Submitted by CARPE DIEM

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.

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