Information asymmetry in the mortgage market

The home buying process can quickly become a nightmare for persons who may know less about the ‘workings’ of a mortgage origination market compared to others or who may not have the ‘brawn’ required to wade through the opaque waters of the real estate process. This category of individuals would be most impacted by information asymmetry, especially the case for first time home buyers and immigrants [1]. Through the use of intermediaries, the information asymmetry effect, ideally, should be mitigated. However, given the limited network of intermediaries, time factor, incomplete buyer profile, dominant market actors and intermediary incentives, agency relationships may not necessarily ease the plight of home buyers. This blog expands on the limitations of intermediaries and highlights how, in addition to home buyers conducting their due diligence, more innovative ways of assisting home buyers are required.

Markets with information asymmetry

Markets are important. Buyer meets seller, product and/or service is exchanged, payment is made, and a transaction is completed, resulting in a satisfied need or want. In markets, one party (buyer or seller) can have more information than the other, resulting in information asymmetry. Asymmetry means imbalance. Simply put, a lack of symmetry. Information asymmetry consequentially enhances the relative market position of one party (the more informed party), be it the buyer or seller, over the other. The outcomes of such market interactions are imbalanced and, as competition aficionados would say, unfair. Economists are generally concerned about how information asymmetry can negatively impact market outcomes for the less informed party and would advocate for competitive markets that facilitate information transparency and mitigate for information failure.

Some markets are prone to information asymmetry than others due to the inherent specialization of key players. Akerlof’s “lemon” theory has come to be the de facto in describing the situation, outcome, and impact of information asymmetry in specialized markets [2]. Insurance, healthcare, housing/real estate and used car markets are examples of markets where some market participants are more informed than others.

Agents, intermediaries, or brokers as a solution

A widely adopted solution for information asymmetry is the introduction of agency relationships where intermediaries bridge the information gap and empower less-informed market actors. In agency driven markets such as healthcare markets, medical practitioners with more specialized training, serve as agents for patients. Insurance brokers act on behalf of the insurance purchaser, lawyers act on behalf of their clients etc.

While intermediaries are endorsed as the solution for the less-informed party to the transaction, since having this extra layer to the market bridges the divide for the less informed party leveling the playing field, one may be easily blinded to market characteristics that nullify the intended effect and worsen market outcomes for the less-informed party.

Mortgage market

Many require a mortgage to afford a home. In obtaining a mortgage, buyers (most) are taking on their biggest debt ever and are faced with significant information deficits. From the difficulty of finding information on the true value of a property (which ultimately affects the size of the mortgage) to having insufficient information on mortgage options and rates (which ultimately affects the cost of the mortgage), the ripple effect of this gap in information, for buyers is costly and manifests in the form of home foreclosures, mortgage defaults, initial home buyer shock, remorse, ‘debt stress’ and lower standard of living [3][4][5]. The International Monetary Fund noted that Canada, Australia, Norway, and Sweden are at the highest risk of defaults on mortgage payments due to the high levels of debts that households in these countries have [6].

The eco-system of real estate can grow from a simple seller and buyer network to a complex network of actors depending on existing policies. A complex eco-system involves several market participants, asides the typical buyer and seller, real estate agents, mortgage brokers, lenders, lawyers, insurers are part of this single transaction. An unawareness of the complexity of this eco-system puts an uninformed buyer at a disadvantage. Buying a home is often depicted as glamorous and the process painted as linear (Figure 1: Home Buying Process - SuperBrokers). This is misleading. Under every stage in Figure 1, there are multiple steps, decisions to make, and interactions with multiple actors within a short period of time. Also, a buyers’ experience is not always transferable as transactions differ per circumstance.

Real Estate Agents and Mortgage Brokers as Solutions

Figure 2 presents a close-to-reality home buying process. It presents complex steps and more importantly introduces the actors that play key roles in the transaction. There are at least two intermediaries present in this market: a real estate agent and a mortgage broker with an insurance broker or financial advisor in some cases.

(Figure 2: Is your real estate process transparent or more like the Big Muddy? - Inman)

A simple scenario is that a real estate agent acts as an intermediary between the seller and buyer, and a mortgage broker is an intermediary between the lender and buyer. While a real estate agent assists with buying or selling a home, a mortgage broker assists in securing a mortgage from a financial institution. Buyers may decide to avoid these intermediaries, but this may come with its own risk. For instance, a buyer can secure the mortgage by shopping around. Going from one financial institution to another. The ideal characteristics of such a buyer: great negotiation skills, some financial education, an understanding of how mortgage rates work, coupled with access to up-to-date financial information. Such a buyer would have enough time and patience to secure a good enough deal. Buyers could go with the mortgage offered to them through the financial institution they have a long-standing relationship with or would use the services of a mortgage broker.

The mortgage broker promises to secure the best deal (e.g., lowest mortgage rate) within his network of lenders. This intermediary arrangement by design should mitigate information asymmetry. The knowledge and information of the intermediaries would be transferred to their clients to help them make an optimum decision. In other cases, intermediaries take more responsibility in decision making thereby saving clients time, effort, and financial resources.

Are agents, intermediaries, or brokers always a solution?

At this point, the quest is not to advocate that the mortgage market is better served without intermediaries but to highlight that intermediaries have unintended consequences and do not perfectly achieve the intended purpose. Agency relationships can breakdown not because agents are bad (some might be), but because there are other market factors to consider. Factors such as limited network of intermediaries, time, incomplete buyer profile, dominant market actors and incentives, outside the control of agents and buyers, may cause a breakdown in the agency relationship.

