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Mortgage brokers feel the heat in Australia's housing fire fight

* Big banks seeking to limit commissions to mortgage brokers

* Brokers account for half of mortgage loans, live on commissions

* Regulator critical of broker model, wants less risky lending

* Brokers say they offer choice, banks fear competition

SYDNEY, July 26 (Reuters) - The cosy relationship between Australia's big banks and mortgage brokers is under threat as authorities worry about risks to the financial system and lenders baulk at the growing costs of incentives for brokers.

Australian banks offer generous inducements to brokers to sign up new borrowers and negotiate larger loans, a system dismantled in the United Kingdom following the global financial crisis.

The Australian Securities and Investment Commission (ASIC) criticised the model in a report earlier this year, saying it encouraged risky behaviour and mis-selling, and created conflicts of interests.

Now, with record low interest rates fuelling a surge in home prices and household debt, the government is working on a review that could lead to an overhaul of the country's A$1.7 trillion ($1.35 trillion) mortgage market.

Big banks, reliant on mortgage brokers for more than half of new loans written in recent years, are quietly pushing for changes that would reduce the influence of brokers, sources said.

"We are still working on the report, it's a hard one," said a senior official at Treasury, which is running the review.

"Banks are hoping for a big shake-up. The mortgage broking industry is not with the banks. There is a lot of tension," said the official, who asked not to be identified because he was not authorised to talk to the media.

The Treasury will release its findings in "due course", a spokeswoman for the minister of revenue and financial services told Reuters.

HEAVY DEBT

As property prices in Sydney and Melbourne have surged by 70 percent or more in five years, Australia's household debt has jumped to 190 percent of disposable income. That has raised alarm bells among regulators about customers' ability to pay off loans in a downturn and its domino effect on the broader economy.

Mortgage brokers have contributed to the surge as loans made by them are typically larger, riskier and are paid off more slowly, according to ASIC.

"The inherent conflict of interest between banks and brokers means that in a downturn there is an increased possibility of higher bad debt than if the banks had sold all the loans through their own branches," said Omkar Joshi, portfolio manager at Regal Funds Management which has A$1.7 billion in assets.

"Mortgage brokers do not take on the credit risk but are remunerated based on loan size and duration."

Australia's banking sector is dominated by four major lenders - Commonwealth Bank of Australia, Westpac Banking Corp, ANZ Banking Group, National Australia Bank.

Banks pay brokers more than A$2 billion annually in payments, including trailing commissions that can continue over the lifetime of the loan. Some banks also offer brokers 'soft dollar' benefits such as loyalty programmes and overseas travel to exotic locations.

In contrast to Australia, all forms of commission to brokers are banned in the Netherlands, and trailing commissions are rare in the United Kingdom and New Zealand.

"These payments are an illustration of excesses built into the financial system following a 26 year economic boom in Australia," said UBS banking analyst Jonathan Mott. "We expect the banks to negotiate materially lower fee-for-service mortgage commissions in coming months."

Others expect banks to continue paying commissions to brokers, although some forms of fee such as overseas junkets and volume-based incentives are likely to be abandoned.

BETTER RATES, BETTER SERVICE

Brokers, most of whom derive their entire income from commissions, argue the big banks want commissions slashed because their earnings growth is under pressure and they are losing market share to smaller lenders and non-bank players.

"Quite often you're getting a better rate going through a broker than from a bank," said Thomas Patrk, senior finance adviser at Sydney-based mortgage broker Orium Finance. "So the whole thing about commissions being a problem is really being driven by the banks. They are losing market share to smaller players who are more nimble, offering better service, better rates."

The market share of Australia's big banks shrunk to under 65 percent in home loans this year from 77 percent in 2013.

A review of retail banking remuneration commissioned by the Australian Bankers' Association (ABA) in April recommended doing away with volume-based incentives, soft-dollar payments and higher pay to brokers who engage in sales campaigns.

The review asked banks to implement the recommendations as quickly as possible and no later than 2020 but progress has been slow.

CBA, Australia's No.1 mortgage lender, is running behind its own July 1 deadline to implement "many of the recommendations" on sales commissions, including to third-parties.

"We haven't made any decisions about changes or how they will be implemented at this stage," a spokeswoman for CBA told Reuters.

NAB said it was committed to moving to a new structure, while others noted the challenges around measures involving brokers.

"We recognise some initiatives particularly those where third parties carry the primary responsibility for progressing matters... may ultimately require regulatory or legislative intervention," Westpac said in a statement.

ANZ said it was "working closely" with the mortgage broker industry and the ABA to make sure the changes were implemented. ($1 = 1.2601 Australian dollars)

(Editing by Lincoln Feast)