The Federal Treasurer was on his front foot this week. A little bit awkward, I know, considering he was announcing a back-step in proposed changes to mortgage broking.
If you watched the royal commission, mortgage broking was one industry that took a lot of heat. What particularly got the commissioner’s attention is the way commissions are structured.
Currently, mortgage brokers work under a two-step commission structure. For writing a loan, the bank pays them an up-front commission, once the loan settles.
The second commission is a trailing commission, typically paid at the end of each month. Both are a base percentage of the overall loan amount.
Originally, the government planned to cull trailing commissions from July next year. In his announcement this week, however, the Treasurer pushed this out to 2022. And even then, it is only for review.
The mortgage broking industry can now take in some much-needed air. But for how long, with an election due within months?
A vital cog
The interesting thing was the market’s reaction to bank shares after the Treasurer’s announcement. If you missed it, bank shares all fell on the news.
Brokers are distribution arms for the banks. They absorb costs that the banks would otherwise have to pay. Like paying employees to work on weekends, or late at night. Plus driving around from one suburb to the next.
These brokers write over half of all bank loans. It’s a system that works well for the banks. They only need to pay these brokers when they send a loan their way.
Until the broker submits a loan, and the bank approves it (and it settles), the bank doesn’t have to pay out a single cent. Until then, brokers work for nothing.
Loans can easily fall over in between application and settlement. The client’s existing bank can offer a special rate, or another broker could sweep in and take the business away. Plus, with tighter lending restrictions from the banks, more loan applications will fail at assessment.
One way to read the fall in bank shares is that the banks will need to keep paying these commissions. But you can also read it another way.
Keeping the current system in place means more competition for the banks. It levels up the playing field, allowing smaller lenders to compete without needing to roll out a branch network.
For example, through brokers, Bendigo and Adelaide Bank can sell home loans in Townsville. Or, Bank of Queensland can sell mortgages in Victoria or Tasmania.
A win either way
The broker distribution network also enables the bigger banks to save costs too. It means they can maintain a sales network, without having to maintain their own branch network.
If the broker network stays as it is, these bankers certainly won’t be crying in their beer. What they will do is crunch and/or change the structure of the commission they pay brokers.
Brokers view the two-part commission as one commission payment split into two. If they received the whole commission up front, they would be jumping for joy. To keep the upfront commission as it is, and just cancel the trail, would likely send most brokers to the wall.
Plus, even though the trail can be attractive, they only get it for the life of the loan. That’s all well and good if the client stays with the one lender for 30 years. But that is not often the case. Many change lenders every few years.
If the broker network does go to the wall, you can expect the big banks to swamp their smaller rivals. The small banks just don’t have the scale and retail network to compete against the big four.
And without that competition, you can be sure that the big four will once again ratchet up their margins to line their own pockets.
That’s why we saw the banks’ share prices fall earlier this week. The market understands that the broker network increases competition. And in doing so, lowers banks’ margins.
Sure enough, the way brokers receive fees for their service is likely to change. However, if the day ever comes that brokers go, you can expect the share prices of the big four to rise in anticipation of higher margins, and profits.
Editor, Options Trader