• Limited network: Your network is your net worth. Same is true when securing a mortgage. Ideally, the broker or intermediary would be required to possess the right amount of information for clients. However, brokers and real estate agents can only provide information based on their own network. For instance, a broker having a network of 10 lenders can only provide accurate information on these 10. “Not all lenders work with mortgage brokers”[7]. Conclusively, deciding to go with one broker does not equate getting the best mortgage rate that culminates in reduced mortgage costs.

• Time factor: Agents must pick and choose which information is most relevant to their clients within a limited period. The housing market is fast-paced, with homes selling within a few weeks of they being advertised. Buyers make decisions within days or even hours on a home of interest. In 2022, a Clever Real Estate survey showed that in the US, the second and third reasons for buyer remorse were that buyers felt their purchase decision was rushed (30%) and they bought too quickly (26%) [8]. This is not surprising. Home buyers may be part of bidding wars and intermediaries may pressure their clients to make decisions quickly to secure their dream homes, considering that brokers and real estate agents, normally, are paid when the transaction closes.

• Incomplete buyer profile: Agents may have vast knowledge of the market, but they need information of client’s personal and financial standing to tailor their advice appropriately. Failure to fully grasp the profile of clients may lead to an inappropriate deal. The buyer ultimately, is in the best place to make an informed decision for himself. Agents may not be able to assimilate or know all about the buyer (within the very short time frame) and clients are also unable to digest the vast knowledge of a broker.

• Dominant market actors: In Canada, 68% of market share of newly originated mortgages by lender type in 2020 were with the Big Six banks. While MFCs, Insurance and Trust Companies, MIEs, Credit Unions and other chartered banks split the remaining 32% [9]. Though intermediaries in the form of brokers should ideally provide buyers with a variety of mortgage lending options, the data shows that most mortgages still go to the top six banks in Canada. Lenders pay brokers, so they dictate the terms of business. If big banks pay higher commissions to brokers (because they can), brokers may be swayed to move mortgages to them regardless of whether they offer the best mortgage rates or not. In this case, complete information is withheld from buyers by the bank and brokers.

• Incentives: The obvious factor is incentives. Motives. Where incentives differ, there is the potential for a conflict of interest. For example, the biggest incentive is payment in form of commission which agents earn per transaction, when a transaction closes. “If broker compensation is tied to loan size and amortization length, they may have a financial incentive to steer borrowers towards these types of products (riskier mortgages with higher loan-to-value ratios and longer amortization)”[10].

Conclusively, to resolve information asymmetry in markets, the first solution would be open data and open access, especially in a form that is digestible by various consumer categories. Platforms like Redfin, help in some way to make available property sale or pricing information but more can be done. Information hoarding that does not put information directly in the hands of all market actors is harmful especially for those who have limited knowledge of the inner workings of this market [11]. Secondly, home buyers should shop around before making commitments. A home buyer should be aware that they need to check for other lenders, independently, to know what better rates or options are out there. This may very well be the most important point of my blog post, that consumers should keep looking, keep asking, shop around with the aim of staying within budget and minimizing regret. The size of your household debt is dependent on this.

RATESDOTCA in their 2019 post state that “It’s important to remember that compensation and lender perks can sometimes sway a broker’s advice. That’s why brokering isn’t always “free.” Despite regulators’ efforts to curb this behaviour, it’s almost impossible for a layperson to know when it is happening. The main thing you can do is ask your broker candidly, “Are there any products in the broker market that offer you less compensation or perks that would save me more money in the long run… And keep in mind, the mortgage with the true lowest cost of borrowing may be available only to borrowers who deal directly with the lender (i.e., non-broker rates).

Finally, market specific policies to reduce complexities. Housing policy reviews, financial intermediation policies that aim to simplify mortgage processes and empower consumers are required. Housing or mortgage institutions should not hoard data. In Thomas Cooper’s words “alter the environment” [12]. This is because the ripple effect of highly concentrated markets is made worse where information failure exists. Here, competition agencies, need to innovate and come up with ways of alleviating the impact of information asymmetry in the real estate market. This may involve going beyond traditional methods of intervention.

References

1. I include immigrants for obvious reasons. Being new to a country’s system may pose a set of challenges, especially as it relates to information access.

2. Akerlof, G. (1970)- “The Market for “Lemons”: Quality Uncertainty and the Market Mechanism” The Quarterly Journal of Economics, Volume 84, Issue 3, August 1970, Pages 488–500

3. To avoid home-buyers’ regret, do your homework - The Globe and Mail

4. 'We Wish Like Hell We Had Never Bought': Voices from the Housing Crisis - The Atlantic

5. Why recent homebuyers have regrets about their purchases (cnbc.com)

6. How Falling Home Prices Could Strain Financial Markets as Interest Rates Rise (imf.org)

7. Pros and cons of using a mortgage broker | Ratehub.ca

8. Why recent homebuyers have regrets about their purchases (cnbc.com)

9. Residential Mortgage Industry Report - October 2021 (cmhc-schl.gc.ca)

10. Allen, J., Clark, R., Houde, J. F., Li, S., & Trubnikova, A. (2023). The Role of Intermediaries in Selection Markets: Evidence from Mortgage Lending (No. 2023-12). Bank of Canada.

11. Speech by Chairman Bernanke on challenges in housing and mortgage markets - Federal Reserve Board

12. Cooper, T. (1992). Signal facilitation: a policy response to asymmetric information.

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Author's bio

Oluwatobi Ogundele's economics experience and interests have been in the areas of competition law and policy, health and migration. She has masters degrees in Economics and in International Public Policy with specialization in International Economic Relations and Global Governance.