Christopher W. Backley
Jeffrey M. Niblack
Cynthia J. Pahl
Terrence C. Risbey
Published July 1, 2006 | July 2006 issue
Over the past 25 years, mortgage brokers have emerged as the principal points of contact between consumers and the mortgage industry. Some brokers have been accused of misrepresenting their clients’ interests, falsifying loan documents and committing fraud. The accusations raise doubts about the effectiveness of current industry regulation. Licensing may be a way to address these quality issues, yet this form of regulation may have the unintended consequence of increasing prices or restricting market access, particularly for already disadvantaged groups. This article examines the pros and cons of licensing, describes alternative regulatory approaches and provides cautious recommendations pending further study.
Interest rate volatility, widespread bank failures and capital market and information technology innovations in the 1980s moved the mortgage industry away from federally regulated banks and savings and loans to more specialized arenas. Today, about two-thirds of mortgage loan transactions transpire through third-party mortgage brokers who connect clients to products offered by mortgage banks and provide those clients with the necessary information to maneuver through the application process. Once an application is accepted and funded, the mortgage bank assumes liability for the transaction. The mortgage bank may service the loan directly or transfer servicing, and may also sell the mortgage itself to a securitizer who buys loans from mortgage banks, bundles them and sells them as securities to investors.1/ 2/
This transformation of the industry has been associated with important benefits. Home purchase loans to low-income borrowers increased by 80.4 percent between 1993 and 2001, compared with a significantly lower 48 percent growth in overall home purchase lending. Some research specifically credits mortgage brokers with helping borrowers get better loan terms.3/ The growing sophistication of the industry added flexibility and concomitant complexity to the market, notably in the form of subprime mortgages. The additional flexibility was a boon for many high-risk applicants who were once denied access to credit.
Unfortunately, the growing complexity of the mortgage industry has given unscrupulous mortgage brokers the opportunity to exploit consumers. While this exploitation, commonly referred to as “predatory lending,” is profitable for the mortgage broker, the consequences for the borrower are often devastating. The costs of predatory lending have been estimated at $9 billion a year,4/ creating the perception that policy intervention in the form of heightened regulation may be necessary. One increasingly widespread regulatory approach, occupational licensing, could have both positive and negative effects on consumers. (See the sidebar below for more on the increase in occupational licensing.)
Occupational licensing could benefit consumers by improving the quality of the mortgage broker industry through gate keeping, behavioral changes and eased enforcement. Gate keeping refers to the fact that requiring mortgage brokers to pay fees, complete educational programs and pass licensing tests can keep some negative elements out of the industry by weeding out incompetents and discouraging impatient scam artists. Licensing might also change the behavior of those who do enter the industry. Required educational components or formal codes of conduct could incline or enable brokers to behave more positively. Finally, licensing and codes of conduct might make enforcement easier. Rather than prosecuting through the judicial system, licensing boards would have their own procedures for investigating complaints and revoking licenses. In theory, licensing provides a quick, easy, affordable way to stop bad apples from practicing.5/
However, the same measures put in place to improve quality could lead to cost increases that tend to reduce competition in the industry. These increases will likely be passed on to consumers through higher fees. In states that require licensing of both the firm and its loan originators,6/ a firm’s total fees for licensing and educating its brokers can quickly accumulate. For example, licensing and examination fees in Wisconsin total $400 per individual.7/ Continuing education costs are substantial as well; a test review course and accompanying textbook can cost $430.8/ If the firm operates in multiple states, it could pay similar fees several times per broker. These costs may reduce the supply of brokers, forcing some firms to reduce staff or close. Barriers to entering the profession may be especially steep for low-income individuals who seek to open small brokerage firms.
In creating public policy on occupational licensing, policymakers must carefully balance the potential quality benefits against the costs of barriers to entry and decreased competition. The balance can be delicate; in several professions the apparent effects of occupational licensing on objective quality outcomes have been meager.9/
In addition to keeping the critical quality-vs.-cost balance in mind, policymakers considering an occupational licensing scheme for mortgage brokers must address two key, practical questions: Who should be licensed—the firm only, or a combination of the firm and all loan originators within it? And what level of government is equipped to carry out the licensing?
