Getting better results for consumers: An economic perspective from a discount mortgage broker

Submission in response to the Discussion Paper on national finance broking regulation


On behalf of

by Nicholas Gruen

15th February 2005

1

Table of contents

Executive Summary......

Introduction......

The need for regulation......

Fringe players......

The mainstream......

A regulatory regime that meets Australian government’s commitments to ‘minimum effective regulation’.

1Ensuring consumers are well informed......

2Resolving disputes cost effectively......

3Removing unscrupulous operators......

Keeping it complex: Why existing and proposed regulation is inefficient......

Providing information......

Finance broking contracts......

Keeping to the script: Why existing and proposed regulation promotes and further legitimates the ambiguity of the broker’s role

The costs of the consumer script: Raising costs, obstructing innovation......

Fee for service lending......

Table of Boxes

Box 1: Comparison rates...... 9

Box 2: From the Discussion paper: Three different approaches...... 14

Box 3: The Ombudsman: An anecdote and some implications...... 17

Executive Summary

It is easy to identify things that are not perfect in the world. It is easy to propose regulation. When the regulatory net was last extended in Australia, to require the industry to publish ‘comparison rates’ the body that implemented the regulation, the Ministerial Council of Consumer Affairs (MCCA), did not comply with the regulatory regime on regulation making to which it is itself subject.[1]

Despite repeated requests and reminders from the Federal regulatory watchdog the Office of Regulation Review (ORR), no Regulatory Impact Statement was prepared. In the publication of the latest Discussion Paper Australian Government’s regulatory policy is so far being followed at least in form. However our submission argues that the procedure is not being followed in substance.

Peach Home Loans proposes that there be national regulation of mortgage broking and that a regulatory regime that was consistent with all Australian Government’s policies to implement ‘minimum effective regulation’ should:

1Ensure consumers are as well informed as possible

With a simple statement to be presented to all clients of mortgage brokers explaining that brokers are effectively sales agents of lenders and not independent advisors and suggesting that consumers stay in charge by ‘shopping around’ and also search for loan products on the internet. Other possible disclosure including commission rates and lenders within a broker’s panel could accompany this statement.
Regulation must choose between having consumers well informed and fully informed, as attempting the latter risks compromising the former. Whilst consumers must have access toall information of relevance to them including information about the operations of their broker, if they are provided with all this information in an unstructured manner, most consumers will either be confused or ignore the information altogether.

2Resolve disputes cost effectively

This can be done with an effective ombudsman scheme. The scheme should be as structured as it is currently but with small deposits for consumers to access the service – refundable on succeeding in their case. This would deter frivolous actions which appear to be quite frequent. In addition there should be some scope to require consumers to meet some of the costs of their actions on consumers where the Ombudsman considers their action to be vexatious. Without this the Ombudsman scheme will be a powerful obstruction to innovation and cost reduction.

3Remove unscrupulous operators

Where operators have been found to be unscrupulous in their dealings with consumers, they should be removed from the industry through a system of negative licensing.

It is very hard to justify regulation beyond this.

Our submission explains why existing regulation adds cost with few benefits for consumers. Further, most regulation is counterproductive in various ways. Thus:

  • The regulation requiring mandatory comparison rates actually confuses and misleads consumers.
  • Existing requirements for brokers to agree to a Finance Broking Contract (FBC) with their clients in NSW seem farcical to us. They spring from a desire to ‘do something’ about certain problems. But even a little reflection, let alone experience with the working model in NSW, shows that getting vulnerable consumers to sign yet another document which is drafted by the very broker it is intended to discipline is unlikely to protect the consumers.
    In our experience the FBC is vexing and confusing to the diligent consumer and broker alike. But we would expect it would add to the ease with which the less scrupulous broker could bamboozle a less sophisticated consumer.
  • Despite this, the Discussion Paper proposes to generalise the FBC procedure and then to add the requirement that the broker “provide the consumer with a statement of reasons setting out why the credit product recommended by the broker is the most appropriate product for the consumer’s circumstances (p. 74)”.
    If required, this advice would be provided as it generally is by ‘financial advisors’ as slabs of text generically drafted by sales executives, vetted by lawyers and disgorged from software that ‘wows’ the customers with its wizardry in their living rooms but is promoted as ‘sales technology’ within the industry.
    In addition to other shortcomings outlined below, the ‘advice’ will neither identify loans outside the brokers’ panel nor their existence. Thus the regulation fits neatly into the sales strategy of inviting the client to view the broker as an ‘advisor’ – suggesting a fiduciary relationship where none does or can exist.
  • The greatest costs of the regulation are the hidden ones, and the ways in which it is actively counterproductive. This regulation imposes substantial costs on consumers, not just in the direct – and relatively small – costs it imposes on the industry but in its obstruction of innovation and cost reduction in the industry.
  • Our inability to charge even a small and refundable deposit for our time prevents us from paying substantially higher rebates and from selling special low margin products. We find it hard to believe that the regulators meant to foreclose such options but that is the effect of their regulation.
  • While bemoaning the incentives on sales agents in the industry, and trying to wave a regulatory wand to make them act like the fiduciaries they are not, the complete prohibition of charging before obtaining credit actually prevents the emergence of an economic model in which brokers could be true fiduciaries. Peach is interested in establishing a fiduciary broking service that would charge clients by the hour – in the way an accountant would.
  • If we did so we could also experiment with offering our own low cost loans direct from funding wholesalers without an interest rate margin - saving clients around 0.25% or more off their interest rate, or $50 per month on a $250,000 loan or over $50 per month. Against this borrowers would occasionally parting with a fee charged on an hourly basis if they wanted to change some detail of their account.
    But in addition to prohibitions on charging before obtaining credit, charging by the hour would upset consumer expectations – even if we told consumers the rules beforehand raising the risk of consumer action against us with the Ombudsman.
    We support and indeed agitated for the Ombudsman before one existed. But because it was designed to appease consumer groups, it is wide open for vexatious and malicious abuse. We have not been taken to the Ombudsman but if we were, we’d face costs of over $7,000 just to successfully defend ourselves without so much as a $10 deposit from the consumer or any risk to the consumer of having to bear some of our costs up to whatever stage of proceedings it took if his or her complaint were be found vexatious. It is hard to imagine anything better calculated to obstruct cost reducing innovation.

