Tuesday, July 7, 2009

After the Honeymoon: Trusting Loan Brokers

Should a loan broker who has established a successful relationship with a lender be trusted by that lender? Not according to research by Mark Garmaise, a finance professor at UCLA Anderson (working paper “After the Honeymoon: Relationship Dynamics Between Mortgage Brokers and Banks”). From a July 6, 2009 Financial Times story on the research:

The financial industry’s vaunted belief in trust and long-term relationships is being challenged by research showing that before the crisis US mortgage brokers fed loans of deteriorating quality to the banks they did most business with.

By questioning the prevailing wisdom that dealing with well-known counterparties is more fruitful and less risky than venturing into new relationships, the academic study puts in doubt one of the banking sector’s most enduring beliefs.

The key findings of the study:

  • The quality of the loans submitted by the broker deteriorates over the course of the relationship
  • The volume of loans submitted grows even as the quality deteriorates
  • The effect is stronger for geographically distant brokers
  • Even though the bank’s ability to evaluate the quality of the broker’s loans increases over time, the bank is increasingly reluctant to terminate the relationship.

It’s easy to dismiss this as a problem unique to loan brokers, but what if it’s true in other situations where initial monitoring is high and then relaxed over time? For example, the first few times you use a new appraiser you might carefully scrutinize the work. Do you need to do that every time, or can you relax? It’s a big enough topic for a separate post, but I think the answer (for commercial real estate, at least), is to check the key elements every time, no matter who you’re dealing with. Finley Peter Dunne had the right idea: “Trust everybody, but cut the cards.”