Some parts of the mortgage industry have the jitters.

First, there are the aftermath effects of the credit crunch in the US, then it's rates and oversaturation of media reportage, and rogue brokers and unscrupulous lending practices - the property market perennially has players and punters buzzing.

Now comes word the next biggest thing to impact on the industry is consolidation - it's been wafting on the agenda for some time, but the degree to which merger and acquisition (M&A) activity is to occur is forecast to have an unprecedented influence on the industry's landscape. And the pressure is growing, from what mortgage managers and non-banks tell MPA Lender.

Certainly, amongst the larger mortgage managers and non-banks, there has been plenty of activity of late in the loan sale area. This includes Challenger's purchase (amongst other things) of a 40% stake in Homeloans Ltd, Columbus Capital's acquisition of $235m worth of Bluestone low-doc and near-prime loans, the mooted sale of ANZ-owned Origin's $7bn loan portfolio, and Firstfolio's acquisition of the $620m prime residential mortgage management book of Capital First, the wholly-owned subsidiary of GMAC-RFC.
 
Yet many smaller loan book purchases go unnoticed in the broader market, so it's difficult to accurately gauge the level of activity amongst smaller mortgage managers and originators. One person though who has a bird's-eye view of activity in the loan book acquisition space is Jon Denovan, partner in banking and finance at law firm Gadens. He is adamant activity has increased of late in this space.

Bernie McIntosh, principal at Victorian-based non-bank lender Victorian Mortgage Management, agrees. "We're seeing an increase," he says. "As to why, I probably couldn't put my finger on it accurately other than I guess our business has matured so people might see us as a potential purchaser. Also, while the percentage of sellers may not change, the increase in the size of the industry by numbers will lead to an increase in numbers selling."

Neil Brett, general manager at CSC Home Loans, is a Sydney-based mortgage manager who has bought loan books in the past. He says that while loan book acquisitions have consistently taken place, the rate of acquisitions has steadied in the past 18 months or so.

"There would be more happening at the moment if the price currently being paid at was higher than what it is," he says. "What's happening at the moment is the price has dropped."

Reasons for buying

According to Brian Jones, managing director of Homeloans Ltd, which itself is now 40% owned by financial services behemoth Challenger, the evolution of the mortgage industry since the early 1990s has seen changes in distribution and product segmentation, which in turn is dictating today's consolidation.

"M&A activity is a lifecycle thing. The advent of broking is one of the leading factors taking the market in a different direction. It's started to plateau out from the high growth levels of the late 1990s, but the data says the growth is still there," he says.

Historically, he says it's the industries which take on a higher level of growth that require a greater level of efficiency.

Josh Norris, director of Gold Coast-based Future Financial, says history is a good leveller in knowing how to value your business by comparing it to similar M & A activity of the past.

"Historically you could look at other sales and the margins. We would get our accountant to look at our figures and the lawyers with the strengths of the agreements. You've got to let the smoke settle initially to see what the business is going to be worth," he says.

Determining what a book is worth though is difficult. Brett believes an average value in today's market is around 1.5 times the trail book. This is well down on the three times value that was the norm around five years ago. He says for many, it's hard to raise the capital to acquire other books.

Why sell?

As to why mortgage managers would sell up, as McIntosh points out earlier in this article, that's difficult to tell.

For Brett, it's that some simply get tired of dealing with borrowers that the banks - which are becoming increasingly competitive - have knocked back. "If you look back to the 1990s, the mortgage manager was a very good alternative to the bank," he says. "That's why 'Aussie' John [Symond] used to sell his own product. He could compete with the banks well on rates. But what with the banks [now] offering pro packs to everybody... sometimes up to 0.8% off standard variable rates... it's then very, very hard for the mortgage managers."

Banks are becoming more competitive, as the recent Fujitsu-JP Morgan Australian Mortgage Report suggests. Recent branch expansions and improvements, along with more competitive pricing, have seen the banks claw back market share from the third party channel.

Moreover, Brett says that for those mortgage managers going direct to consumers, advertising is extremely expensive. "[But] so is paying out a 0.6% and 0.25% trail [to brokers]. They're both expensive." It's tough for mortgage managers regardless of the distribution channel they use.

Brett believes his company, which receives an even share of business from brokers and direct from consumers, has survived because of its decision to diversify their product offering. "If we hadn't diversified, I wonder if we'd be here today."

Buying the book

According to Jonathan Karlovsky, it's the job of groups like PKF Chartered Accountants and Business Advisors, for whom he is partner, to groom and prepare businesses ready for M&A activity.

Within Business and Advisory Services, there is an outsourcing department solely responsible for managing M&A activity and due diligence.

Depending on the party they are acting on behalf of and the contractual arrangements, Karlovsky typically assists the client in drawing up an information memorandum, including advertisements for tender.

