Hello FTT faithful, I’m Ryan. Long time reader, first time guest poster.
I co-founded Truework (think modern credit bureau, starting with income and employment data) in 2017 after seeing how broken certain aspects of financial identity had become.
I’m here to share with y’all the most important things I’ve learned about the mortgage industry over the past four years and how certain elements can be applied to other lending verticals to improve market outcomes and fuel responsible growth. There’s a lot to cover, so this will take place over two posts.
Mortgage Lending Lessons
Mortgage lending is one of the most niche, complex, highly-regulated and important financial services in the world. Mortgages receive a lot of scrutiny because
- The maslowian stakes are high
- We’ve made a huge mess of it in the past
This scrutiny has radically transformed the mortgage industry. It’s evolution has been defined by the good (improved risk management + housing access), the bad (frustratingly slow and laborious consumer experience) and the ugly (poorly designed derivatives that led to the 2008 crisis).
I want to dive into the good. Specifically, better risk management.
Defaults are threatening sustainable lending growth
Last month, Ohad & Co. provided a great overview for FTT readers of the growing consumer debt balance. Additionally, BNPLs such as Klarna are seeing growing losses as demand for fast credit increases. While consumer debt may show up as assets on lenders’ balance sheets, these trends show the mounting default risk in that asset pool.
Not every BNPL and consumer lender operating today is going to survive the long haul. There will be acquisitions, mergers and some closures.
Those that win consumer lending will be those that manage risk responsibly without sacrificing growth. Easier said than done.
Understanding mortgage risk and liquidity
At face value, mortgages are full of risk. A standard term for a mortgage is 30 years, and the median sale price for a home in the U.S. peaked above $400k for the first time last quarter. Lenders are giving massive sums to consumers and trusting they will pay back principal + interest over multiple decades. Given banks have a fairly low risk tolerance, this behavior is a bit counterintuitive.
Yes, a mortgage is a collateralized loan (most consumer lending is not), but regardless of the details (there are many!), in an undisturbed market you’d expect mortgage lenders to offer much different terms to mitigate risk… and that used to be the case! In the early 1900’s mortgages were repaid over a handful of years. Not decades.
What changed lending behavior in the mortgage market for the better? … intervention by Government Sponsored Enterprises (GSEs). Two of the most important GSEs in mortgage are, of course, Fannie Mae and Freddie Mac.
Why GSE intervention is great for lending
GSEs create liquidity in the market by agreeing to purchase mortgages that meet certain criteria from lenders’ balance sheets. This assures lenders they will have a buyer for certain loans, allowing them to free up capital by selling (aka liquifying) qualifying mortgages to GSEs.
Lenders are then incentivized to re-deploy that capital by reaching more borrowers with better rates. Thus, more folks can afford a home.
GSEs, however, won’t buy every mortgage- that would incentivize unmanageable risk. Because GSEs are the buyer, however, they’re able to dictate the qualifying criteria required of each eligible mortgage to ensure that risk is properly managed on every loan.
Fannie and Freddie both have “selling guides” that outline specific criteria which all mortgages must meet in order to be purchased (fun fact- Fannie’s selling guide is 1169 pages long). Fannie Mae Day 1 Certainty and Freddie Mac AIM are two programs that guarantee the most important data used to underwrite the loan (i.e. assets, employment, income) is accurate.
Both GSE programs rely heavily on data quality standards to minimize default risk.
Applying the GSE framework to consumer lending
Unlike the mortgage market, consumer lending has no government charter enabling secondary market liquidity.
Instead, liquidity in consumer lending is provided by a decentralized network of private equity companies, hedge funds, investment banks, and insurance companies (to name a few). And today, GSEs don't need to intervene to encourage more lending because it’s already happening.
The lack of standardized criteria used to minimize secondary market risk has created unnecessary turbulence in consumer lending over the past few decades, threatening sustainable growth.
Right now we find ourselves in an environment with historically low cost of capital (subject to change cc: J. Powell). When this does change, capital will flow to lenders that have clear and easy to understand underwriting methodologies with strong data accuracy standards.
The second half of this guest post will explore how consumer lenders can use GSE standards to improve risk and create more liquidity in secondary markets, fueling responsible growth in a crowded field. Stay tuned!