Shrinking Fannie, Freddie Will Leave Tech Vacuum
by Dain Ehring, CEO, Dorado Corporation
April 29, 2005

Fannie Mae and Freddie Mac continue to be the subject of substantial interest among the nation’s regulators and elected officials. Just last week, hearings were held in the U.S. House of Representatives to assess the need to strengthen regulation of these government-sponsored entities (GSEs) and reign in the two mortgage behemoths. This week, the Senate Banking Committee held a similar round of hearings, with both powerful lobby groups and the respective GSE CEOs testifying

This latest round of scrutiny was precipitated by testimony given on April 6 before the Senate Committee on Banking, Housing and Urban Affairs by Alan Greenspan, the chairman of the Federal Reserve. In his remarks Greenspan said, “to fend off possible future systemic difficulties, which we assess as likely if GSE expansion continues unabated, preventive actions are required sooner rather than later.” His thoughts were soon echoed by Treasury Secretary John Snow, who commented, “the sheer size of the mortgage-based investment portfolios of the GSEs has grown well beyond anything needed in carrying out their housing mission." Snow, too, suggested that if unchecked, these two entities could indeed threaten the economy.

Reminiscent of the old Chinese curse, events for Fannie and Freddie just continue to get more and more interesting.

Things Fall Apart

Fannie Mae and Freddie Mac have been enormously important in creating the modern mortgage marketplace, and are to be saluted for helping to establish the conditions that have allowed home ownership to flourish in the U.S. Through their government sponsored charter of providing affordable housing and liquidity they have succeeded in creating market efficiency and access to capital for a majority of potential home buyers. In 2003 the housing denial rate, according to the Department of Urban Housing and Development (HUD), was 14% for conventional loans – the bulwark of home ownership credit. This rate is almost half the denial rate of 28% for the same loans in 1998. In the same five years conventional loans almost tripled in volume, and both U.S. home ownership and housing starts hit record highs.

One reason for this market success has been the ability of the GSEs, by virtue of their market dominance, to provide efficiency through vertical integration. The size, scope, and centrality of their operations have given Fannie Mae and Freddie Mac the ability to impose what have become in effect de facto standards.

In fact, the clout of these two giants has helped forge order from what would otherwise have been a much more chaotic, friction-based marketplace. Yet the very thing that created this efficiency in the market, i.e. their size, is now at issue -because it creates too much risk for the economy. Now Congress appears ready to act to cap the size of their portfolios – or under Treasury Secretary John Snow’s proposal - restrict them to guaranteeing payments on mortgage-backed securities only. Either action may effectively cut their present bulk by 65% and severely limit their ability to define the marketplace. It’s worth asking… what kind of operational environment is likely to then arise?

For all their presumed faults, Fannie Mae and Freddie Mac play many important roles in the home lending process. Consider that today’s $170,000 average loan transaction involves approximately 40 different players and 7 distinct companies before it even reaches the secondary market. Fannie and Freddie integrate investors, insurers, securitizers, and mortgage bankers with correspondents and loan officers through their own proprietary network services, keeping the entire market stable and flowing freely. Again, it has been their size that enabled this efficiency. Any changes to this landscape will require systemic changes to maintain continuity. Without that alternative, affordable housing, and therefore the entire industry, will suffer.

Fannie and Freddie hold an indispensable role in creating affordable housing and liquidity. Since being established by the government many years ago, the two GSEs have set the standard in how home loans are packaged for the secondary market. The absence of these oligarchs will create at least a temporary vacuum, forcing the market to rely on new companies and constituents to ensure that industry standards continue to evolve.

Bringing It All Back Together Again

With a flood of investment companies and large banks trying to coordinate transactions in the mortgage market, the industry will have to move quickly toward technology that vertically integrates processing and underwriting functions, and links parties together who provide securitization, insurance, and investment directly to the mortgage point of sale. Without a single corporate umbrella like Fannie or Freddie to artificially remove the friction between key constituents in these transactions, open, reliable, scalable, and independent technology will be required to provide the catalysts of affordable housing (beyond capital).

This technology will have to provide ubiquity of access, including the ability to foster equitable lending standards in minority communities, security, and accurate and fair risk assessment. The latter is particularly important with the possible upcoming approval of the Basel II Accord.

The technology landscape is littered with the remains of companies that failed to adopt and conform to a reasonable set of industry standards. Whether Betamax or the Wireless Access Protocol (WAP) for cell phones, the net effect of past failures to promulgate an effective set of industry-wide standards has been to slow adoption of new product and services, and drive up costs for end users. This would be particularly bad news for the banks operating in the mortgage industry, which have worked for years to reduce overhead, eliminate redundant systems, and drive their origination and fulfillment costs down.

We believe that it won’t be another financial service company or a set of imposed industry standards that will fill the vacuum in efficiency left by the weakened GSEs. Clear leadership in open technology in the mortgage industry, outside of Fannie Mae and Freddie Mac, has been lacking – and what services exist are very fragmented. Without seriously disrupting existing market flow, leading banks taking up the void will need to adopt an open technology platform. That platform will eventually enable standardized integration of multiple parties, collaboration, and information sharing as it has in other industries such as the travel and airline reservation industry. Having more players involved in the lending process will ensure consistent fair market pricing, and open technology architectures will allow that to happen.

Standards, Security, and Basel II

There is no reason to believe that the efficiency of the industry as a whole cannot be improved as a result of all this. Further, tighter integration of the various organizations that are party to a mortgage transaction may also help address another pressing issue for the industry: security. As if anyone needs a reminder, recent news about identity theft and fraud have again put financial institutions on notice. The ability to develop and share industry standards based on best practices will help address the weak links in the security chain.

Finally, there is the question of the lender’s ability to understand and mitigate risk across the lending platform. With the Basel II Accord set to redefine risk capital, it will be imperative that banks understand their exposure to the mortgage markets, the relative quality of their portfolio, and ways to reduce the risks of taking on larger lines.

The home lending market has grown significantly in recent years, fueled by rising real estate prices, population growth, and low interest rates. Housing is becoming the primary investment strategy for most families looking to pay for retirement, education, medical bills, and other major expenses. This is an important trust, and structural changes to this highly successful market should not be undertaken lightly. Technology companies can bring tremendous efficiencies to this process, to the benefit of both the banks and the consumers, and protect against the devastating outcome of a lack of affordable housing and liquidity in a post GSE world.