In regard to the question of who should be licensed, state policies vary.10/ Twenty-eight states license the firm only. General reasoning for this policy is that firms can be punished for the actions of individuals within their organizations, so firms will police their employees through internal policies and regulations that conform to state and federal laws. Furthermore, firms are less mobile and more wealthy than individuals, making it easier to enforce license revocation or seek damages when necessary. Many of these 28 states impose additional standards on employed brokers, short of formal licensing, such as continuing education, registration, or licensing for independent contractors. Eighteen states go further, licensing not only brokerage firms, but also the individual brokers they employ.11/ 12/ Theoretically, this approach prevents unethical individuals from moving to other firms.
Regarding the second key question, licensing policies are currently carried out by states. However, federal legislation is occasionally proposed. Since many large firms work in multiple states and are subject to multiple, diverse requirements that increase their business costs, federal licensing could simplify regulations and alleviate cost increases by imposing uniformity. However, the idea of federally imposed uniformity raises the question of whether states would have the power to adjust regulations and licensing requirements based on their own needs. To balance the benefits of uniformity and state innovation, a coalition of state regulators is working toward a national, cooperative licensing system that will promote efficiency and make it easier to identify and punish fraudulent behavior in the mortgage industry. (See the sidebar below for more information.)
As indicated above, the two most common policies adopted by states are to license either brokerage firms alone or the brokerage firm and all of its brokers. What does a comparison of the two approaches reveal about their effects on quality and competition?
To explore that question, we turn to a brief analysis of licensing policies in the Ninth District states of Minnesota and Wisconsin. The two states have similar mortgage markets, but different licensing policies and histories.
In 1988, Wisconsin implemented a policy of licensing mortgage firms and individuals within them. In 1999, Minnesota adopted licensing of firms only. Working with the limited amount of mortgage industry data available, and assuming for our purposes that Minnesota and Wisconsin mortgage markets are nearly identical, we can compare indicators of policy success to shed light on the effectiveness of licensing for the mortgage broker industry.
If foreclosures are viewed as a problem caused partially by predatory lending and poor advice given by bad mortgage brokers, foreclosure rates would change with changes in the quality of services. When each state adopted licensing, its foreclosure rate fell. Also, the gap between Wisconsin’s generally higher foreclosure rates and Minnesota’s rates was smaller during the period when both Wisconsin’s strict licensing scheme and Minnesota’s relatively lax policy were in place than in the period before 1988 when neither state had licensing. This tentative finding suggests licensing improves the quality of the mortgage broker industry and that licensing individuals might confer additional benefits above licensing firms alone.
Theoretically, a licensing policy for employed brokers could lead to harmful effects for both firms and consumers—partially through increased costs, but mainly through the elimination of brokers from the market. Some of the costs associated with licensing, such as license fees and educational expenses, are easily documented. However, the increased direct costs to the consumer and indirect costs to the firms are not. With the current licensing mechanisms in place, there are fewer mortgage brokers in Wisconsin, with .32 brokers per 1,000 owner-occupied housing units compared to .52 brokers per 1,000 owner-occupied housing units in Minnesota. This suggests licensing individuals is a significant barrier to entry. However, Wisconsin has only slightly fewer mortgage applications than Minnesota and a similar number of subprime mortgage applications, implying that when the number of brokers decreases, access to credit does not.
When one considers minority participation in the subprime lending category, people of color experience significantly higher denial rates in Wisconsin than in Minnesota. This finding could indicate that these communities are underserved due to a relative shortage of mortgage brokers and the guidance they provide.
A more thorough analysis of these disparate pieces requires further data (including time-series studies) and research, and our results here are more suggestive than conclusive. But as they stand, our findings indicate licensing may have effects on quality and on market price and quantity.
One complication policymakers face when making decisions about licensing is the apparent difficulty of reversing licensing policies. Given the difficulty, it seems valuable to consider other viable regulatory strategies as complements to or substitutes for licensing. The benefit of these alternative policies is their minimal restriction on consumer choice. Of course, as with licensing, the benefit can depend critically on the details of program criteria and enforcement.
Registration can be an unobtrusive and inexpensive system for providing consumers with at least minimal information about mortgage brokers. A typical registration policy would require individuals to file their name, address and qualifications with a specified government agency before practicing within a particular state.
