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Morningstar | Proposed Changes to Industry Structure Cloud Outlook for Mortgage Choice; FVE Cut to AUD 1.10

Royal Commission recommendations covering the mortgage brokering industry could disrupt and damage the business model of Mortgage Choice. We have been too optimistic in assuming existing remuneration arrangements would continue with only minor adjustments to the revenue model would remain broadly intact. Instead, the Royal Commission’s final report recommended drastic changes to broker remuneration and if fully implemented will significantly reduce the profitability of mortgage brokers, including Mortgage Choice. Key recommendations call for the initial removal of trail commissions and then subsequently banning upfront commissions. Both commissions are currently paid by lenders to brokers.

As a result of the significant uncertainty surrounding future changes to broker remuneration, we cut our fair value estimate 27% for Mortgage Choice to AUD 1.10 per share from AUD 1.50 previously. At current prices the stock is undervalued, trading 28% below our valuation. The future of the mortgage broking industry is clouded by the wide-ranging Royal Commission recommendations, and consequently we increase our uncertainty rating to Very High from High.

It is clear the structure of commissions paid by lenders to mortgage brokers will change, with the government confirming trail commissions will cease on July 1, 2020, for new loans and in three years’ time a review will be undertaken to assess the impact of the changes on consumer outcomes and competition of moving to a borrower pays remunerations structure.

It is not clear whether, from July 1, 2020, lenders will increase upfront commission payments to mortgage brokers to compensate brokers for the loss of trail commissions. Our reduced valuation assumes lenders do not increase upfront commissions to compensate brokers for the loss of trail commission, although this remains a possibility. We model a drop off in new loan volumes of about 20% per year from July 1, 2022, as a result of the new upfront payment structure.

The potential change of government, with elections expected in May 2019, adds to the uncertainty. The stock has fallen sharply since the start of the Royal Commission, down about 68% with a current market valuation of just AUD 100 million. The Labor opposition party initially stated all Royal Commission recommendations will be implemented in full if they gain power, thereby banning both trail and upfront commissions and forcing mortgage brokers to charge upfront fees to borrowers. But initial rhetoric has softened somewhat, and we think a future Labor government would likely follow the current government’s plan to review the impact of changes on consumers and competition of moving to a borrower pays model in three years’ time.

Following the industry review scheduled for early 2022, we think the government of the day will likely not implement the borrower pay model where only customers of mortgage brokers pay the upfront fee. Another alternative outcome could be all home loan borrowers, irrespective of origination channel, will be required to pay a loan origination fee whether borrowers deal with brokers or go direct to lenders. Both potential changes will impact the structure of broker remuneration.

Ironically, the Royal Commission’s recommendation for borrowers to pay a fee to mortgage brokers and the banning of commission payments from lenders to brokers works to the advantage of the four major banks, particularly Commonwealth Bank of Australia and Westpac Banking Corporation, due to large branch networks and online processing capacity. We think a strengthening of the major banks’ market power is not a desired outcome for the government and regulators.

Uncertainty also persists around whether fees paid by borrowers to brokers would be a flat fee or variable, based on the loan size. A key consideration will be whether lenders would be required to charge the same upfront fee to borrowers who apply directly, bypassing the broker channel.

About 56% of all loan applications are currently processed via brokers and based on industry surveys, most borrowers are satisfied with the service provided by brokers. But if in the future brokers are required to charge an upfront fee to borrowers and lenders are not required to charge the same fee to borrowers, we would expect a significant drop in mortgage broker clients as new borrowers revert to the fee free lender channel.

A for service model is not implemented industrywide, and at worst, if implemented lenders would be required to charge a similar fee to borrowers thereby offsetting the negative impact of the fee for service charge. We assume new trail commissions are banned effective July 1, 2020, with trail commissions in place as at June 30, 2020, grandfathered. For Mortgage Choice, we expect grandfathered trail commissions to run off to very low amounts by the end of fiscal 2024.

Average commission income received by Mortgage Choice is currently about AUD 4,000 per loan, including AUD 2,000 upfront and about AUD 2,000 in total trail commission spread over approximately four years based on an initial average loan size of AUD 345,000. Approximately 75% of upfront commission income received is passed through to franchisees. Approximately 72% of trail commission income received is passed through to franchisees.

Under our view of future changes to industry structure, our bear-case fair value estimate declines to AUD 55 cents per share. Under this scenario gross upfront commission income declines to AUD 60 million in fiscal 2023 from AUD 70 million in fiscal 2018. But the big impact is to gross trail commission where we forecast a sharp decline to just AUD 28 million in fiscal 2023 from AUD 98 million in fiscal 2018. The percentage pass through to franchisees remains broadly constant at 75% for upfront commissions and 72% for trail commissions.