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The money trail

There has never been a more lucrative time to be a mortgage broker. Commissions on the average deal currently stand at between £300 and £500 and a credit-impaired case can be as much as £2,000. This income can be increased with case administration and some intermediaries also have a policy of charging the client a fee. Add income from selling other products and the picture starts to look very rosy. Small wonder that some lenders want to join the broker market and share in the rewards.

However, with more and more lenders now mooting the concept of trail commission, soon this could all change and ill-prepared brokers could be left high and dry.

The way in which commission is normally paid also gives the intermediary the incentive to &#39churn&#39 their client bank and remortgage clients out of uncompetitive variable rates as soon as they emerge from a redemption period. It was two years ago that lenders removed overhanging redemption penalties for most of their products as a result of consumer and government pressure. It is now estimated that as a result of those changes there will be £20bn of existing business emerging from the redemption penalty period in the first few months of the new year (see Table 2).

Bernard Clark at the CML supports this view as he points out: “CML statistics show that remortgages are more popular in the early months of the year with house purchase taking the lion&#39s share in the summer. Also, short-term fixed rates and discounts have been popular for the last few years with redemption penalties ending after the discount or fixed period. Remortgaging reached 31% of total lending in August this year. Last year there were £34bn of remortgages. We estimate by the end of the third quarter this year remortgages will have accounted for £36.5bn of gross advances.” (See Table 1.) The new year, therefore, will provide a profitable target market for brokers, particularly with the current low rates and special remortgage deals from aggressive lending institutions. However, this will pose a real challenge to the existing lenders who will have to devise new ways to retain their best customers.

James Mayne, manager, business planning at Britannic Money, confirms that lenders are worried about customer retention. “The retention of customers is a major concern for lenders,” he says. “This is likely to be addressed by lenders through the removal of &#39free&#39 remortgaging, the reintroduction of early repayment charges and the continued development of more feature-driven products.”

Over 60% of Standard Life&#39s mortgage book has been introduced by IFAs and mortgage intermediaries and this is reflected in its attitude to brokers – now paid through trail commission.

Alan Dring, head of sales at Standard Life Bank, says: “Any retention strategy must take into account the needs of the agent as well as the customer. Rather than treating retention as something to address when clients are looking to redeem, we try where possible, to engineer retention into our mortgage proposition at the outset.”

Dring says that this can be done in two ways. Firstly, by offering long-term value in the rates SLB offer by balancing the need for an attractive introductory pay rate with a low longer-term SVR. And, secondly, by offering long-term value products – many of the bank&#39s products are designed to offer best value when the customer utilises their features.

“In addition to designing products that encourage customer loyalty, we are also rolling out a customer contact strategy to ensure that clients understand the value of the features and services available to them,” says Dring. “Whilst a growing number of clients have flexible mortgages, only a very small percentage fully understand its potential.

“We also identify customers who are thinking about leaving us and try to address their concerns. Where possible we try to retain them, if this is not possible we try to gain a better understanding of why they are moving.”

Much of what SLB tries to do with brokers mirrors this customer process. By helping brokers understand the real long-term value of its products and making it easier for them to demonstrate these features to their clients, SLB believes that it creates a better platform for retention.

“We also align the rewards that an intermediary can receive to the value of the business he brings with a trail commission available to certain intermediaries. The amount paid on the trail depends on the mortgage still being on our books.”

The options for &#39loyalty-based&#39 commission offerings is something that SLB is keen to develop further.

However, Ray Boulger of Charcol is just one of many brokers not in favour of trail commission. “With regard to trail commission we have discussed the possibility with a number of lenders, but if the renewal fee means that the up-front fee is reduced I do not think many intermediaries will be interested,” he says.

“The lazy broker who is not interested in his ongoing relationship with his client might find it attractive but we do not.”

Richard Griffiths, managing director of Network Data, the information supplier and packager, is also dubious about trail commission.

“Trail commissions of 0.05% to 0.1% are not good enough to give brokers an incentive to stop giving remortgage advise to clients. In the general insurance market renewal commissions are 20% and 80% of business renews with the same provider. In fact, fees in the mortgage market are far too low at the present time,” argues Griffiths.