Eight states have a more legally binding form of registration that begins to resemble licensing of individual brokers.13/ 14/ Indiana, for example, mandates that brokerage firms submit the names of their employed brokers, along with proof that those brokers have completed educational requirements. This differs from individual licensing in that the firm is responsible for submitting applications and remains the object of punishment or enforcement. A light variation of registration is identification, in which the brokerage firm is required to submit the name of and a small amount of additional information about each broker to the state. New Hampshire requires identification.
Certification refers to a voluntary system of either national or state standards that requires a level of initial and continuing education for brokers. Although certified individuals gain exclusive rights to the title granted to the profession, noncertified individuals are not barred from identifying themselves by alternative titles or competing for business with certified brokers. Certification provides potentially useful information to consumers about providers’ qualifications while still allowing them to hire a noncertified individual at a possibly cheaper rate. No states currently sponsor certification for individual mortgage brokers, but the National Association of Mortgage Brokers offers a certification plan that requires an application and the successful completion of an exam.
Mounting evidence of negative behavior in the mortgage industry suggests continued government regulation of mortgage professionals. However, our empirical analysis and the theoretical issues discussed above suggest the importance of caution in the adoption of additional regulation, so as to minimize undesirable anticompetitive effects. With that in mind, we suggest the following:
1) Intensify current enforcement mechanisms to more effectively combat predatory lending.
Enforcement agencies need political support, effective organizational structures, and steady and adequate resources to better implement existing mortgage broker regulation. Revenue streams generated by licensing, which are often diverted into a general revenue pool, could be used, in part, to improve enforcement of the mortgage broker industry.
2) Improve data on complaint rates, foreclosures, license revocations, trends in license applications and other industry markers in order to more easily analyze the extent of problems and the effects of regulation.
Changes to the data collected under the Home Mortgage Disclosure Act would provide tremendous benefit, particularly if more detailed background information on individual loans—for example, data on whether a broker was involved in a loan transaction—becomes available. Greater centralization of data would also help, since data are currently fragmented across numerous government agencies.
3) Seriously consider the alternatives to licensing discussed above, such as certification.
4) Seek neither rapid expansion nor significant rollback of individual mortgage broker licensing at this time, but revisit the issue if future studies more conclusively show whether quality benefits exceed or fall short of costs.
In other professions, licensing is rarely reversed, the positive effects of licensing on quality often fade over time, and barriers to entry typically increase as licensing requirements grow progressively stricter. Given that the preliminary data analysis here suggested only modest quality gains under the licensing of employed brokers, we cannot recommend stricter regulation of the mortgage industry at this time.
If future studies based on expanded data confirm the initial findings that licensing has a positive effect on quality (e.g., declining foreclosure rates or fewer complaints filed), broader licensing of individual brokers should be reconsidered. However, this recommendation comes with a critical caveat: Changes should include steps to mitigate the negative impacts of any increased licensing on minority and low-income communities, particularly in regard to potential limits to professional advancement or access to credit.
Christopher W. Backley, Jeffrey M. Niblack, Cynthia J. Pahl, Terrence C. Risbey and Jeff Vockrodt are graduate students at the University of Minnesota’s Hubert H. Humphrey Institute of Public Affairs.
1/ M.G. Jacobides, “Industry Change Through Vertical Disintegration: How and Why Markets Emerged in Mortgage Banking,” Academy of Management Journal 48(3), 2005.
2/ Brokers also sometimes fund loans initially and resell them.
3/ Amany El Anshasy, Gregory Elliehausen and Yoshiaki Shimazaki, “Mortgage brokers and the subprime mortgage market,” Proceedings, Federal Reserve Bank of Chicago, April 2005.
4/ E. Stein, Quantifying the costs of predatory lending: A report from the Coalition for Responsible Lending, July 25, 2001 (revised October 30, 2001).
5/ In practice, states need to close loopholes that allow brokers to practice without a license. By its nature, detailed information on the number of brokers operating without licenses is difficult to obtain.
6/ States differ in how they refer to brokerage firms and the individuals who work for them. In Wisconsin, for example, the firm is licensed as a “mortgage broker” and the individuals within the firm are generally “loan originators.”
7/ Wisconsin Department of Financial Institutions, State of Wisconsin: Loan Originator and Loan Solicitor Handbook, 2005.
8/ Wisconsin Association of Mortgage Brokers, Educational Opportunities, 2005.
