June 19, 2000
"In a recent column, you said
that many mortgage brokers lock the borrower's interest rate at their own risk
rather than at the lender's risk. Since brokers have no special expertise
in forecasting interest rates, this makes no sense to me."
Brokers don't have to have the
ability to forecast rates, but they don't have to. Because
of the way the market works, the broker wins if interest rates don't change
between the lock date and the closing date, or if rates decline.
Brokers only lose if rates increase appreciably during the lock period
Consider a
borrower who wants rate protection for 60 days. His
mortgage broker shops the market for the best wholesale prices.
The price on a loan delivered today (the "float" price) is 8%,
plus 1 point (each point is percent of the loan). The
price on a loan delivered within 60 days (the 60-day lock price) is 8% plus 1.5
points. The broker adds a markup
of, say, 1.5 points to the 60-day lock price, making the final cost 8% plus 3
points.
The difference of 0.5 points between the float price and the 60-day lock price
reflects the lender's
"lock-jumping" risk. If
interest rates increase during the 60-day period, the lender is nevertheless
committed to delivering the lock terms. But
if interest rates decline, the borrower may walk away and negotiate a cheaper
loan elsewhere.
Since the borrower in the example wants the rate protection, the mortgage broker
provides it. The borrower is
guaranteed that the loan will close at 8% plus 3 points.
If the broker locks the loan with the lender, the lender gets 1.5 points
and the broker makes 1.5 points.
Alternatively,
the broker may lock the loan at his own risk.
If so, and if interest rates don't change during the 60 days, the loan
will be delivered to the lender at the float price, or 8% plus 1 point. The
borrower pays 3 points, as before, but the broker makes 2 points instead of 1.5.
If interest rates increase during the 60-day period, the broker could lose the
extra profit, and even the markup. If
the float price after 60 days turns out to be 8% plus 3 points, for example, the
broker will make nothing on the deal.
If interest rates
decline, on the other hand, the broker will make more than 2 points, assuming
the borrower stays with the deal. If
the borrower threatens to walk, the broker will be forced to share some of the
benefit of the rate decline. For
this reason, gains from rate declines don't fully offset losses from rate
increases.
Brokers who lock at their own risk believe that the profits they earn in a
stable market will be greater than their losses
from market fluctuations. Through most of the 1990s, losses have been small
because market fluctuations have been small.
Is the practice kosher? Brokers
believe it is because the borrower is protected.
Brokers absorb the loss if interest rates go against them.
But it is fair-weather protection that disappears when the consumer needs
it most -- during an interest rate spike.
For
example, in the two-month period January-March, 1980, mortgage rates jumped from
12.88% to 15.28%. A broker who
locked for 60 days at 12.88% would have to pay a lender about 15 points to
accept a loan with that rate in a 15.28% market.
The broker would either go out of business, or deny that a lock was
given. (Broker locks are oral
commitments.) The borrower would be
left high and dry in either case.
Broker locks are a deceitful practice because the borrower is led to believe
that the lender is providing the lock. To
protect yourself, insist on receiving the rate lock commitment letter from the
lender identifying you as the applicant.
Copyright Jack
Guttentag 200