“If lenders could compare the costs involved through other channels, such as branch networks and direct sales where the lender has to support advertising campaigns and call centres, they would realise that the intermediary channel is good value. Lenders really need to look at their pricing models because if they continue to try to buy business with crazy pricing they will go bust.” Lenders need to form close relationships with intermediaries and packagers, he goes on to say, as it is they who can provide volume business with sensible rates that give the borrower a good deal – not only at the front end but through the life of the loan.

“The commission can then reflect the value that the intermediary brings in reducing the lenders overall cost of acquisition,” he adds.

Many lenders are uncertain on where trail commission is heading and how it will affect their relationship with intermediaries. Some lenders have responded by buying distribution channels. The Skipton has purchased Pink Home Loans, the Bradford & Bingley has Charcol while Bristol & West has made some strategic purchases with its acquisitions of Money Extra, Willis National and Chase De Vere.

Debbie Staveley, spokesperson for Bristol & West, stressed, however, that the lender had no intention of directing business to itself from its subsidiaries.

She says: “It is important that Money Extra, Chase De Vere and Willis National have total independence to place mortgage business where they think it is best for the client. The whole question of customer retention and intermediary commission is currently under review within Bristol & West and we have a range of strategies to consider.”

Some lenders are developing new strategies to deal with both distribution and retention. Ian Jeffery, sales director at Intelligent Finance, explains: “The industry up until now has had product-based commission structures. This leads to front-loaded commission and an incentive to &#39churn&#39 business. We have adopted a client-based system that gives intermediaries the opportunity to earn out of the increasing value of the portfolio of mortgages built by them.”

In the past, some lenders have given intermediaries &#39no cross-selling&#39 guarantees. But Jeffery says Intelligent Finance actively cross-sell other products to its clients. The difference being though that it makes sure the originating broker shares in the new income streams by passing on commissions on the sale of these products as well.

Intelligent Finance is a new company, which, as yet, is without an existing client bank to protect. Other lenders who do have existing loans need to adopt a different approach to keep their clients.

Tony Ward, deputy chairman designate of the CML and chief executive of Britannic Money, has a different view. “In my opinion trail commission does not work for intermediaries because, as yet, it is just not possible to make the renewal element big enough to stop brokers churning the business.”

By attempting to introduce both front loaded and trail commission, lenders end up paying more, yet results stay the same.

“It would need renewal commissions of up to 0.5% to provide a powerful enough incentive for intermediaries but with current margins it would be impossible for lenders to make a profit,” says Ward.

Britannic Money is taking a two-step approach to this problem. Firstly, it is reintroducing redemption penalties for some products and, secondly, it intends to work in co-operation with its intermediaries to help them sell the benefits of its current account mortgage to ensure clients use the functionality.

“We believe this is the way to retain our customers in the long term,” says Ward. “The real problem is that some large brokers will always look for the lenders who want to achieve volume at the expense of profit. These intermediaries look for large front-end commissions but then churn the client when they can.”

Ward says that Britannic Money is in the process of reviewing its distribution strategy to identify these brokers and deal with the problem in hand.

“We want to build relationships on a partnership basis with intermediaries who value the features our products contain. However, once we have done this I would not rule out trail commission altogether.”

“I think the real problem,” he goes on to say, “is that some of the larger lenders are mindful of a slowing of housing transactions next year and are indulging in a &#39feeding frenzy&#39 by launching unprofitable products with high commissions.”

They may well claim they can justify their pricing on cross-selling other products or their lower funding costs, maintains Ward, but this is leading to a position where small lenders may be put under pressure and the industry rationalised into a number of large groupings.

Stephen Knight, chairman of GMAC RFC, is rather sceptical about the intermediaries&#39 ability to &#39churn&#39 their clients.

