (0.017) Rate 0.332 (0.008) Fees/Rev 0.270 (0.045) Observations 315,837 Summary

• Brokers extract profits. Example: FL loans, avg. revenues $4,400, profits $1,500 (34%) for FRM.

• Profits: • ↓ FICO • ↑ Limited doc; Stated doc; Refi; Cash-out refi; Hybrid; Prepay penalty • ↓ Stricter, more compreh. lending laws; stricter regulation of mortgage brokers, exception financial req’s • ↑ % minority in zip-code • ↑ Higher 3-year lagged house price appreciation

• Loan Performance: Loans that generate higher broker profits are more likely to become 60-day delinquent, after controlling for borrower and loan characteristics (+ other covariates)