Kenneth Hayne got it wrong on mortgage brokers

In the two weeks since the release of the final report into Misconduct in the Banking, Superannuation & Financial Services Industry, rather bizarrely the most contentious recommendation deals not with bank misconduct but mortgage broker remuneration.

This was primarily a Royal Commission into misconduct by the big four banks and they were lambasted by Kenneth Hayne for the pursuit of short term profit at the expense of basic standards of honesty. Yet despite all the horror stories, Hayne basically concluded that existing laws and regulations are generally adequate to protect borrowers it’s just that the banks have not always obeyed them and the regulators have not done a good enough job in enforcing them.

Meanwhile, Hayne pilloried mortgage brokers for having a conflict of interest because they act for the borrower but get paid by the lender. But unlike the banks, Hayne found little, if any, evidence of systemic misconduct yet his recommendation to replace commissions with a user pays fee for service has significant implications for borrowers, brokers, banks and the broader economy.

The banks had to be brought kicking and screaming to the Royal Commission, although they would say it was their recommendation to the then Treasurer Scott Morrison that led to its establishment in December 2017. Up until then, they stuck to the “it’s just a few bad apples” defence that the Government willingly bought.

Meanwhile mortgage brokers have been proactive in industry self-regulation. Following on from the April 2017 Sedgwick Report, bank and non-bank lenders, aggregators and brokers and consumer groups established the Combined Industry Forum (CIF) to drive better customer outcomes through improved governance and remuneration practices. Whilst the CIF was on this journey, the Productivity Commission and ASIC were conducting their own reviews and tellingly neither called for the scrapping of broker commissions.

Other recommendations re mortgage brokers:
In addition to the recommendation relating to brokerage remuneration, Hayne made two further recommendations:
1. A duty to always act in the best interests of customers. This is a lift in brokers current obligation which is simply to procure a loan which is “not unsuitable”. This change ought to ensure their primary focus is the borrower. No-one should have any issue with this.

The best interests test should be given the opportunity to flush out and punish poor broker conduct before any decision is made on removing lender paid commissions. This is no different to the approach Hayne is taking with the banks i.e. “just obey the law and everything will be all right but if you don’t, this time the regulators will come down hard on you.”

2. Brokers would be subject to stricter future of financial advice (FoFA) laws like those that apply to financial planners. This means brokers will have to render a comprehensive statement of advice every time they suggest a loan and could be sued if the product was inappropriate for the customer in question.

This will add to the compliance burden that someone (the borrower) will have to pay for. Arguably this extra step is unnecessary in light of the new best interests test.

Will this be the end for mortgage brokers?
It is understandable why the recommendation to remove commissions is an emotive issue for mortgage brokers. If implemented as currently proposed, it would fundamentally impact the viability and value of their businesses and put at risk jobs in a sector that employs 50,000 people. Brokers have a strong case and are prosecuting it vigorously. A grass roots industry petition has already gathered 77,000 signatories objecting to the recommendation.

Supporters of Hayne’s recommendation argue that this will not herald the demise of brokers but rather it will lead to an overdue consolidation. Going back to its origins some thirty years ago, mortgage broking was quite a lucrative profession. A booming demand for home loans, significant increases in property values combined with banks losing sight of their customers lead to the current position where 59 per cent of all home loans are written through the broker channel.

In recent times, banks have tightened up on broker remuneration and this, combined with more brokers competing for less business when the demand for, and prices of, housing are falling, has impacted on the profitability of brokers who on average now earn $85,000 pa.

A recent survey showed that over 95 per cent of borrowers would not be prepared to pay for a broker. But really, what other response could be expected? No one is keen to pay for something that is currently free but there are no free lunches and borrowers invariably pay one way or another.