“In my experience, intermediaries threaten to churn clients but, in reality, they are not very good at it,” he reasons. “By the time the client comes out of his redemption penalty the original sales person has left and intermediaries are not that interested in their clients.” What is happening, says Knight, is that clients who have enjoyed give-away discounts are deciding to move their mortgages and do not need any encouragement from their original intermediary.

“This is identifiable customer behaviour for a sector of the market. With regard to trail commission there are three problems. Firstly, it&#39s too complex and adds to the lenders processing costs. Secondly, the amount of the renewal commission is usually not big enough to offset the smaller upfront commission and, thirdly, the customer goes anyway because he has moved on to a new intermediary.”

The real problem, Knight believes, is lenders subsidising new borrowers at the expense of the existing book and therefore encouraging this customer behaviour. “The differential between new business rates and existing rates will reach an equilibrium when the number of existing borrowers on high SVR reduces and lenders cannot afford the incentives any more.”

Knight says that this is happening already as current discounts are much reduced on discounts a few years ago.

“Lenders need to realise that they have to pay for an intermediary channel and will need to find new ways of reducing the cost of mortgage processing and administration to pay for it.”

John Sutherland, divisional director of central services at Nationwide and chairman of Mortgage Brain, agrees that trail commission does not work.

“We looked at trail commission some time ago but realised that it just does not work. Our response to the problem of customer retention is to give our existing borrowers the same deal as new borrowers. The issue here is does commission affect the intermediary when he gives advice and does business go in the direction of the higher fees?” Sutherland says that the ways in which this can be approached is either the imposition of a standard commission rate or intermediaries not taking commission and charging fees for advice. Neither of these options are likely to be adopted in the short term but the important thing, he believes, is to protect vulnerable borrowers such as first-time buyers.

As far as the MCCB is concerned, the payment of trail commission is within the terms of the current code.

Brad Baker, head of communications at the MCCB, says: “We are aware of the changes in the payment of commission. However, as long as these fees are disclosed to the borrower they fall within the current perimeters of the code. We are also aware of concerns about best advice but we have found no evidence of this in our audits to date.”

SLB&#39s Alan Dring is more straightforward. “Regulation will bring with it changes that will certainly impact on introducer&#39s income. Changes to intermediaries&#39 income streams that will generate longer periods of comfort and better client retention need to be developed. We are currently looking at many options, one of which is how best to monitor and implement renewal commission for everyone&#39s benefit.”

So if intermediaries are going to be policed by lenders to make sure that they are not churning their borrowers, where does that leave &#39best advice&#39 for borrowers?

Ray Boulger of Charcol is very clear on this issue. “Intermediaries should provide their clients with the best product at all times,” he says. “Our role is to look at the market and provide clients with the products that meet their current needs regardless of their current lender.”

But Rob Clifford, managing director of mortgageforce, disagrees. “With regard to best advice – let&#39s face it, complete open market access by most brokers is unrealistic.”

Clifford argues that the typical broker has key relationships with around six lenders and even then the majority of the broker&#39s business is going to one lender.

“Some brokers suggest that the reason for this &#39multi-tied&#39 approach is as a result of the number of products, quality of processing and the relationship with the lender,” says Clifford. “I think N3 will flush this out into the open as lenders will probably be dealing with fewer brokers and brokers will need to build better partnerships with their chosen lenders.”

Nigel Giles, director at Carrington Carr, a mortgage intermediary who specialises in remortgage business, says: “We pride ourselves on our dedication to excellent customer services. We specialise in rescheduling client&#39s debts to save them money. We expect an up-front commission from the lender and are open-minded with regard to trail commission as we do look after the client in the longer term and we do not expect to churn that customer.”

Giles says that once the client&#39s finances have been restructured “we think he should not need to rate-hop and we would only remortgage him again if the client required it or the lender got totally out of line on rate. We tend to have very close relationships with lenders”. With regard to trail commission he adds that it would obviously depend on how much the renewal commission was and if it increased the value of the business as a result.

Stuart Stevens, financial services partner in KPMG Corporate Finance, thinks Carrington Carr are right not to dismiss trail commission out of hand, as he suspects it could be a potential gold mine for intermediaries. “Based upon precedents in, for example, the insurance industry, the introduction of trail commission should impact the valuation of mortgage intermediary businesses in two fundamental ways.”

