Future of Mortgage Lending Hangs on a Balance Between Innovation and Safety
Mortgage finance has been going through major evolution, with even more in sight. Non-bank companies are playing a greater part than ever in origination and services while having fewer regulatory burdens than do the fintechs. As the home lending business grows to multi-trillion-dollar levels the question of the future status of Fannie and Freddie becomes more urgent. The role of government at all levels in the housing business has come under scrutiny, as well, even as concerns about housing supply grow in Washington — which has little influence at the local level.
By Jason Cave Patomak Global Partners
Mortgage credit has become one of the most scrutinized asset classes in the financial, regulatory and political arenas, and for good reason: Americans now hold over $20 trillion in outstanding mortgage debt, with mortgage debt increasing over 50% from 2013 to 2023, per Federal Reserve statistics.
Despite record-low interest rates in recent years, which spurred a surge in mortgage activity, rising costs have created new challenges for the industry. As home prices soar and demand outpaces supply, policymakers and industry leaders are grappling with a critical question:
How can we balance stability, affordability and innovation in the housing market?
Lack of Supply-Side Solutions Exacerbates Rising Credit Costs
As Americans rushed to lock in sub-2% mortgage rates, the cost of originating those mortgages rose significantly as lenders, burdened with legacy systems, struggled to meet demand. Many mortgage lenders still rely on 1980s-era paper-based processes, particularly in back-office underwriting and loan administration functions. This adds time, increases costs, and leads to more errors. Average origination costs have increased by 35% over the past three years, according to Freddie Mac. Moreover, in 2022 alone, closing costs for single-family homes rose by 13.4%, with the national average reaching $6,905, according to the most recent figures from CoreLogic.
Mortgage originations slowed in 2023 as the Federal Reserve raised interest rates to combat inflation, but the high costs of mortgage processing persisted due to a lack of investment in new technology. These costs gained even more attention when President Biden highlighted them in his 2024 State of the Union address, sparking discussions about potential solutions across the mortgage industry and among the regulatory agencies overseeing it.
As a result, housing policy has increasingly become one of the most pressing national issues. It’s not surprising homeownership has become a presidential campaign matter. In recent years, demand has consistently outpaced supply, causing home prices to rise faster than wage growth. Between 2010 and 2022, housing prices rose by 74%, while average wages increased by only 54%, per federal figures. Furthermore, from the first quarter of 2023 to the first quarter of 2024, housing prices saw an additional 6.6% increase, according to the Federal Housing Finance Agency (FHFA).
Housing's Missing Link:
Washington policymakers explore various initiatives to reduce costs and improve access to housing. However, the ability to lower housing costs largely lies beyond their control.
The most critical factors determining housing supply — such as local zoning laws and building codes — are under the jurisdiction of local governments, not federal authorities. As housing policy expert Mark Calabria, former FHFA director of the Federal Housing Finance Agency, aptly noted in an interview with HousingWire, "Washington doesn’t have a lot of levers in terms of housing supply."
Calabria believes that community banks could play a pivotal role in providing builder financing. In the interview he emphasized that "You need to address this if you want to make construction financing readily available. It’s one reason we’ve seen consolidation among builders — you have to navigate the construction lending side of it." The basic principles of supply and demand illustrate that if demand increases while supply remains constant, prices will inevitably rise.
For example, between 1980 and 2000, the population of Las Vegas tripled, yet the median housing price there remained stable. In stark contrast, during the same period, Palo Alto’s population stayed the same, but the median home price quadrupled, according to Thomas Sowell’s The Housing Boom and Bust. The difference? In Las Vegas, an abundance of available land and less restrictive regulations allowed housing construction to keep pace with demand. By contrast, Palo Alto’s strict "open space laws" dramatically restricted the construction of new housing.
This leaves first-time homebuyers, and others in the market, struggling to gain a foothold as rising home prices erode the value of their savings for a down payment. However, forward-thinking market players are stepping up to help first-time homebuyers break out of this vicious cycle.