In my experience, brokers almost always deliver better outcomes than the borrower on their own would be capable of achieving. Measures like customer satisfaction rates, net promoter scores and repeat business all suggest brokers are highly valued, certainly more so than bankers. Brokers know the value of what they do for their customers although to date it has not been imperative that they be able to demonstrate this. Regardless of whether we move to a user pays system, brokers need to ensure they are able to clearly convey their value proposition to existing and potential customers.

Brokers who are not convinced their value proposition is sufficiently compelling to retain existing customers and win new ones may well exit the industry. This would not a bad outcome – brokers are not immune the challenges and opportunities change can bring such as open banking.

While some may exit the industry, the bottom line is brokers provide a much needed and valued service. And borrowers who currently say “we wouldn’t pay a fee to a broker for arranging a loan” are likely to change their minds after they try to arrange a loan themselves.

So even if brokers were to be paid by borrowers and not lenders, to the extent they are able to demonstrate value for money, their customers, sooner or later, will come to accept this as part of the cost of getting the loan. However in the meantime there would be substantial disruption.

Laughing all the way to the big banks.
The big banks will clearly be the winners in the event of the demise of mortgage brokers. Competition will be reduced and bank profits will rise with analysts recently estimating the major banks alone could save $1.68 billion a year if commissions were axed. Of course, the banks could pass these savings onto customers in the form of lower rates but would they?

CBA is by far the nation’s biggest home loan lender and so has the most to gain from the demise of mortgage brokers. Its CEO Matt Comyn was advocating the move to a borrower pays system even before Hayne recommended it.

Meanwhile, Aussie Home Loans which is owned by CBA has also argued a smaller broking industry would limit consumer choice and access to credit. This shows that CBA believes it has more to gain by the demise of brokers than it has to lose in the value of its investment in Aussie Home Loans.

Smaller banks will be disadvantaged because they simply don’t have the branch network.

But borrowers would be worse off.
It wont just be harder to get a home loan from a bank, it will also take longer. If all or even some of the home loans currently written through broker channels went straight to the banks, they couldn’t cope. They don’t have the people, branches have been shut and although it works for some, online applications invariably necessitate human involvement. This will be a challenge for those customers whose financial literacy and computer skills are not strong.

With implications for the economy.
The recommendation could contribute to a downturn in the economy. To the extent that borrowers find it increasingly difficult to obtain finance, this will put further pressure the construction industry with associated flow on effects and it will put downward pressure on house prices.

Household debt doesn’t decrease in value but house prices can.

The latest research from Martin North at DFA Analytics reveals that over one million households representing 31 per cent of owner occupied borrowing households are under mortgage stress ie when net income (cash flow) does not cover ongoing costs. Meanwhile, there are in excess of 600,000 home loan borrowers on interest only loans, many of whom will struggle if/when those loans are rolled into principal and interest.

It could get even worse under a Shorten Government.
Labour, which appears to be as close to a “shoe-in” as you could ever get in federal politics, has said it will implement all of the RC’s recommendations. It’s ironic that Labour which is philosophically opposed to the big banks, is actually supporting measures that would only increase their powers and profits. Assuming Labour wins the election and proceeds with their commitment to adopt all of the RC’s recommendations this, on top of their policies on negative gearing and capital gains tax, poses a material threat to Australia’s economy.

WHERE TO FROM HERE?
The risks associated with replacement of commissions paid by lenders with a user pays system outweigh the benefits that might arise from removing the issue of conflicted remuneration.

Introduction of the best interests test together with the establishment of AFCA, the new national body that deals with consumer complaints, will better protect the interests of borrowers. Meanwhile, the momentum for self-regulation is being maintained by the Combined Industry Forum which provides updates on progress in achieving agreed reforms to Government, Treasury and ASIC on a semi-annual basis.

The recommendation to fundamentally change mortgage broker remuneration is more likely to hinder than help customers. It is economically risky and potentially unnecessary. The best interests test combined with self-regulation initiatives should be given the opportunity to work before steps are taken to overhaul the way brokers are remunerated.

Comments and feedback are invited.