Jack M. Guttentag The Mortgage Professor

Because the mortgage market has slowed in recent months, loan providers (lenders and mortgage brokers) find themselves with excess capacity. Rather than go out of business or fire loan officers, many have taken to purchasing mortgage leads.

What Are Mortgage Leads?

Mortgage leads are packets of information about consumers -- consumers loan providers can hopefully convert into borrowers. Leads have value based on the likelihood of their becoming closed loans. If you were attracted by an ad such as “Mortgage rates as low as 1%” and filled out a questionnaire about yourself in response, you're a lead.

The questionnaires ask about the things that matter to a lender in assessing a loan, including income, employment, credit, house price, and loan amount. They also ask for identifying information including telephone numbers and email addresses. The more information, the more valuable the lead, but lead generators are fearful of asking for so much that the prospect gets discouraged and aborts the process.

Leads Before the Internet

Before the Internet, leads were usually generated by loan providers themselves, poring over public records to find borrowers who might want to refinance. The public records would show homeowners who had mortgages carrying interest rates above the current market. The pitch to the lead was basic and often persuasive. For example, “You have an 8% mortgage, I can get you one for 6.5%, which will save you $X a month.”

When interest rates rose, this type of lead activity largely disappeared. While refinancing for the purpose of raising cash (cash-out) continued, there was no easy way to identify in advance which borrowers might be interested.

Internet-Generated Leads

With the development of the Internet, the lead business changed dramatically. Most leads are now generated not by loan providers but by lead specialists who may know very little about mortgage lending. When they say, “We don’t care how bad your credit is,” they're telling the truth -- they don’t care because they're not the ones who'll lend you money. Of course, the loan providers who buy their leads do care.

The leads business has become specialized because the skills required to harvest large numbers of leads at very low cost on the Internet have nothing to do with mortgage lending. The effective lead generators are skilled at developing marketing pitches, at the placement of ads in search engines, and at finding ways to slip their direct email messages past the surveillance of spam filters.

Where leads in the era before the Internet only targeted borrowers who could refinance into a lower rate, Internet-based leads cover a wide range of possible consumer concerns. For example, consumers with lots of non-mortgage debt might be enticed with “Pay off high-interest credit cards.” Consumers struggling to make their mortgage payments might succumb to “Payment options starting at 1%.” Borrowers with adjustable rate mortgages who are worried about rising future payments might be receptive to “Rates are rising, lock in a fixed rate today.” Consumers anxious about their credit may be mollified by “Credit not perfect, no problem."

Whether the loan providers to whom the leads are sold will be able to deliver on these promises is wholly irrelevant to the lead generator. The purpose of their message is to generate leads, period. I'm reminded of the wonderful ditty by Tom Lehrer about the rocket scientist, Wernher Von Braun: “'Once the rockets go up, who cares where they come down. That’s not my department,’ says Wernher Von Braun.”

Why You Should Not Respond to Leads

Lead generators have no responsibility to borrowers, and offer no warranties about the loan providers to whom they sell leads. Since the “bad guys” in the industry get few referrals from satisfied customers and business contacts, they're much more dependent on leads than the “good guys.” And that means that consumers who become leads and respond to the loan providers who contact them face adverse selection. In responding to a solicitation, their chance of getting a predator is greater than if they opened the yellow pages to “mortgages” and threw a dart at the listings.

If you made one mistake by becoming a lead, don’t make a second one by responding to a solicitation.

How Do Leads Differ from Referrals?

The basic economics of leads and referrals are virtually identical. For example, assume I place an ad on my web site that entices readers to enter information about themselves, which I then sell to loan provider LP for $10 per lead. Also assume that 10% of the leads result in a closed loan. This means that in obtaining loans through me, LP has a marketing cost of $100 per closed loan.

Now suppose that instead of doing it this way, my deal with LP is that he pays me $100 for every lead that results in a closed loan, otherwise nothing. Instead of 10 payments of $10 each, I now receive one payment of $100, but over time the same amounts change hands.

Although the economics is much the same, the law sees the two approaches very differently. The $100 payment contingent upon a loan being closed would be an illegal referral fee under the Real Estate Settlement Procedures Act (RESPA). In contrast, the sale of a lead is not directly related to a real estate transaction, and is not therefore subject to RESPA. Given that the purpose of the RESPA restriction is to protect borrowers from being overcharged, is there are any reason for treating referrals and leads differently?

(Note: The above paragraph was criticized by several lawyers familiar with RESPA. Because my interpretation is not central to my argument, I've placed their legal points in a note at the bottom of this column.)

Borrowers May Be Better Served by Referrals

Lead generators -- the ones who entice you with promises of fantastic mortgages at rock-bottom rates -- accept zero responsibility for the actions of the loan providers who are supposed to redeem the promises. Those who refer borrowers to loan providers for a fee, in contrast, may accept some responsibility to the borrower.

