Economic commentary: Mortgage brokers and fair lendingStanley D. Longhofer and Paul S. Calemfair lending laws, brokers, lenders, compliance
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necessarily those of the Federal Reserve Bank of Cleveland, the
Board of Governors of the Federal Reserve System, or The Mortgage
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Mortgage Brokers play an important role in the housing-finance
market, but they also present unique challenges to regulators
attempting to enforce fair-lending laws. Should lenders be held
responsible for the pricing decisions of brokers from whom they
receive loan applications, or should fair-lending laws instead be
applied directly to the brokers themselves?
Fair-lending issues have gained new prominence over the course
of the last decade. Spurred in part by the controversial findings
of the now-famous "Boston Fed Study,"1 financial institutions have
come under more intense scrutiny over compliance with fair-lending
laws, with the Department of Justice taking action in more than a
dozen lending-discrimination cases since 1990.
Although the initial focus of these investigations was primarily
on whether lenders illegally discriminate in the course of their
underwriting decisions (that is, on relative denial rates), recent
efforts have targeted bias in the pricing of mortgage loans.
The traditional mortgage loan origination process involves a
lender with in-house (retail) loan officers who both collect the
information that is used to make the underwriting decision and
negotiate the ultimate price of the loan with the borrower.
Many mortgage lenders, however, also originate loans that are
solicited by outside independent Mortgage Brokers. Such "wholesale
lending" presents unique challenges for the enforcement of
In this Economic Commentary, we discuss the role of brokers in
the housing-finance market, focusing on the question of how
responsible lenders should be for the pricing decisions of
independent Mortgage Brokers. Although recent investigations by the
Department of Justice appear to be based on the principle that
lenders should be completely accountable for the actions of their
brokers, we argue that this policy may be misguided.
In contrast to a lender's relationship with its in-house loan
officers, with wholesale loans it is the broker and not the lender
who negotiates the price the borrower pays on the loan.
Furthermore, the relationship between the broker and the lender is
typically "arms-length," implying that the difference between the
price charged by the broker and the wholesale price is not, in any
way, controlled or influenced by the lender. Therefore, we question
whether a lender should be held accountable for patterns that may
emerge in the prices brokers negotiate with borrowers. Further, we
are skeptical that one can conduct an adequate statistical
evaluation of broker pricing practices using only data obtained
from a single lender, in part because the typical broker deals with
multiple lenders. As a result, we believe it is unreasonable to
hold the lender accountable for the pricing decisions of its
brokers. Instead, we argue that fair-lending investigations into
the pricing of brokered loans should be targeted at the root source
of any discriminatory behavior: the brokers themselves.
An overview of mortgage pricing
In order to investigate an institution's pricing decisions,
regulators must first confront the question of how to measure the
mortgage's "price." As was argued in a previous Economic
Commentary, the proper tool for conducting such investigations is
through statistical comparisons of "overages" paid by different
groups.2 Essentially, an overage is calculated by comparing the
up-front fee (the number of "points") a borrower actually pays on a
loan with that listed on the lender's rate sheet on the day the
borrower's interest rate is locked (the "required price").3 This
comparison would take into account regional location, the length of
the borrower's rate lock, the size of the loan, and any other
elements according to which prices may be arrayed on the rate
To evaluate an institution's compliance with fair-lending laws,
examiners calculate the overage charged each borrower, and then
compare the frequency and magnitude of overages charged to
minorities with those charged to similarly situated white
borrowers.4 Raw differences in pricing across racial groups would
not constitute evidence of illegal discrimination in and of
themselves. Rather, these differences must remain statistically
significant even after controlling for other factors that might
reasonably affect loan prices.
When a loan is originated through a broker, the process of
calculating an overage is essentially the same. As with their
direct loans, wholesale lenders provide brokers with a rate sheet
listing the prices at which they are willing to underwrite loans
during a given time period, and they generally have a standard set
of origination fees they charge on brokered loans.
However, there are important differences between brokered and
direct lending that make testing for discriminatory lending
patterns in brokered lending a fundamentally distinct exercise.