Financial innovations in the mortgage sector are rapidly emerging, something I witnessed firsthand when I established the FHFA’s fintech office. Some of the most promising fintech solutions offer ways for savvy homebuyers to afford down payments by allowing lenders to share in future equity appreciation.
A fair question arises: Where does this leave potential homebuyers who cannot access these new innovations? And are these innovations simply increasing demand without addressing the underlying issue of housing supply?
Read more: As the Fed Trims Rates Banks Must Adjust Both Deposit and Credit Strategies
Washington’s Enduring Dilemma: The Future of Fannie and Freddie
One of Washington’s favorite parlor games: What to do with Fannie and Freddie? These two mortgage finance giants have been in conservatorship for an extended period — since 2008 — but they continue growing larger and more influential over time. Together, they guarantee over 1 million securities, including pass-through pools amounting to a market size of $9.3 trillion, with daily trading volumes averaging over $240 billion.
The Fannie/Freddie Dilemma:
To some, these government-sponsored enterprises are pillars of stability in the mortgage market. To others, they wield an outsized role in credit allocation and pricing, a rarity in most capitalist systems. Still, for others, so long as they remain in conservatorship, they pose a lingering threat to financial stability.
With Freddie Mac’s net worth now exceeding $50 billion and Fannie Mae’s reaching $86.5 billion, the possibility of these entities exiting their conservatorships grows increasingly plausible. However, how the mortgage industry — so heavily reliant on the GSEs — will adapt to a privatized Fannie and Freddie remains the subject of significant debate.
- How would the Treasury exit its position?
- How would the Fed address the concentration of holdings of mortgage-backed securities (MBS) at the largest banks — where the top five holders collectively managed $1.3 trillion in mortgage-backed securities as of March 2023 — once the GSEs become private?
- Additionally, how would the Treasury continue to backstop new GSE MBS issuances?
These are just a few of the critical questions that must be resolved before a smooth exit from conservatorship can be considered.
Addressing the challenges of privatizing Fannie and Freddie with innovative and coordinated policies can help stakeholders turn a complex situation into an opportunity for a more resilient and dynamic mortgage market.
The mortgage origination process needs to be reimagined with the consumer at its center, meeting borrowers where they are in their technological journey. Incorporating the latest advances in technology will ultimately pay for itself through greater cost efficiency, enhanced security, and improved consumer satisfaction.
However, to fully realize these benefits, lenders must adjust their time horizons beyond the typical two-year boom/bust cycle.
Moreover, the impact of unrealized losses tied to recent investments in low-yielding securities cannot be ignored. The Wall Street Journal noted late last year that the worst-affected GSE MBS, issued in early 2021, have dropped 30% in value. This could lead to unpleasant surprises, depending on how much of that vintage has made its way into bank portfolios — or worse, into leveraged hedge funds outside the regulatory framework.
If the Fed changes the treatment of available-for-sale securities, forcing large banks to recognize unrealized losses in their regulatory capital, it could reduce demand for GSE securities. As a result, consumers could face higher costs as GSEs struggle to attract other buyers. All these factors are closely interconnected.
Fannie and Freddie have dominated the MBS market for the past 15 years, but a seismic shift in the origination and servicing space has seen many non-bank competitors displace commercial banks. These non-bank entities are not subject to the same capital, legal and operational constraints that were imposed on traditional depository institutions following the financial crisis.
Read more: Amid Rising Delinquency Rates, Auto Lenders Seek Safe Growth
Growing Role of Non-Bank Mortgage Originators and Servicers Poses New Risks
Escalating bank capital requirements post Dodd-Frank have significantly increased costs for traditional banks servicing mortgages, driving much volume toward non-bank lenders.
It's Not Your Grandparents' Mortgage Industry:
The Financial Stability Oversight Council's May 2024 report on non-bank mortgage servicing indicated that non-banks now originate two-thirds of mortgages, up from 39% in 2008, and service 54% of balances, up from 4% in 2008.
