There was never anything wrong with the independent mortgage broker.  In fact, in many ways working with a mortgage broker was far superior to going to a bank.  Mortgage brokers typically had more experience, and by being able to shop between several lenders brokers could usually get their buyers a better deal.  Plus banks usually had higher overhead, and those costs are eventually paid by the borrower; mortgage brokers almost by definition had much lower overhead, and were willing to go into areas and markets where banks would not go.  As far as loan quality goes, the simple fact is mortgage brokers have never created a loan program, or had any authority to approve any loan; that was always done by the bank or investor that closed the loan.  All the broker did is compile the loan package and submit it to the lender who would then underwrite, approve and close the loan.

So consumers had three different options when it came time to get a real estate loan.  They could work with a bank, but the banks were really usually interested in only doing their fairly limited loan products.  They could go to a mortgage company, but while mortgage bankers had more programs, they were still restricted to the loan products they carried.  Or they could go to a mortgage broker who had no money to lend, but put lenders and borrowers together, working with the “wholesale” side of many different banks and mortgage companies.  That was until the State of California changed the laws so that companies with consumer finance lender licenses (CFL) could not only do real estate loans, they could also broker mortgage loans.  The CFL is the license that payday lenders, check cashing companies and consumer finance companies get.  The thought was that banks and mortgage companies were not serving the low income borrower because their standards were too tough.  Mortgage brokers were not much help because they had to follow the same standards as the banks and mortgage bankers.

So starting in 1995, CFL lenders were in the mortgage business.  Sure they were restricted to only being able to broker to other CFL lenders, but just about every lender – especially the sub-prime lenders – had CFL licenses.  CFL lenders do not have to have a physical presence in the state of California, and require no licensing or background checks on their employees.  Basically a lender out of Guam could open a virtual office here in California made-up entirely of people who were on house-arrest for fraud wearing ankle bracelets.  By contrast The Department of Real Estate (DRE) requires that each company have a designated broker who holds the brokers license, and also requires all loan officers to be individually licensed as well. DRE requires all licensees to complete college level education classes, pass a state exam, and pass a Department of Justice background check.  They then must take continuing education to remain licensed.  Additionally consumers can file complaints with the DRE and even receive compensation for damages caused by wrongful acts through a special fund, even if the broker is insolvent.

The path of least resistance, of course, was the CLF license.  If you wanted to start a mortgage company or get into the business it really didn’t make sense to go through the hassle of a DRE license.  It took a while for the change to take effect, but by the turn of the century the mortgage broker industry was becoming dominated by the CFL lender – especially in lower income areas.  CFL lenders were different.  They didn’t look at their role as counselors, but rather as sales people – and sell they did.  After all, they weren’t burdened with the inconvenience of fiduciary responsibility like DRE licensed lenders.  Rather than explain how a loan program worked this new breed of lender sold their borrowers – sometimes into very bad situations.

Of course at that time nobody really cared if the loan program was bad – the house was worth 20% more the next year and the borrower could just refinance.  Since the investors didn’t require verification of income, why not just overstate the income.  That way everybody could realize a huge profit when the home went up in value.  That 1% rate (that was only in effect for one month) allowed borrowers to buy twice as much house!  Super-loan sales people were making $50,000, $100,000, or more a month but couldn’t explain how the loans they were selling worked.  Those of us who took the time to explain why buying a $400,000 house on a $30,000 a year income was not such a good idea were laughed at as being stupid, or behind the times.  “You see, even though your payment is only $1,300 a month, the interest alone is actually $2,000 after the 2nd month and going up every month as your balance grows.  You really should be paying $2,400 if you want to pay off your loan in 30 years.”  Hey, everybody’s getting rich!  What’s the problem?  I WANT THE BIGGER HOUSE!”

Yea, it all blew-up.  One year the home values only went up about 5% and some people couldn’t make their payments.  When they tried to sell, there weren’t enough buyers so the next thing you knew, home values started to actually go down.  I think the rest of the story is pretty well known.  Mortgage brokers became the fall-guys – and rightly so in many cases.  A lot of experienced lenders ignored their guts and drank the Kool-Aid right along with the idiots who really didn’t know any better.   But brokers don’t create loan programs, they don’t set underwriting guidelines, they don’t approve loans, and they don’t fund loans.  At the end of the day all the brokers did was match-up the borrower with the loan product they wanted.  During that time borrowers didn’t care about the loans they got, investors didn’t care if the loan file was a complete work of fiction, and rating companies just cashed the checks.  Everybody got what they wanted, but nobody understood what they got.

Five years later only about 10% of the mortgage brokers that were around at the height of the insanity are left.  Many had no business being in the business in the first place, but many more just closed their doors because they were legislated or regulated out of business.  Their employees retired, got out of the business, or went to work for banks or mortgage bankers.  The ironic thing is that the very companies that created the toxic loan products have successfully reduced the brokers to insignificant players in the market.  All of the “Financial Reform” we hear about mysteriously exempts depository lenders (read banks), creating a very unlevel playing field.  It will be interesting to see just what happens next.