First, in brokered lending, the actual origination and discount
points charged, as well as the nominal interest rate, are set via
negotiations between the borrower and the broker, not the wholesale
lender that underwrites the loan. Second, in most cases the broker
is able to keep any excess points that it is able to charge a
borrower over that required by the lender's rate sheet. In other
words, the broker is the full beneficiary of any overage paid by
the borrower. The lender does not share in the overage. Third,
brokers generally are not bound by exclusivity agreements with
lenders. The typical broker deals with several different lenders
simultaneously, selling each loan to the lender that offers the
best price on any given day. As we shall see, these features of
wholesale lending have important implications for the
interpretation of brokered-loan pricing patterns in data from an
One lender's story
Consider the case of Acme Mortgage Company, a hypothetical mortgage
bank that works with a large number of brokers to solicit business.
Suppose that in their analysis of Acme's brokered lending
portfolio, bank examiners find that black borrowers pay overages
more frequently, resulting in a pricing disparity of 1.5 points
between white and black borrowers, even after controlling for other
borrower and loan characteristics that might legitimately and
legally influence the prices of these loans.
In common parlance, this disparity means that the "typical"
minority borrower paid $1,500 dollars more in up-front fees on a
$100,000 loan than did an identical white borrower for a loan with
exactly the same terms.
If such a disparity existed within Acme's direct lending
portfolio (among those loans processed by Acme's own loan
officers), it would be strong preliminary evidence of illegal
discrimination by Acme, and the regulatory agency would investigate
further and possibly refer the case to the Department of Justice.5
There are a number of reasons, however, why a referral may be
inappropriate with regard to an institution's wholesale portfolio
(those loans processed by outside brokers).
It is important to note that pricing disparities within Acme's
wholesale portfolio can arise in two distinct ways: either "across"
or "within" individual brokers. "Cross-broker disparities" result
when minority borrowers tend to apply at brokers that charge higher
fees, while white borrowers tend to apply at brokers that charge
lower fees; despite this difference in pricing across brokers,
however, no individual broker actually treats its own minority and
white customers differently. In order to hold lenders accountable
for cross-broker disparities, regulators would need to prove that
the cause of the disparity was differential treatment of borrowers
based on their race, and not cost or other legitimate factors. This
would be very difficult. Indeed, there are many conceivable reasons
why individual brokers might charge more or less for their services
than other brokers and why some brokers specialize in lending to a
particular segment of their community. For example, a cross-broker
disparity might be observed if higher-fee brokers provide a fuller
array of services, such as spending more time with customers, and
minority borrowers tend to prefer these brokers. As a result, we
argue that regulators should not view cross-broker disparities on
their own as evidence of illegal discrimination.
Alternatively, "within-broker disparities" arise when white and
minority customers of the same broker are treated differently.
Within-broker disparities can give rise to an overall pricing
disparity in Acme's portfolio in either of two ways: if such
disparities are pervasive across many different brokers with whom
Acme does business; or if a single broker with such a disparity
supplies a large proportion of Acme's loans.
Although within-broker disparities are, on the surface, more
suspect than cross-broker disparities, in practice it can be quite
difficult to reliably interpret whether they are truly the result
of illegal behavior. Proper evaluation requires separately
examining the data from each individual broker for evidence that a
particular broker is engaged in discriminatory practices. Separate
statistical tests should be conducted because different brokers
generally are subject to different economic factors affecting their
pricing patterns. Evaluating each broker individually, however,
entails two types of difficulties. First, for any given lender, the
number of loans originated via any one broker is often too small to
permit a meaningful statistical analysis. Such an analysis requires
controlling for various factors that are likely to affect the
broker's propensity to seek an overage, which in turn, requires a
large sample of observations.6 More importantly, because an
individual broker typically deals with multiple lenders, the loans
the broker sends to any one lender may not be representative of the
broker's overall activity. The loans sent to that lender may happen
to include a disproportionate number originated to minority
borrowers and from which the broker obtained an overage. Thus,
while the data from a given lender may indicate a within-broker
disparity, the broker's total activity may show no evidence of
Should lenders be liable for their
Even if regulators could reliably identify discrimination arising
from cross- or within-broker disparities, the fundamental policy
question remains as to whether Acme should be held accountable for
the behavior of its brokers. We argue not. As noted above, broker
agreements generally do not require the broker to work exclusively
with any one bank, nor do they require a certain number of loans to
be presented. Instead, they usually represent quintessential
arms-length transactions.7 The broker solicits potential borrowers,
collects and verifies the information on their applications, and
forwards the completed applications to the lender offering the best
price on any given day. Pricing of these loans is the result of
negotiations between borrowers and the broker. Indeed, the borrower
and the broker may agree upon a price long before the ultimate
lender is even chosen.8 In any event, the lender typically is not a
party to this decision, and receives no portion of any overage
obtained by the broker. Given these facts, it seems hard to justify
holding Acme responsible for a pricing decision in which it had
little or no input.9
Indeed, the relationship between the broker and Acme is
substantively no different than that between a lender and Fannie
Mae or Freddie Mac, the two major secondary-market institutions
that are credited with making mortgage loans substantially more
affordable for consumers.10 When lenders prepare their rate sheets,
they do so based on estimates of the prices at which various loans
will sell in the secondary market weeks in the future. They then
allow borrowers to lock in an interest rate well in advance of the
actual funding date. Of course, once the loan is actually funded,
the actual price at which it will trade on the secondary market may
be vastly different from that anticipated when the rate was locked.
