Wednesday, July 30, 2008

Incentives Matter

From Steven Levitt at Freakonomics:

Why do mortgage brokers get paid everything up front when they originate a deal?

This sort of contract gives brokers terrible incentives. They just want to get a deal done. It matters very little to them whether the borrower eventually defaults or not.

Chris Harris offers a simple solution to the problem: instead of paying mortgage brokers a lump sum when the deal closes, have them pay a small amount out of every mortgage payment. That way, the mortgage brokers will have a disincentive to initiate high-risk mortgages that are likely to default.

MP: This example of incentives reminds me of a story about the transportation of convicts from the U.K. to Australia during the late 1700s and the early 1800s. Private companies were paid to transport the convicts/prisoners, and the first payment schedule was based on the number of prisoners who boarded ships in the U.K. As you might imagine, there was no direct incentive to deliver living prisoners to Australia, and many of them died during the trip, due to overcrowding, lack of food and water, unsanitary and unsafe conditions, untreated diseases, etc.

The payment schedule later changed, and was subsequently based on the number of living prisoners delivered to Australia. The incentives changed, and the outcome improved: fewer prisoners died during transport.

9 Comments:

At 7/30/2008 11:51 PM, Blogger Brian Shelley said...

In the insurance world this is called a trail commission. When we sell deferred annuities we don't really like to give all the commission up front because people tend to lapse early (that is, withdrawal their money). The agent has little incentive to sell policies only to those people who actually want it. It is definitely a principal/agent problem, and trail commissions are rather effective.

 
At 7/31/2008 12:34 AM, Blogger randian said...

This reminds me of how real estate agents receive commissions on commercial leases. Their commission is based on the total dollar value of the lease, paid up front by the landlord, even if the tenant goes belly up years or decades before the end of the lease. They are remarkably resistant to getting paid month-to-month, and will even go so far as to poison other agents against you if you demand monthly payment.

 
At 7/31/2008 7:55 AM, Anonymous QT said...

Radian,

"even if the tenant goes belly up years or decades before the end of the lease"

Can one reasonably expect a real estate agent to be held responsible for the financial performance of an organization over which he exercises no control?

Businesses fail for many reasons...mismanagement, a downturn in the sector, inadequate traffic in the case of retail, inadequate succession planning, death of the owner, etc.

The risk of renting commerical space is the landlord's not the real estate agent's. Adopting the system you propose would make leasing less attractive for agents who would likely move to selling buildings rather than leasing. The landlord would end up stuck with trying to find tenants in addition to managing his present tenants and maintaining his property. He would have no better luck with determining which were sound businesses and which were not.

When there's very little profit for the effort or increased risk, people simply switch to the areas of the sector that offer higher returns and low risk.

It might be more effective in the case of mortgages to raise deposit requirements, and limit the percentage of a home's equity that can be mortgaged.

 
At 7/31/2008 8:35 AM, Blogger randian said...

Can one reasonably expect a real estate agent to be held responsible for the financial performance of an organization over which he exercises no control?

Note that "belly up", in my view, includes businesses who simply say "screw you I'm leaving" as well as those who actually go bankrupt. From a landlord's point of view why they aren't paying doesn't matter.

In that case, why should I pay the agent based on the size of the lease? It's remarkably greedy to demand pay-for-performance without actually having to perform. If you were in any business employing commissioned salesmen, would you pay your salesmen their commission as soon as the purchase contract is signed, before the buyer actually forks over their cash? Surely not, the salesman's incentives would be so out of alignment with yours you'd never agree to it absent duress (like a government enforced monopoly on salesman's services).

 
At 7/31/2008 9:41 AM, Blogger David said...

It's always important to get the incentives right in sales situations--some of the things you generally need to worry about are;

1)Avoid overpaying for sales of low-margin products
2)Avoid incentivizing the sale of services to customers who will soon go away
3)Strike the right balance in the size vs time-to-close aspects of the sales pipeline--will the sales rep be able to chase the big deal that may take months to close, or will his incentives drive him exclusively to smaller/quicker deals?
4)Avoid selling to customers who are such a pain in the ass that they will be more trouble than they are worth.

In the specific case of mortgages, the bank or other institution which is issuing the mortgage may have no incentive to worry about the long term, because it ALSO is going to sell the paper rather than hold it.

 
At 7/31/2008 3:48 PM, Anonymous QT said...

David,

Banks used to securitize and sell mortgages but the demand for these products has largely
dried up.

Randian,

"It's remarkably greedy to demand pay-for-performance without actually having to perform."

I guess you have never worked on solely on commission as a real estate agent does. Their job entails advertising, arranging for showings, presenting offers to the leasor/owner, negotiating the lease, and drawing up the contract. If the deal falls through, they receive $0.00. Their job is to rent the property not administer payments.

Do you require a real estate lawyer to ensure that the buyer of a home pays their mortgage payments on time?

Many landlords and homeowners choose not to use a real estate agency. There is no law that says you can't do it yourself. Whether one uses the service or not, it is a voluntary transaction. If the landlord did not find value in the product, he would not use it.

 
At 8/01/2008 1:49 PM, Blogger Doug said...

I know of mortgage brokers that got their commission after the person with the mortgage makes the first payment. Who actaully made the first payment? The mortgage broker...

 
At 8/02/2008 2:55 AM, Blogger OBloodyHell said...

> Their job is to rent the property not administer payments.

qt:

I think both sides have merits, and probably it should be tied to at least some measure of performance -- perhaps a flat up front amount which covers the agent's up-front costs you mention plus the work involved, balanced by an amount to be paid to the agent yearly for the first five years. I'd say that if it takes more than five years for a lessor/buyer to default, that would not reasonably be blamed on the agent, as it likely involves factors outside their possible window of knowledge.

That way they have a vested interest in not just finding ANY buyer/lessor, but one which will perform over time.

 
At 10/21/2008 10:55 AM, Blogger terence said...

I am an overseas owner of an Australian house. The agents there work on a commission based on each month's rental collected - so this trail commission scheme is not unusual. But in Singapore, where I live, agents will not touch this plan with a 10 foot pole.

 

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