Brokers are able to charge a lot per transaction because borrowers usually don't know at the outset how much the broker will make. If they find out, usually the deal is too far advanced to do anything about it.

Only the loosest relationship exists, furthermore, between broker charges and the amount of work the broker does for the borrower. The general rule is that brokers charge what the market will bear. Unsophisticated borrowers who visit a single broker will generally pay more than knowledgeable borrowers who shop alternative sources.

The Independent Contractor Model of the Industry: The dominant ideology of mortgage brokerage, as promulgated by the National Association of Mortgage Brokers and the various state associations, is that brokers are independent contractors. They view themselves as merchants who buy at one price and sell at another price, and how much they make on a transaction is no one's business but their own. The independent contractor model supports the view that brokers are entitled to make as much per transaction as they can.

The Independent Contractor Model Generates Distrust, Which Increases Costs: Distrust runs like a red line through the hundreds of letters I receive every month from borrowers relating experiences with brokers. And distrust translates into higher costs.

Brokers detest borrowers who flit from one broker to another, submit applications through multiple brokers, or pump them for information and then deal elsewhere. Yet these practices arise from attempts by borrowers to protect themselves against brokers they don't trust. Borrower reactions to distrust raise broker costs, which pressures brokers to make more per transaction, which generates more distrust in a vicious circle.

Other Fallacies of the Independent Contractor Model: The fact is that brokers are service providers, not merchants; they do not buy and resell anything. Furthermore, shopping mortgages is so difficult that few borrowers can do it effectively. Brokers are the experts at shopping mortgages, not borrowers. The optimal arrangement for most borrowers, therefore, is to purchase the shopping expertise of brokers for a fixed fee. Fortunately, it is now possible to do this.

The Agency Approach of Upfront Mortgage Brokers: Upfront Mortgage Brokers (UMBs) operate according to a different set of rules than the remainder of the industry. UMBs view themselves as the agent of the borrower, to whom they owe a fiduciary responsibility. A UMB agrees with the borrower on total broker compensation from the transaction, and passes through the best price from the broker's lenders.

The advantage of the UMB approach is that it breeds confidence, which lowers costs and increases productivity. I know UMBs who charge half the industry average per transaction but close 3-4 times as many loans. Their secret is a continuous stream of referrals from previous clients - and from me. They are listed on my Web site.

Implementation of the Agency Approach: The way to break the circle of distrust is to change the operating model, from independent contractor to agency. The broker trade associations will never do this, because they cater to the lowest common denominator of member opinion.

Government should but probably won't mandate the agency approach because it would be opposed not only by the broker associations, but also by the wholesale lenders, who are as short-sighted as the brokers. They support the independent contractor model in order to limit their own liability for broker misdeeds. The agency approach will have to win the battle in the marketplace, which it will, slowly but surely. When this was written, there were 113 UMBs, many with multiple loan officers.

The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.

Copyright 2005 Jack Guttentag