If loans are trading at a premium, the lender pockets the
difference; if they are trading at a discount, the lender must eat
the loss.11 In either case, the borrower is helped by the fact that
the rate can be locked in advance, effectively providing insurance
against interest rate volatility.
This is essentially the same service that brokers provide to
borrowers. The broker is an intermediary between the lender and the
borrower in the same way that the lender is an intermediary between
the borrower and the secondary market. Because brokers are in
constant contact with lenders, they may be able to obtain better
prices than borrowers could by contacting the lenders directly. If
lenders were to be held liable for the pricing decisions of
individual brokers, direct application of the same logic would
suggest that Fannie Mae and Freddie Mac should be liable for the
pricing decisions of anyone who sells loans to them, a policy that
few are proposing.
What should we do?
Given the difficulty of evaluating lenders' wholesale loan
portfolios for evidence of pricing discrimination, how are
regulators to proceed?
Clearly, brokered lending should not be exempt from fair-lending
laws. This is an important and growing part of the housing-finance
market, and basic fairness requires that all market participants be
subject to the same rules and regulations. Nevertheless, the need
for some kind of enforcement does not justify the use of methods
that can be both unreliable and misleading.
We contend that fair-lending laws should be applied directly to
brokers, not indirectly through the lenders they work with. The
only way to determine whether a broker discriminates is by looking
at all of that broker's pricing decisions, not just those loans
that were funded by one particular lender or another. Only by
observing the entire universe of a broker's loans can we begin to
make a determination of whether a pattern of illegal discrimination
Why is this not the current state of affairs? Most likely, the
answer is historical accident. Depository institutions and their
subsidiaries are already subject to regular examinations to verify
their compliance with a host of consumer regulations. In contrast,
independent Mortgage Brokers are not subject to regular
Nevertheless, the most effective and accurate way of enforcing
these laws is to evaluate Mortgage Brokers directly. Just as we do
not hold Fannie Mae and Freddie Mac liable for the pricing
decisions of the mortgage banks that sell them loans, neither
should we hold lenders responsible for pricing decisions that are
wholly out of their control.
Testing for pricing bias
When regulators test for compliance with fair-lending laws, they
typically conduct statistical analyses to see whether lenders
systematically charge minority borrowers a higher price than they
do whites. In doing so, they control for other factors that may
affect the pricing of mortgage loans, many of which are correlated
with race. For example:
(1) Negotiation Skills: Older, better educated, and more
experienced borrowers may be more skilled at negotiating the terms
of their loans.
(2) Credit History: Borrowers with poor credit histories may not
deal for lower fees because they have fewer alternative sources of
credit, and originators may seek higher fees to compensate for the
extra time and effort such borrowers may entail.
(3) Willingness to Shop: Some borrowers may place a high premium on
their time (for example, high-income borrowers) and choose not to
shop for the best rate.
(4) Market Conditions: The competitiveness of the loan market may
vary over the course of the year.
