Chalke, president of Mortgage Harmony Corp., has written an op-ed about the "disposable" nature of today's mortgages and why he thinks loans need to be more "durable."
Something's not quite right in the mortgage business. I'm not talking about the obvious relaxation of underwriting standards in recent years (now corrected a bit too much), but something deeper-something fundamental to the business itself. During the past 20 years, the residential mortgage has become disposable. The consumer keeps a product only as long as it remains fashionable and rates don't move too much. Should product trends change or rates move, borrowers toss their mortgage aside like an old suit and obtain a new one. We all know this, but the fundamental issue continues to fester.
It seems odd that the investor makes a 30-year commitment every time a mortgage is sold; yet today's products are not more durable from the consumers' perspective. This asymmetry in the residential mortgage ultimately is baked into the price by investors, and in the long run consumers lose.
Many have blamed loan officer compensation for the perpetual mortgage churn that occurs when rates drop. This certainly is a part of the problem. Since loan officers are paid on a transaction basis, we can expect a lot of transactions. In some ways this is similar to the problems the financial service industry faced with stockbroker compensation a generation ago. Brokers were paid on a transaction basis, and transactions are what we got. Portfolio churning emerged as a big issue, and stockbroker compensation gradually transformed from transaction-based commissions to "wrap fees," a form of recurring compensation independent of transaction frequency.
Recurring compensation models bring significant long-term advantages to the value chain, most notably the alignment of incentives. In the case of stockbrokers, the move to recurring compensation aligned the interests of the consumer and the broker. This compensation change happened gradually, but enabled profound changes in the relationship between the consumer and broker. In fact, stockbrokers are now universally called "financial advisors."
The transformation in loan officer compensation from purely transaction based to recurring compensation is inevitable. However, as in the investment advisory space, this shift will require changes in product design.
Unlike the investment advisory market, the primary misalignment of incentives in the mortgage industry is between the investor and the loan officer. Loan officers, by and large, move consumers to cheaper products when economic conditions allow. This is generally in the consumer's best interest. However, it is this very process that curtails returns to the investor. In past generations, investors relied on consumer inefficiency in the pricing of loan products. Significant resources were (and still are) devoted to analyzing prepayment behavior in attempts to quantify this inefficiency. However, in recent years, much of this behavioral inefficiency has been driven out of the market. When rates drop, consumers who remain creditworthy refinance as fast as the loan officer's queue permits.
If there's any chance of moving loan officers to recurring compensation, we must develop products that allow the loan officer to credibly retain consumers within a single product. The product needs to be durable enough to last.
For starters, the mortgage product must perform at least as well as the series of products that borrowers typically buy today. Let's look at what borrowers do-they purchase a fixed rate loan, and whenever rates drop by any appreciable amount (say, 50 basis points or more), they refinance to a new loan. This series of transactions becomes the benchmark for financial performance for the consumer, since the borrower can always refinance should the new product not provide similar or better value. This is the only way that loan officers can, in good conscience, manage the customer over time within a single product.
How will this new product design work? Well, to mimic current borrower behavior, we're talking about a mortgage where rates fall when market rates fall, but rates DO NOT increase when market rates rise. This one-way adjustable fixed rate loan is precisely what consumers buy today. They just buy it with a series of loan purchases rather than within a single vehicle. Loan officers have become quite efficient in packaging this "product" for consumers through strategic refinancing.
Such a product would allow for the introduction of recurring loan officer compensation, since the loan officer would not be compelled to move the client to a new product whenever rates fall. With a much longer expected life, this durable mortgage would allow the loan officer to accrue the economic benefit of the trail commission.
Interestingly, the recurring compensation model is not only workable with a durable mortgage product, it is actually required by the marketplace. Past experiments with one-way adjustable products (usually referred to as "modifiable mortgages") have generally been unsuccessful because loan officers do not want to sell them. Loan officers may spend years of effort building a book of business, and much of their future economic value is in continuing to service this book of business.
Traditional loan products leave intact the future income to the loan officer from future refinancing. However, one way adjustable loans are designed to transcend future interest rate environments, so by their very nature diminishing the loan officer's future income stream. It's understandable why loan officers have shunned these product experiments in the past. I believe the reaction is quite similar to the financial advisor community's reaction to immediate annuities-loss of future income from that portion of the portfolio is undesirable, and even led the moniker "annuicide!"
In fact, lenders experimenting with proactive loan modification to conserve business are a great risk of alienating their distribution systems. We're seeing this effect now, with brokers in particular steering away from lenders who might reduce interest rates post-origination without the participation (economic or otherwise) of the original salesperson.
Recurring compensation models rectify the loan officer acceptance problem. If the loan officer sees ongoing economic value from his or her book of business, they'll be much more sanguine about placing customers in a more durable product. In fact, any loan officer knows the nature of their "feast or famine" world. When rates rise, they work hard for purchase money transactions. Yet when rates fall, they can barely keep up with their book of business, even while working long hours. Research shows the ability to smooth out both income and workload is quite desirable.
Sales compensation and product design must move together. Recurring compensation models don't stand a chance without more durable product designs. More importantly, durable product designs don't stand a chance without recurring compensation.