Firstly, the prospect of annuity income should drive up valuations by adding substance and increased certainty of future earnings.

Secondly, it should result in a greater focus on the quality and profile of the business being written, beyond simple volume levels, he says.

If KPMG are correct and renewal commission becomes the way forward, then the size of the intermediary&#39s existing customer book will directly relate to their own value. This could have expensive consequences for any lenders wishing to secure their intermediary distribution by purchasing mortgage intermediaries in the future.

Despite the differences of opinion on front-end and renewal commission, lenders are all agreed that the retention of borrowers is a key issue in their struggle for profitability.

The intermediary channel has developed into a critical source of distribution for lenders and, without any foreseeable alternative, it may well be the intermediaries themselves who decide how future commission is paid. The real immediate challenge for lenders, however, is the correct analysis of their existing businesses. They need the ability to quantify the cost of sales across channels and by individual intermediaries.

If lenders do not know whom their most profitable introducers are, then they could be wasting their money. It is only with this detailed analysis that lenders will be in a position to make the business critical decisions, which will secure long-term profitability.

There is one point we can be sure of: with lenders chasing a potentially decreasing market next year, commission is on the way up. There&#39s never been a better time to be a mortgage intermediary. v Frank Eve is a specialist in mortgage strategy and a senior partner in Frank Eve Consulting The long and winding road

The mortgage industry is only just starting to realise the cost of supporting an intermediary distribution channel of its own. Very few lenders have been able to quantify the cost of sales across different intermediaries or even different distribution channels. With the industry undergoing structural change as a result of new legislation combined with new products, new technology and rationalisation through mergers and take-overs, lenders will have to look at the way they are incentivising intermediaries and the consequences.

Twenty years ago, most intermediary-based mortgage business was channelled directly to lenders without fees or came via an insurance company that packaged the case, again without charge. The insurance company was satisfied with the endowment business, the intermediary received commission from the endowment and the lender was extremely happy with a free distribution channel.

A lender&#39s intermediary distribution strategy was simply to have a number of endowment-hungry insurance companies on its panel, who would market and package the business free of charge.

However, during the property recession in the early 1990s many endowment policies started to lapse. This caused insurance companies to reconsider business practices. It did not take long to realise that they were spending too much on packaging mortgage business for someone else, with very little reward. This provided the opportunity for intermediaries to package business on behalf of the lender for a fee. Currently, endowment sales are all but gone, so the intermediary channel has to be supported by commissions from lenders.

Ray Boulger, senior technical manager at Charcol, reckons that there will be more than £20bn of mortgages up for grabs in the early part of next year. “Short-term fixed rates and discounts have been very popular over the last few years with some lenders doing away with redemption penalties altogether,” he says. But he adds that he also does not like to use the term &#39churning&#39 as it has negative connotations.

He conceded, however, that this has been a ongoing problem for lenders as they continue to launch more competitive products but do not offer them to existing customers. “The role we play as an independent intermediary is to find our clients the best deal,” says Boulger. “This has to take into account not only the best rate on the market but also redemption penalties and indemnity premium. I do not think we will see a return to long lock-in periods, as consumers will not buy them. It is up to intermediaries to ensure that lenders keep competitive, both in terms of new business rates and existing borrower rates.”

Lenders, he goes on to say, have created this position for themselves and the pressure is now on as far as the smaller lenders are concerned, particularly with the Halifax moving its SVR to 1% over bank base.

“The Nationwide has made its entire new business product available to existing borrowers and, therefore, I think its retention figures will be getting better,” says Boulger. “The Halifax and the Abbey have different deals for new and existing borrowers but are still offering existing clients a good deal.”

The problem is that lenders have set very high targets for lending from the intermediary market and a number of them are not reaching them and have misjudged the competitiveness of their product offering. “They now have a difficult decision to make,” says Boulger. “Miss the target, launch a more competitive product and risk making a loss on it or reduce the target and reduce profitability at the same time. I would certainly rather be an intermediary in the mortgage market at the moment than a lender. When large lenders are short on there target and they move their new business rate down, the whole market has to move with them.”