From this, an advertisement may generate 50 or 60 expressions of interest, these parties would then sign a confidentiality agreement and the information memorandum is made available.

"This will include information of the business over the past few years, how the offer is to proceed, how they're to put in [an] indicative non-binding offer... everything without seeing the clients of the business or borrowers," he says.

Following this, they may get 15 or so non-binding offers, of which approximately four will be short-listed and those parties are then able to perform due diligence on the company being tendered and, according to Karlovsky, this option has proven success.

"If you've got something worth any substance it's the best way to put your business on the open market. It's the best outcome in the long run," he says.

Firmly of the belief that companies should know what the business is worth well before the tender process has begun, Karlovsky says the ability to measure the degree of risk in acquiring a business is also critical to the process.

"If people don't know what their business is worth, they shouldn't be in business. They need to keep on top of it all. It's hard when you're smaller, but you've got that personal touch. The smarter ones factor risk very well. People like Liberty do it very well," he says.

Due diligence

Knowing exactly what you're buying though is tough, Denovan warns.

"The key issue when buying a book is you buy it warts and all," he says. "It doesn't matter how much due diligence you do, or what your lawyer does, you still get all the warts. People, in my experience, have often been disappointed because they buy the book, and the next moment the LMI knocks back a claim, or some fraud happens, and you get a claim against you. You've only got to have one or two loans go bad and that's [worth] $1m."

Denovan believes buying books is a reasonably high-risk strategy, unless your vendor is strong enough to give you a personal guarantee that if something goes wrong, they'll help fix it.

Brett agrees. He says it is impossible to conduct a 100% complete due diligence of a loan book prior to purchase. "There are some mortgage managers out there that tell you that they've done all the mortgages in-house, and then you can go and buy the loan book, and then as soon as you've bought it you then have a couple of brokers call you up and ask where their trail is. It happened to us."

"You don't really know. I mean, how good is a piece of paper [the contract]? An agreement is only an agreement on paper. To enforce an agreement, you have to spend money," Brett continues.

McIntosh says his company won't buy a mortgage manager's portfolio. "We're not interested in that type of business basically because I have issues with loans and portfolios that have been originated through other channels. If you were to take over an income stream, I just think it would be very difficult to meet the price expectations of the seller and retain enough margin to develop that business further."

There are other hurdles to consider, Denovan adds. "A lot of people get the tax wrong. When you buy a book, and pay $1m for it, that's not tax deductible, that's a capital purchase price. So they have to make $2m in trail to break even... assuming a 50% tax rate."

Denovan says that while some, seeking a lower tax rate, might put the sale through a company, that's not much use as invariably it's classed as a deemed dividend.

Generating enough income from the book to justify the purchase is therefore a risky proposition. "What's been happening in America has reminded us that when we invest money that we have to appropriately price it for risk. Everybody has been buying these books thinking there's no risk, that the trail is just going to happen. Well, what if it doesn't?"

Sting in the trail

A third factor needs to be considered as well, Denovan continues, and that's the security of the trail commission. "Many brokers and managers, when they set themselves up, they didn't really look at the agreements very carefully," he says. "They just took them all on blind faith. And so they don't know the circumstances where the trail can be lost.

"Trails can be lost [on the basis] of it being a windy day in Manly. And there are a lot of windy days in Manly. People haven't been enforcing those clauses in the past because the market has been bubbling along, but let me tell you, if the market gets a bit tighter, that's the kind of clause they'll rely on," he says.

Brett points to two things he looks for when assessing the value of a book. "The first thing is the level of arrears," he says. "The only ones that are getting sold at the moment have good arrears. The ones that have terrible arrears, well, there are no buyers because often you pick up the liability.

"The second thing is: is it a direct book or is it one sourced through brokers? The trouble is, if you buy a mortgage manager that's heavily purchased through brokers, it's not really [on] to then go and market to the brokers' clients."

Buying a book that has been originated by the mortgage manager directly, and not via brokers, means you have more control over the client, he says.

Specialist advice hurdles

Surprisingly perhaps, there aren't many legal experts operating in this arena. Stephen Moulton, chairman of partners for Mills Oakley Lawyers, says that despite a high level of M&A activity, the number of legal practitioners specialising in the mortgage space is incredibly low.

He believes the reason is that the tedious nature of the work has turned many lawyers to other areas of banking and finance.

"The lawyers who have become more involved in the industry have been involved in the work available. A lot don't want to play in that space is it's not seen as sexy work - it's high value, low volume business.

"It's a difficult area to run a profitable practice in. Most of the lawyers at that level have a greater understanding than those who don't," he says.

Mills Oakley Lawyers as a practice cater to non-bank lenders, mortgage managers and brokers, and are involved in the banking and finance sector, including commercial lending.

