John Mangels and Steve Walsh had been dreading the decision for years. But the nature of their industry had changed, and now to stay healthy the business had to somehow change, too. Just a few years ago, Mangels and Walsh loved their top salespeople so much they awarded them trophies. Now these very same star performers were causing a crisis. What was the best way out?

Walsh and Mangels had built Scout Mortgage of Scottsdale, Arizona, by paying their loan officers on commission, the standard form of compensation in the industry. Only four years ago, when the real estate market was booming, paying employees as much as $300,000 a year didn't seem outrageous. But in recent years the market has cooled. Scout's business dropped by more than half from 2003 to 2006, and those lavish commissions started to look excessive.

The work changed too. Selling that once depended on developing leads had become passive, a matter of taking phone calls generated by newspaper ads and direct mailings. So Walsh and Mangels considered something radical: paying their loan officers salaries--relatively low ones--instead of commissions. They knew the decision could cause friction, maybe chase their best salespeople out the door. It could bring turmoil to a company facing a tight market. But something had to give.

Walsh and Mangels had met while working together at another mortgage company and founded their own brokerage in 1999. Scout grew quickly, fueled by Arizona's real estate boom and a wave of refinancing. In 2003, the company funded more than $600 million in mortgages and employed 25 loan officers, plus an equal size support staff. "In higher volume, you can really survive under just about any model," says Mangels.

In the mortgage industry, the overwhelming majority of loan officers work on commission. Traditionally, a salesperson works to generate a lead--often through contacts with real estate agents or builders--finds a lender, does the paperwork. Loan officers typically earn a percentage of the loan amount (1 percent when borrowers have good credit) plus miscellaneous fees and premiums. In some cases, they can earn higher commissions by persuading the customer to accept a higher interest rate, though Walsh and Mangels say their reps weren't steering people with bad credit to risky loans, as some involved in the subprime loan mess apparently were.

For Scout's loan officers, it was a great gig. Each mortgage generated a commission of $4,000 to $7,000, which was split 50-50 between the loan officer and the company. A rep could do quite well closing just three loans a week. In 2006, the firm's four top loan officers made between $250,000 and $300,000 each.

But business slowed down when interest rates edged up in late 2003. By last year, volume had dropped to about $240 million in mortgages funded. Much of the company's share of that was eaten up by payroll taxes, benefits, and marketing costs. "We were working for tips as owners of the company," says Walsh.

It wasn't just the housing market that was evolving. Using search engines, loan officers easily could scan hundreds of lenders to find the best deals. With automated underwriting software, files could be processed in seconds. The process of approving a loan became automatic, as software programs spat out approvals or denials of loans based on credit scores and other data. Working with loan shoppers who came in over the transom as prospects, Scout's team of loan officers began to seem like a highly paid phone bank. "They would come in at 10 and say, 'What's for lunch?" Walsh says. "One of them said we'd have to pay him a higher commission to actually get out of his chair and go out and get business."

The solution seemed clear--replace the commissioned staff with cheaper salaried ones. But it wasn't so simple. Making the switch meant bucking the basic paradigm of the industry. And losing the company's most experienced employees could hurt customer service. Some of the top performers were stars who closed more than 20 loans a month. There was Chris, the superstar salesman with a knack for finding ways to close with problematic borrowers such as people with little equity or poor credit. There was Nancy, the grandmother who worked 13-hour days and stayed by her phone until 9 or 10 at night. And there was Marcy, not only a top performer but a generous host who frequently invited the staff to parties at her house.

Most painful of all, there were personal ties. These loan officers were friends with families. They socialized after work and played with one another's children at Christmas parties. "How do you tell someone they're overpaid and they're no longer needed?" says Mangels.

They tried to avoid layoffs with a halfway measure. They began hiring salaried loan officers starting at $40,000 and kept existing staffers on commission. But it just led to tension. When the new hires realized the grass was much greener on the other side of the cubicle, some began asking to switch to commissions. Says Mangels, "There was whispering, 'Why are you guys working for $4,000 per month when you could be making $12,000?" After initially thinking they'd been too draconian, the owners began to wonder if they hadn't gone far enough.

The Decision

In April, Walsh and Mangels decided to bring down the ax. "Basically, what we really needed to do was just scrape down to the foundation and start over," says Mangels. They would eliminate sales commissions and switch entirely to a salaried staff. They decided to break the news at the end of the week, looked at the calendar, and groaned--it would be Friday the 13th.

When the day arrived, Walsh and Mangels sat down in a conference room and summoned the employees one by one. A glass window overlooked the cubicles on the office floor. Employees stole glances toward the conference room. In the days beforehand, the owners had tried to soften the blow by leaking hints of the coming changes. Some employees urged them to reconsider: One even tried to change Walsh's mind by approaching Walsh's brother.

They had decided to fire five commissioned loan officers plus three members of the support staff. Walsh and Mangels considered offering the commissioned employees salaried positions but decided there would be too much bad blood. It seemed clear no one would stay for maybe half of what he or she made in the past.

Chris, Nancy, Marcy, and others were gone. Six of the newer salaried officers were allowed to stay. Under the new structure, mortgage officers would earn a base salary of $36,000 per year plus a flat commission of $100 for closing a loan. Depending on productivity and volume of business (which fluctuates with interest rates), they might earn $60,000 to $120,000 a year.

The staff changes were part of a larger rethinking of the business that the owners hope will attract business: Walsh and Mangels will pass savings to customers by covering closing costs.

In the fall, Scout plans to roll out a website on which customers will be able to compare mortgages. Walsh and Mangels are betting that the industry is approaching a day when customers will be able to shop for mortgages online much as a person can shop for airline tickets on Orbitz. They expect to be licensed in all 50 states by 2008. In the fall, Scout plans to roll out an aggressive ad campaign of direct mail, Google ads, TV and radio spots, and billboards. New ads may promote the idea that Scout reps have no incentive to steer customers toward high-interest or risky loans. "Unless you separate compensation from the program, you cannot get honest advice from anybody," says Walsh.

Scout hopes higher volume will outweigh lower margins. "If we can offer absolutely the lowest rate possible, will we gain market share? It has to be a yes," says Walsh. "It could be the greatest or best decision we ever made, or the worst. Only time will tell."

The Experts Weigh In

A great first step

Commissioned loan officers are a costly anachronism. On easy loans, they are much overpaid. On difficult loans, few have the training and skills needed to guide a befuddled client. And those that are qualified are not disinterested. There is hardly a mortgage lender in the business who would not bounce their commissioned loan officers if they knew a way to replace the lost production. Whether Scout will succeed will depend on how well it executes. Lowering the price to reflect the absence of large commissions is a great first step.

Jack Guttentag
Emeritus Wharton School

The right decision

Bravo to John Mangels and Steve Walsh for having the guts to make the right decision. In 1991 the company I own faced a similar crisis. I spent most of my time devising elaborate commission incentive contests and refereeing commission arguments. The sales staff was solely interested in how much commission they made. When I switched to salaries, 30 percent of the sales staff quit immediately, including many top performers. Within one year, sales went up 40 percent, and 16 years later things continue to improve.

Jim Mcingvale
Gallery Furniture

Not enough upside

The move will help Scout avoid minimum wage lawsuits, which have plagued employers of low producers who don't earn the minimum wage in commissions. It will draw a higher-quality employee looking for stability. But while lower earnings per transaction may decrease incentive to steer borrowers to higher-cost mortgages, it may drain the incentive to excel in selling, leaving Scout paying salaries regardless of revenue. Given today's depressed market, there doesn't seem to be enough upside for such fixed expenses.

Sam Garcia