IntroductionEconomics of Mortgage OriginationsBrokers and the yield-spread premiumBargaining over mortgage termsPotential consumer confusionPointsIndustrial organization analysis of mortgage brokerageData and Data Description ModelDescription of the FHA dataThe yield-spread premiumDescriptive modelConsumer ConfusionModeling market equilibrium with rational shoppingBenefits that borrowers failed to gain from more intensive shoppingDistribution of the broker's marginThe Division of the Closing Charge between Cash and the YSPConcluding RemarksEarlier ResearchResearch on mortgage costsFindings from the Auto-Loan MarketResearch Outside of LendingDetails of Shopping CalculationsCalculating smoothed densities from quantilesInferring the distribution of broker costInferring the distribution of broker marginSimulating outcomes for more intensive shoppingDiagnosing Consumer Confusion and Sub-Optimal Shopping Effort:Theory and Mortgage-Market Evidence∗Susan E. WoodwardSand Hill [email protected] E. HallHoover Institution and Department of Economics,Stanford UniversityNational Bureau of Economic [email protected]; website: Google “Bob Hall”May 11, 2010AbstractMortgage loans are leading examples of transactions where experts on one side of themarket take advantage of consumers’ lack of knowledge and experience. We study thecompensation that borrowers pay to mortgage brokers for assistance from applicationto closing. Two findings support the conclusion that confused borrowers overpay forbrokers’ services: (1) A model of effective shopping shows that borrowers sacrifice atleast $1,000 by shopping from too few brokers. (2) Borrowers who compensate theirbrokers with both cash and a commission from the lender pay twice as much as similarborrowers who pay no cash.∗A file containing the calculations is available at Hall’s website. Woodward: Sand Hill Econometrics, 115Everett Ave., Palo Alto, CA, 94301 (650) 462-8700; Hall: Hoover Institution, Stanford University, Stanford,CA 94305 (650) 723-221511 IntroductionConsumers often transact with imperfect information about the best price available for aproduct. Some examples are mundane—a shopper does not know the price of kleenex atevery nearby store. Others are more substantial, such as the best available price for a newFord Focus or the best expense ratio for an S&P 500-indexed mutual fund. We study alarge expenditure that the majority of consumers make only a few times in their lives, thepayment for mortgage origination services. These payments range from zero to $30,000 formortgages of normal size. The payments are described as “origination fees,” “points,” and amyriad of other terms; frequently the borrower pays for a dozen or more different categoriesof origination services. On average among the loans we study, about half of the value thatthe borrower transfers to the broker takes the form of a payment by the wholesale lenderto the mortgage broker. The borrower bears the burden of this part of the payment in theform of a higher interest rate on the loan.These payments are compensation to mortgage brokers for their services in arrangingthe origination of a mortgage. Because consumers enter the mortgage market infrequentlyand because of features of the market that make it difficult to learn the best price, mortgageorigination pricing is a leading example of a market where one suspects that many consumerspay well above the best price. Our results confirm this suspicion strongly.We stress that this paper is about how much borrowers pay their brokers for originationservices. The broker is an administrator of the process of loan origination. The broker bearsnone of the risk of default on the mortgage, so that risk is not a determinant of the broker’scompensation.We reach our conclusion by studying the distribution of origination charges for a largesample of mortgages involving brokers, where federally mandated disclosure documents re-port the entire amount of the broker’s revenue, including both the total charges imposed onthe borrower and the additional amount the lender pays the broker. We consider a mini-mal shopping strategy that borrowers might pursue in trying to find the best price—gettingquotes from two brokers, asking the one with the higher proposed price to beat the lowerprice of the opponent, and continuing this process until one broker is unwilling to improveon the other’s best proposal. This process is an English auction, in which the lower-costbroker gets the business and the charge equals the cost of the losing broker, according tostandard auction principles.It’s a standard statistical exercise to find the distribution of a variable from the distribu-tion of the larger of a pair of draws from the variable. We perform that exercise to calculatethe distribution of broker cost. We find that the implied cost is generally quite high, butmore important, the upper tail of the cost distribution is thick—a significant fraction ofmortgages appear to cost the broker more than $5,000 to originate. When we repeat the2exercise for shopping among three and four brokers, we find that the implied distribution ofcost is completely implausible, with an even larger fraction implied to cost more than $5,000.The distribution has an implausible shape as well. We conclude that among our shoppingmodels, only the one where borrowers shop from just a pair of brokers is close to reasonable.Our conclusion that borrowers consider no more than two mortgages draws support fromsurveys of borrower behavior as well.Given this conclusion, we ask what benefit a borrower who shopped from only two brokerspassed up by not shopping from three or four. The answers are so large that we believe thatmany of the borrowers must have been unaware of the likely benefits of more shopping.For example, for a mortgage with $100,000 principal, a borrower would save a median of$981 by adding one more broker to the mix and $1,393 by adding two. And with $200,000principal, the savings are $1,866 and $2,664 . Because we do not believe that borrowerswould intentionally pass up such large benefits just to avoid talking to another broker, weconclude that confusion about how this market works caused borrowers to shop too little.Our second approach to studying confusion among mortgage borrowers is to compare (1)the total closing charges for loans where the borrower pays a higher interest rate to fundthe closing charge to (2)