The lack of responsibility of lead generators reflects the largely impersonal nature of this market. Lead generators typically sell to any loan providers willing to pay their price. Leads are often sold to more than one loan provider, and increasingly there's an intermediary between the lead generators and the loan providers. If a loan turns out badly for the borrower, there are seldom any recriminations for the lead generator, who is remembered by the borrower, if at all, as a glitzy web site with no face.

In contrast, those who refer a borrower to a loan provider will typically have a relationship with the loan provider. If the loan sours, the borrower will know and likely blame the person who directed him to that loan provider. Disgruntled borrowers will not refer their friends to real estate agents or others who refer them to bad loan providers. As a result, referrers often have a long-term business interest in having their referrals vindicated by the favorable experience of borrowers.

This doesn’t mean that a referrals system works well in protecting borrowers -- it doesn’t, but it does offer some protections where existing leads systems offer none. Discouraging referrals by outlawing referral fees while leaving the leads market free is perverse. I'm not arguing that the leads market be regulated, heaven forbid, but restrictions on referral fees should be removed.

Emergence of a Different Type of Lead Generator

To date, the development of the leads market has not benefited borrowers because the lead generators (hereafter “LGs”) accept no responsibility for the actions of the loan providers, or LPs. But it doesn’t have to work that way.

An LG could elect to deal only with LPs who commit to follow well-defined standards of behavior, and allow themselves to be monitored by the LG. This is a more costly way to operate, as the LG would have to negotiate deals with each LP, but the payoff would be substantial.

The LG, instead of attracting leads through glitz and deceptive promises, could offer real guarantees regarding the operations of the LPs. Since the lead provides a benefit to the borrower, more borrowers would sign up, and a larger proportion would convert themselves from leads to borrowers.

Wholesale Prices and Markups

Like automobiles and TV sets, home mortgages have wholesale prices. These are the prices quoted by a small number of large lenders or “wholesalers” to the many thousands of smaller lenders and brokers who deal directly with borrowers. Like automobile dealers, retail loan providers formulate their own price to the borrower by adding a markup to the wholesale price.

Wholesale Price + LP's Markup = Price to Borrower

Like automobile dealers, mortgage loan providers don’t ordinarily disclose their wholesale prices because that reveals their markup, which is their gross profit on a transaction. Amerisave is the first mortgage lender to deviate from that practice.

Amerisave discloses its wholesale prices and markups to its customers. It sets markups based solely on loan amounts, not with the borrower’s credit, down payment, type or location of property, or anything else.

How Uniform Markups Protect Borrowers

All the abuses to which borrowers are subjected have the objective of increasing the loan provider’s markup. Here are five of the most common:

Overcharging: Many loan providers charge what the market will bear, which means that borrowers who are naive and trusting and don’t shop alternatives will pay higher markups than knowledgeable and aggressive shoppers.

Market niche misclassification: Borrowers are sometimes classified as belonging to a higher risk category than is in fact the case, which increases the markup. Borrowers who are erroneously classified as subprime get whacked twice, since the wholesale prices on subprime loans are higher, and markups are also higher.

Price low-balling: Loan providers sometimes deliberately quote a very low price in order to “hook” borrowers who are shopping. Later on, the low price disappears because (allegedly) the market changed, or the lender discovered fees that were not mentioned before, or for a dozen other reasons.

Price omissions: Fixed-rate mortgages ordinarily have three price components -- the interest rate, points, and fixed-dollar fees -- while adjustable rate mortgages have more. Loan providers quoting prices sometimes omit one or more price components until it is too late for the borrower to do anything about it.

Markups on third-party charges: Some lenders add a markup to third party charges such as appraisal fees or credit report charges. The borrower is billed for these charges without knowing about the markups.

If the LP’s markup on a loan of given size is disclosed to the borrower, there can be no tricks. The borrower who is a smart lion and the borrower who is a naive lamb will pay the same markup. Of course, their wholesale prices could be different, which would result in a different price.

Legal Postscript

I made the point earlier that the distinguishing difference between a legal “lead” and an illegal “referral fee” was whether the payment made by the loan provider was for information about a potential borrower, or for information that resulted in a loan closing. Two lawyers familiar with RESPA tell me that that's not the distinguishing difference, though they don’t agree on what is.

One says that the key difference is whether or not the payment is made to a professional engaged in the real estate business. In this view, payments to professionals are illegal referral fees, no matter how they are made. On the other hand, “If you or I were to go into the business of selling names of potential borrowers to lenders, the payments for our services would not be a RESPA violation, even if made on the basis of closed loans.”

The second lawyer says that the difference is whether or not the party receiving the payment has affirmatively influenced the selection of the loan provider. This says that if I sell information about a potential borrower to a predatory lender, so long as I don’t tell the potential borrower anything about the lender, it is a lead. If I direct the potential borrower to a lender who I recommend because of his integrity and good pricing, it is a referral.