The following I read on Freakonomics blog.

Blog reader Chris Harris raises an interesting question in an email to us: Why do mortgage brokers get paid everything up front when they originate a deal?

This sort of contract gives brokers terrible incentives. They just want to get a deal done. It matters very little to them whether the borrower eventually defaults or not. (It is possible that if their clients always go into foreclosure, then the lenders with whom they work will steer clear of them; but since most loans are sold off by the originating banks anyway, this mechanism is likely to be a very weak form of discipline.) We’ve written in the past about my student Zahi (Itzhak) Ben-David’s work on real estate fraud and the role that mortgage brokers played.

Chris Harris offers a simple solution to the problem: instead of paying mortgage brokers a lump sum when the deal closes, have them pay a small amount out of every mortgage payment. That way, the mortgage brokers will have a disincentive to initiate high-risk mortgages that are likely to default.

One has to be a little careful with this sort of solution, however, because if you pay the mortgage brokers a percentage of the mortgage payment, they will have an incentive to make the mortgage payment as high as possible, which is definitely not a good idea.

A simple alternative is to make the mortgage broker’s monthly payment a fixed percentage of the value of the loan. This isn’t perfect either, but it might be a step in the right direction.

Any thoughts?

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