In response, the council (FSOC) has shifted its focus to the growing dominance of non-bank entities. For example, in a recent report the FSOC highlighted the potential systemic risks posed by mortgage servicing, particularly if one or more of these non-bank entities were to fail. Unlike previous reports, this one emphasizes the potential impact on consumers should mortgage servicers fail to meet their obligations.
While the report raises several issues and makes a series of recommendations, one might question whether the FSOC’s designation of non-bank servicers as "systemically important" truly provides for stability beyond potential access to the Fed’s discount window.
A closer examination of these servicers might reveal that they are operating more efficiently and effectively than their bank counterparts.
Moreover, despite FSOC’s concerns about the dominance of non-bank entities, the regulatory group’s members appear committed to increasing capital requirements for the remaining mortgage business within banks. However, a recent speech by Fed Vice Chairman for Supervision Michael Barr suggests that there may be reductions in the proposed Basel III Endgame capital requirement increases.
Moreover, FSOC’s May 2024 report on Nonbank Mortgage Servicing encourages Congress to grant the FHFA and the Government National Mortgage Association additional authority to establish standards for, and examine, nonbank mortgage servicer counterparties. It also recommends establishing a fund to provide liquidity to nonbank mortgage servicers in bankruptcy to ensure the operational continuity of servicing.
While the report discourages Congress from designing a fund reliant on "taxpayer-funded bailouts," it urges legislators to provide regulators with "sufficient authorities" to "maintain the fund" and "mitigate risks" associated with its implementation. Given regulators’ history of financial bailouts post-pandemic, financial markets are beginning to expect federal intervention. As a result, it is reasonable to assume that taxpayers may ultimately be the guarantors.
Consequently, this report represents regulators’ latest attempt to level the playing field between non-banks and traditional depository institutions, continuing the arms race between novel financial innovations and regulators’ perpetual desire to subject these institutions to new regulatory regimes.
Adding to the uncertainty are rising delinquency rates, increased risks within the GNMA portfolio, and the possibility that housing prices may stabilize — or even decline — further complicating the market outlook.
Read more: Does Rapid Growth in Home Equity Credit Signal a Coming Repeat of the 2008 Meltdown?
Upcoming Decisions Will Shape Economic Future
Amidst rising costs, regulatory hurdles, technological innovation and the uncertain future of Fannie Mae and Freddie Mac, the mortgage market finds itself at a crossroads. As policymakers, regulators and industry players grapple with these issues, one thing is clear: The path forward will require thoughtful coordination and decisive action.
Policymakers can double down on government intervention in mortgage markets and continue to propagate regulations that stifle financial innovations offering everyday Americans realistic paths to homeownership.
Conversely, they can work with state and local regulators to address housing shortages and create a workable plan for privatizing Fannie Mae and Freddie Mac, ensuring that taxpayer dollars no longer subsidize risky mortgages on banks’ balance sheets.
What remains to be seen is whether stakeholders can rise to the occasion and create a mortgage system that balances stability, accessibility and growth. The choices made today will shape the future of homeownership and economic resilience.
About the Author:
At Patomak Global Partners Jason Cave, senior consultant, advises clients on regulatory matters in banking, mortgage finance and technology.
Cave spent nearly three decades in executive roles at the Federal Deposit Insurance Corp. He served as FDIC’s executive representative on the Deputies Committee of the Financial Stability Oversight Council (FSOC), where he helped build FSOC’s non-bank designation program and establish the process for identifying, analyzing, and designating firms that were determined to be a systemic risk.
After his time at FDIC, Cave joined the Federal Housing Finance Agency (FHFA), becoming a deputy director and chief fintech officer. In addition to overseeing FHFA’s fintech strategy and innovation program, he was responsible for managing the conservatorship and readiness program governing Fannie Mae and Freddie Mac.