1

Introduction

I founded Peach Home Loans, Australia's first national discount mortgage broker, in April 2000.

We provide the same service to clients as other mortgage brokers. We help our clients identify loans that suit their circumstances. Someone with detailed knowledge of a wide range of product offerings discusses their needs with them. If necessary research is performed using the internet and networks within the industry to identify products that meet specific needs.

Clients are then sent detailed product information and then we assist them through the process of application with any one of a wide range of lenders. Home visits are frequently arranged, though, where lenders’ policies permit, we also allow clients to apply at a distance using phone, fax and internet communication such as e-mail.

Peach then provides a rebate to its clients reflecting its lower margins. The normal level of rebate paid is provided in the accompanying table.

Loan Amount / Peach Rebate
$120,000 – $149,999 / $350
$150,000 – $249,999 / $500
$250,000 - $499,999 / $1,000
$500,000+ / $1,500
We pay an additional $1,000 for each additional $250,000 in the loan above $500,000. However to qualify for rebates over $1,500 you must check with Peach.

Peach also provides a range of free benefits to people, whether or not they are clients of ours. We send out monthly newsletters on lending and financial matters to those who have subscribed, ‘savers’ newsletters to those who are still saving for a deposit.

We operate a free property sale website - – and also distribute free of charge sophisticated property investment software that allows people to model the financial impact of property investment scenarios – available at We know of no way of obtaining comparable software other than paying between $80 and $400 for it.

The need for regulation

Graham Samuel, Chairman of the Federal consumer watchdog the Australian Competition and Consumer Commission, has recently commented that consumer regulation can hurt consumers.[2] He argues that consumer regulation should seek to ensure that consumers get accurate information and then generally leave them to make their own choices.

Where competition is able to operate effectively and efficiently, the disciplines of competition will result in consumers receiving the benefits of lower prices, of greater choice. What that means then is that consumer protection primarily is directed towards ensuring that businesses are honest, that the information they provide to consumers to enable them to make their choice is honest, is not misleading and deceptive.

Samuel argues that that is the “broad tenor of the Consumer Protection Provisions to the Trade Practices Act” and that accordingly a clear case must be made out for going beyond its provisions.

As we see it there are two problems in the industry which might warrant going beyond the Trade Practices Act. The first is that there are what the Discussion Paper calls ‘fringe players’ who employ all sorts of highly dubious tactics and prey off people’s vulnerabilities. The second is the ambiguity of the role played by mortgage brokers. These issues are tackled in turn.

Fringe players

On the unscrupulous fringe of mortgage broking, consumers are lured and/or pressured into unsuitable credit contracts. These are frequently of much greater financial significance for customers than a faulty consumer good.

There is a substantial industry that involves some or all of the following practices.

  • cold calling;
  • ‘pressure’ sales on home visits;
  • compelling but frequently dubious demonstrations of how consumers can save money by ‘consolidating’ existing debt; with
  • consumers being asked to sign to make an immediate payment of a substantial sum – usually by signing credit card authorisation.

Following this, the customer is refinanced into an expensive ‘line of credit’ type of service which is often neither suitable for the customers given their level of financial sophistication, nor is the product competitively priced.

It may be appropriate to impose some regulatory regime on this industry. We do not know much about it, so we cannot propose regulatory solutions. However we would hope that customers’ basic choices are respected. The regulatory task is to try to alleviate the ‘horror stories’ at the same time as allowing people to make legitimate choices. We expect most people’s choices will reflect their interests and regulation should only seek to help them be informed consumers and perhaps address the question of sales pressure with ‘cooling off’ periods etc.