The Halifax also realises the increasing costs of intermediary distribution. Jack Saxton, head of intermediary markets for the Halifax, says: “It has only been over the last five years that the Halifax has paid commission to intermediaries; before that we only paid commission to our agencies who were accountants, solicitors and estate agents.”

The intermediary channel now, however, is a high priority for Halifax. “We recognise that intermediaries provide an important service for clients and lenders and we need to be competitive with our intermediary offering,” says Saxton.

“Having said that, the customer proposition and service is paramount. We want to give borrowers a reason to stay with the Halifax in the long term and this we do through the provision of a different range of products for existing borrowers. We are speaking to intermediaries about trail commission and any decisions will be based on this feedback.”

Doing it down under

As the debate over margins, customer churning and retention strategy rage, one area of the world has led the way with handling trail commission – Australia.

The Aussie mortgage market has been built on flexible and current account type products and it has no problem with renewal commissions for brokers.

Rob Clifford, managing director of mortgageforce, explains: “We have looked very closely at the Australian model and, although the deregulation of financial products only happened eight years ago, it has a very sophisticated intermediary mortgage market.” Commissions in Australia are much higher than in the UK, with average commissions on prime business at about 0.7% upfront and 0.3% on renewal.

However, it is not the financial return which prevents intermediaries from churning mortgage business, it is the lenders themselves.

“Each lender pro-actively monitors the performance of their brokers on redemption and outflow,” says Clifford, “and if they find that the profitability of an individual broker&#39s portfolio of introduced business drops (perhaps through remortgaging clients away) they are removed from the lender panel.”

“This could be the way forward for UK lenders,” he adds. “It comes down to lenders understanding and monitoring their profitability by channel and specifically by intermediary. They can then compare the cost of acquisition across direct and indirect channels and make sure they have their commission fees priced correctly.

“This will also give them the information they need to ensure that they have profitable broker distribution and increased retention.”

Standard Life has already started to identify those intermediaries who bring in business that stays and are rewarding them.

Alan Dring of Standard Life says: “We are improving at assessing the value and quality that individual IFAs bring to the organisation and are keen to match the rewards that we pay, to both the size and quality of individual IFA&#39s books. If IFAs are bringing in long-term business too, we want to reward accordingly.” Retention needs to be considered as a long-term strategic goal and cannot be dealt with solely by offering a new discount or fixed rate to client&#39s who threaten to redeem otherwise.

The industry says

John Stewart, director Basildon-based IFA “I don&#39t think it will stop clients and broker switching lenders, because the trail won&#39t make up for the initial fee that can be earned elsewhere.”

Kim North, director London-based IFA Pretty Financial “Trail commission is very good for IFAs because, in order to keep business, they will have to look after their clients.”

Phil Ambler, Chesterfield-based IFA “Trail commission might pay more in the long run but bills don&#39t wait. Trail commission does not have a place in the mortgage environment.”

Jim Gillespie, director Hartlepool-based Independent Financial Services “It is certainly good in terms of rewarding brokers for fully explaining the benefits of a current-account or an offset mortgage.”

Harry Katz, principal Stanmore-based Norwest Consultants “If you&#39re recommending a policy just because the lender offers trail commission when there could be a better product elsewhere, then that&#39s unfortunate.”

Matthew Wollaston, Lutterworth-based IFA Manor House Financial Advisers “Trail commission from an income point of view, is an attractive proposition for IFAs.”

Chris McMullen, director Bourne-mouth-based IFA McMullen “Trail commission builds the long-term value of the client relationship.”

Howard Horne, principal Guildford-based IFA “We don&#39t get very much out of a mortgage anyway; to take it as trail rather than up front would be cutting off our own noses.”

Barrie Jeffery, partner Worcester-based C&J IFAs “There are few clients that are aggressively chasing lower rates, and the trail helps to build sustainable business.”

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