Moulton estimates that the finance and mortgage industry law component of the business would represent 5% of total volume, and says this figure has been steadily increasing since his introduction into this division eight years ago.

Specialist help

David Vitale, general manager of Loan Book Securities, a company structured specifically to acquire loan books, says he was attracted to this style of business because he recognised an apparent niche in the market, as well as the opportunity it presented to non-bank lenders.

"We identified the need for our company in the marketplace to give non-bank lenders the opportunity to cash in on the trailing income built over time to either cash flow, reinvest into their business or simply an exit out," he says.

Following the recent events in the US sub-prime market, there is a heightened need for all mortgage groups to assess their position and, according to Vitale, there has never been a better time for consolidation in this space.

There is a particular case for non-bank lenders to be cautious.

"The competition for non-bank lenders is getter tougher, without a doubt, and we're seeing this first-hand," he says.

Vitale believes it's the oversaturation of players in the mortgage industry that's driving the consolidation, and ultimately, it will be a monopoly effect with the bigger players overcoming their smaller counterparts.

Merging needs

Some believe merging operations, either in full or part of the business, may be an alternative to an outright purchase of a loan book.

"A lot of mortgage managers actually enjoy what they do, but they probably feel it's easier being a bigger entity," says Brett. "Also, staff ... like to see their company growing... they can obviously progress and diversify."

He adds that it is good to have partners with a proprietal interest in the business as well, as they have an interest in keeping the business moving while you are away.

Merging back-office functions is another means of driving efficiencies. "We'll see a bulking together of mortgage managers for economies of scale," Brett continues. "There's no point [in] five mortgage management companies having five credit departments when one would do the job.

"But it's about dealing with people you can trust... I think there's a lot for mortgage managers working together. If they work together and they want to do a joint advertising campaign, they can obviously split the costs."

If merging, both Jones and Norris admit the aligning of corporate culture between the two merging groups will have a fundamental influence on the success of a move.

Norris admits that branding is also of high importance in the event of a prospective merge, however, if the cultures aren't in sync from the outset, it severely limits the chance of success.

"It's very important. You look at certain companies... we would never want to work with. We've got a certain culture to look after the broker - that's our main culture," he says.

Similarly, while in support of complementing cultures in all M&A activity, Jones says the notion of matching the two is impossible in this marketplace.

"Corporate culture is very important. You need to see a culture that's going to work. Sometimes there may be differences, but there are key points of synergy. It's very hard to match two cultures," he says.

The big picture

So, what next for mortgage managers and non-banks? Moulton points out that while the non-bank lenders promote service, trust and loyalty, the banks are still attracting the major proportion of the market - approximately 80%.

Ultimately, he believes the industry's make-up will be dominated by those who are able to ramp up distribution channels on a national scale, and the number of independent players will be minimal as groups will be forced to merge.

"The reality is there will be a lot more merger activity and consolidation where players will get together and rather than have 50% of a little, they'll have 50% of a lot," he says.

Building distribution also seems to be important, as Firstfolio chief executive Mark Forsyth pointed out after the purchase of Capital First's prime loan portfolio. "We see great potential not only to generate a healthy return from the book as it stands, but also to introduce the Firstfolio range of flexible and innovative lending products to active Capital First mortgage brokers," he said at the time. "These brokers are now valued members of the Firstfolio network. We'll be opening a dialogue with brokers very soon to reassure them of a smooth transition and explain how they can benefit from the Firstfolio network."

Challenger's acquisition of aggregator Choice for $163m, 19% of FAST, and its planned purchase of the 85% of PLAN it doesn't own next year, also shows how valuable distribution is to some non-banks and wholesale lenders.

Whether buying a loan book gives a mortgage manager control over the broker that may have sold the loans though is questionable.

Denovan sees significant challenges for mortgage managers going forward. "Mortgage managers used to pride themselves on product and service, and the banks have responded to that... trying to differentiate yourself is pretty difficult."

Both Denovan and Brett point to Aussie Home Loans' shift into broking as evidence of how tough it is to survive solely as a mortgage manager. That Aussie generates around 85-90% of its revenue now from bank loans rather than from Aussie-owned mortgage products emphasises this point. And that's with Aussie having a strong, well-known brand, Denovan says.

"If I'm sitting out there and I haven't got a very well-known brand, why do I get excited about white labelling things? What's my advantage with being a mortgage manager? Well, the answer is, if I make more trail or I make more margin out of it, or I get to own the customer, or someone eventually wants to buy my book."

It gets back to distribution, he says. "That's the key fundamental for a mortgage manager, to acquire a distribution channel that they own, rather than the brokers own. Then they've got something that someone will pay for. That's the worth of Aussie, Virgin and Wizard."

He says mortgage managers get so exited about giving the broker ownership of the customer, that they forget about the importance of 'owning' the distribution network.
"That's what mortgage managers should aim for."