More important from our perspective is the need to come up with a means of addressing the issues thrown up by this kind of lending that does not impose costs on those in the industry who are operating in a quite different manner. For example, as argued below, restrictions on unreasonable charges at a home visit may be appropriate, but the outlawing of any deposit taking whatever is one of a number of practices which prevent service providers such as Peach from cutting their margins further.

The mainstream

As the Discussion Paper acknowledges, the bulk of the industry operates in a very different manner to the fringe. The problem with mainstream brokers is quite different.

Like its cousin, ‘financial planning’ or ‘investment advice’mortgage broking operates in a netherworld.

Within the industry, brokers are treated and thought of as a “sales channel” and remunerated as such. Thus brokers are paid commission by lenders for selling loans, they are paid bonuses for volume sales, and lenders conduct sales campaigns amongst brokers with bonuses and various benefits in kind.

For all these reasons we encourage our customers to see us as sales people – and the closest analogy is selling consumer goods like fridges in a department store. We are not ashamed of being straightforward about this relationship. Salespeople are usually honest and good sources of advice because of their extensive product knowledge. And where a salesperson can offer products from many different providers – as salespeople in department stores can – there are obvious efficiencies and savings for customers.

So long as they think they’re operating in a competitive market, salespeople also have strong incentives to try to find the best product for their customers. If they don’t, another salesperson will beat them to the punch.

Not only is this analogy an accurate reflection of the realities of mortgage broking, it is one that customers are familiar with, and so it is a very direct way of ensuring that they are empowered. In department stores, customers understand that they should ‘shop around’ and stay in charge because salespeople only offer access to some brands and not others and salespeople are there to make a sale.

In broking as in ‘financial advice’ there are hefty rewards for practitioners who can get their customers to think that, despite their remuneration as sales agents, they act as fiduciaries – that is on behalf of their customers, the way a good doctor or accountant would.

Thus, though we wonder what took it so long, we support the increased vigilance ASIC is showing towards misleading claims being made in the industry, particularly claims of ‘independence’ and ‘impartiality’ from people who are in fact sales agents.

A regulatory regime that meets Australian government’s commitments to ‘minimum effective regulation’.

The process by which we arrive at any national regulation of mortgage broking is governed by the Principles and Guidelines for National Standard Setting and Regulatory Action by Ministerial Councils and Standard-Setting Bodies.[3]

When the regulatory net was last extended in Australia, requiringpthe publication of ‘comparison rates’, the body implementing the regulation, the Ministerial Council of Consumer Affairs (MCCA), did not comply with the regulatory regime on regulation making to which it is itself subject.

Preeminent amongst the principles of good regulation set out in that document is this principle.

Legislation should entail the minimum necessary amount of regulation to achieve [its] objectives.

Because of the unusual importance of what brokers do, and because of the ambiguity of their role in the marketplace, we think there is a case for regulation to go beyond simple reliance on the Trade Practices Act. It should encompass three objectives

  1. the provision of simple, useful information to consumers to ensure they understand what brokers are;
  2. the provision of cost effective dispute resolution for consumers to seek relief against service providers; and
  3. removal from the industry of unscrupulous operators

1Ensuring consumers are well informed

The ambiguity of the role of the broker should be addressed by simply requiring brokers to make a short simple statement to borrowers to the effect that they are sales agents, that they do not cover the whole market. They should also be required to advise borrowers to consider ‘shopping around’ by consulting more than one broker as well as searching the internet for available options.

Peach has processes in place for ensuring that its brokers are not financially motivated to sell one product ahead of another. However we believe the concern about this matter in the community arises from the ambiguity in the way in which brokers are conceived of within the community as ‘advisors’. If it is understood that they are salespeople and people understand that this is their role, and if there are sanctions for dishonesty, then whether they are paid additional commission for some loans or not becomes secondary, as indeed do ‘soft dollar’ commissions.

There are two pronounced problems with excessive concern for differential commission structures. Firstly the idea of constraining differentials in remuneration between products implies that the consumer should put themselves in the hands of the broker and seek his ‘recommendation’.

The idea that brokers ‘recommend’ loans is a major theme of the discussion in the Discussion Paper and a foundation for proposed regulation.

If we instead strive to ensure that the consumer understands the need to stay in control, that he or she should ultimately use service providers to assist in his or her search for a product, then commissions are incidental.

Perhaps more importantly, focusing on the issue of equality of commission distracts attention from a range of other conflicts of interest that brokers have. Most particularly, brokers are remunerated by the extent of their sales. So a broker generally has a financial incentive to maximise the borrowing of the consumer. We don’t believe the answer is to outlaw this kind of conflict of interest. One could argue that it should be disclosed. We have no real problem with it being disclosed and frequently disclose it ourselves. But it is also imperative that consumer information should be simple and brief. If it is not, consumers will not read it, and so their attention will be diverted from the most important issue.