9/ Morris Kleiner, Licensing Occupations: Ensuring Quality or Restricting Competition? Upjohn Institute for Employment Research, 2006.
10/ The descriptions of licensing policies presented here are accurate, to the best of our knowledge. However, it is important to note that licensing policies can change frequently and distinctions among them can be subtle.
12/ These 18 states have specific policies that require licensing of W-2 employees of licensed firms. The states are Arkansas, California, Florida, Hawaii, Idaho, Louisiana, Maryland, Montana, Nevada, North Carolina, Ohio, Oklahoma, South Carolina, Texas, Utah, Washington, West Virginia and Wisconsin. Two states— New York and New Mexico —have stricter versions of registration for firms only; Alaska and Colorado license neither firms nor their broker employees.
14/ These states are Connecticut, Illinois, Indiana, Kansas, Kentucky, Mississippi, Nevada and New Jersey.
Public interest vs. industry capture: The rise in occupational licensing
Occupational licensing is an increasingly important policy, as the number of occupations licensed by federal, state and local governments continues to rise.1/ Policy analysts offer two main explanations for the rise in occupational licensing: public interest and industry capture.
The public interest theory holds that “consumers demand regulation to correct the problems caused by market failure,”2/ with the alleged market failure frequently being inadequate information about the quality of services. Policymakers may respond to these demands by requiring occupational licensing in order to signal quality. For occupations in which the potential damage to consumers can be very high—such as mortgage brokering, in which inappropriate mortgages could cost consumers their homes—the public interest theory helps explain consumer demand for occupational regulation.
In contrast, capture theory holds that professionals “often expend considerable resources in an attempt to convince legislators that regulation will benefit the public,” when in fact they seek regulation mainly “to protect themselves from competition and thereby increase their incomes.”3/ In short, those already in the profession may support licensing to keep new competitors from entering the market. Both motives—public interest and industry capture—can be at work, and both effects—improved quality and reduced competition—can result.
1/ Morris Kleiner, Licensing Occupations: Ensuring Quality or Restricting Competition? Upjohn Institute for Employment Research, 2006.
2/ C. Cox and S. Foster, The costs and benefits of occupational regulation, Bureau of Economics, Federal Trade Commission, October 1990.
National Mortgage Licensing System is in the works
Regulations governing mortgage lenders and brokers developed rapidly after the fall of the savings and loan industry and vary widely among states. Currently, there is no central repository to collect and provide information about lenders’ and brokers’ backgrounds and service histories. The lack of centralization leaves many regulators, consumers and law enforcement agencies without convenient access to information on incompetent or potentially dishonest mortgage service providers.
In late 2004, two national organizations of mortgage regulators launched an effort to address the issue. The Conference of State Bank Supervisors (CSBS) and the American Association of Residential Mortgage Regulators (AARMR) joined forces to develop a national licensing system and database for the mortgage industry. The goals of the National Mortgage Licensing System (NMLS) are to give consumers convenient access to mortgage service providers, lower the incidence of mortgage fraud, increase accountability in the industry and reduce unnecessary administrative duplication.
The NMLS will provide uniform mortgage applications that meet the requirements of all states. It will also serve as a central repository of information on qualifications, licensing status and enforcement actions for all state-licensed mortgage brokers, loan originators and lenders. Mortgage service providers operating in states without licensing requirements will have the opportunity to submit information voluntarily. Consumers, regulators and licensed service providers will have access to various areas of the database, depending on their needs and the nature of the information.
Supporting partners in the CSBS-AARMR effort include the Residential Mortgage Regulatory Task Force, a group representing mortgage regulatory agencies from 20 states (including the Ninth District states of Montana and South Dakota); a mortgage industry work group that includes investors, lenders, brokers and private mortgage insurance companies; and the National Association of Securities Dealers, which is developing specifications for the licensing system.
The effort’s sponsors hope to debut the completed NMLS by early 2008. Notable accomplishments as of Summer 2006 include conducting a survey of state mortgage regulators and designing uniform mortgage application forms for use by lending and brokerage companies, branch locations, control persons and individuals. The forms are already in use in several states.
For more information on the NMLS, contact Bill Matthews, senior vice president of mortgage products for CSBS, at (202) 728-5711 or firstname.lastname@example.org.