(5) Length of Rate Lock: Borrowers who let their rate float may be
more susceptible to overaging at the time of closing; on the other
hand, such borrowers may be more sophisticated and less prone to
(6) Loan Size: Many of the costs associated with originating a
mortgage do not vary with the size of the loan, giving originators
a stronger incentive to overage borrowers with small loan
(7) Type of Loan: Cost differences across different loan products
(conventional vs. government insured, home purchase vs.
refinancing) may result from regulatory and market factors
independent of the borrower's characteristics. Fair-lending
analyses attempt to control for these and other factors to isolate
the effects of race on the pricing decision.
1. Alicia H. Munnell, Lynn E. Browne, James McEneaney, and Geoffrey
M.B. Tootell. "Mortgage Lending in Boston: Interpreting HMDA Data."
Federal Reserve Bank of Boston Working Paper No. 92-7, October
1992. This paper was later revised and published in the American
Economic Review, vol. 86, no. 1, March 1996, pp.25-53.
2. See Stanley D. Longhofer, "Measuring Pricing Bias in Mortgages,"
Federal Reserve Bank of Cleveland, Economic Commentary, August 1,
3. The rate sheet indicates the number of discount points required
by a lender to fund loans with various nominal interest rates. For
an example of a rate sheet, see Stanley D. Longhofer, "Measuring
Pricing Bias in Mortgages," Federal Reserve Bank of Cleveland,
Economic Commentary, August 1, 1998.
4. For expositional convenience, we discuss only racial disparities
in this article. Of course, disparities across other protected
characteristics such as age, gender, or marital status are illegal
as well, and are considered by examiners in their fair-lending
5. By law, if the Federal Reserve or other bank regulator uncovers
substantial evidence that discrimination may have occurred, it is
required to pass this information on to the Department of Justice
for further investigation. Note that a referral to Justice does not
constitute a conclusion of discrimination, merely that further
investigation is warranted.
6. These are generally the same as the factors that influence a
lender's propensity to seek an overage with a retail loan. For
example, brokers typically are paid a fixed percentage of the loan
amount by the lender as compensation for originating the loan, and,
therefore, they have greater incentive to seek additional
compensation (in the form of an overage) on smaller loans.
7. Some broker agreements tie the broker much more closely to the
lender, with some brokers acting little differently than a lender's
in-house loan officers. Obviously, the degree to which the lender
should be held responsible for the broker's behavior should depend
on the amount of freedom the broker has to act independently of the
8. This fact suggests that the very notion of an overage is less
meaningful in the context of the brokered lending relationship.
That is, the proper measure of pricing bias would compare the
points paid by the borrower with those required by the broker on
the day the borrower's loan terms are set.
9. Some might argue that lenders, if they so desired, could act to
influence the prices charged by the brokers with whom they deal
(for example, by placing restrictions on the spread between the
wholesale price and the price paid by the borrower), and that
lenders should therefore be held accountable for broker pricing
behavior. Such restrictions, however, would likely reduce brokers'
abilities to obtain the best rates for borrowers, either by
reducing competition among brokers or by constraining their ability
to shop among lenders.
10. The secondary-mortgage market comprises a wide variety of
investors who purchase pools of mortgage loans in order to receive
the principal and interest payments they generate. Participants
include depository institutions, institutional investors such as
insurance companies and pension funds, and wealthy individuals. The
primary difference distinguishing the relationships between broker
and lender and that of lender and the secondary market is that
brokers rarely fund loans and hold them on their own books prior to
delivering them to a lender, whereas mortgage banks generally do
hold loans for a short time before selling them on the secondary
11. Lenders do, of course, hedge these risks using a variety of
12. Technically, enforcement of the Fair Housing Act and the Equal
Credit Opportunity Act with respect to Mortgage Brokers falls under
the jurisdiction of the Federal Trade Commission, but this agency
does not conduct regular examinations of these brokers.
Stanley D. Longhofer is the Stephen L. Clark Chair of Real
Estate and Finance at Wichita State University. The work on this
Economic Commentary was completed while he was an Economist at the
Federal Reserve Bank of Cleveland. Paul S. Calem is a Senior
Economist at the Board of Governors of the Federal Reserve System.
The authors thank Glenn Canner for helpful comments and
Article reprinted with permission from the Research
Department of the Federal Reserve Bank of Cleveland.