HOUSING BUBBLE 2.0: ready for another housing market crash?

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1 CROSSINGS: The Journal of Business Transformation HOUSING BUBBLE 2.0: ready for another housing market crash? A study of the current housing finance market reveals the multidimensional reaction to events from the last decade is still in play throughout the global financial system. New regulation and regulatory bodies, wholesale legislative changes, the formation and adoption of new risk-management frameworks, reduced securitizations by private-label banks and increased scrutiny by the press are just a few of the factors contrasting today s mortgage market with the pre-crisis era. But are mortgage markets truly more stable now than they were before 2008? In this article, Hans Godfrey and Adi Ghosh discuss how the government and regulators, as well as the primary and secondary markets, are preparing to mitigate the factors that caused the 2008 crisis. Plus, they will highlight the counter-effect and additional risks that these new policies, tools and systems may create. Movements in the housing market, then and now, are widely recognized as a leading indicator of economic cycles. In 2015, a large degree of economic growth is being driven by expansionary monetary policy and the access to easy credit this enables. Combined with a renewed focus on affordable housing and upward trending jobs data, home prices have seen significant appreciation since the US mortgage market bottomed out in However, questions are being asked on the sustainability of this appreciation. There is already mention of the lead up to the start of the next housing bubble 1. While economic cycles and housing bubble formations are inevitable, there are significant differences in the current housing finance structure from seven years ago. Old and new regulatory agencies implemented rules with sometimes unintended consequences, causing a dramatic change to the housing market landscape in less than a decade. For example, risk aversion in the market has given rise to players outside of traditional banking, while the increasing use of technology has disrupted traditional business processes. REGULATIONS DIRECT AND INDIRECT CONSEQUENCES Despite the pace of change, significant modifications have been made to the regulatory framework in the last few years, particularly in terms of a more concentrated focus on overall standardization. Better defined terms, more transparent guidelines and eligibility requirements and increased accessibility and transparency of data are some of the areas where new regulations have made an immediate impact.

2 A work-in-progress example of this drive toward standardization is the development of the Common Securitization Platform (CSP) under the auspices of the Federal Housing Finance Agency (FHFA). The CSP provides a common infrastructure for Fannie Mae and Freddie Mac to securitize loans and help ensure consistency in terms of security onboarding, pricing and transparency. Efforts to create a single security between Fannie Mae and Freddie Mac are another step toward bringing consistency in the housing finance market. From a guidelines perspective, defined standards, such as Basel III, Private Mortgage Insurer Eligibility Requirements (PMIERS) and Servicer Total Achievement and Rewards program (STAR), all help manage counterparty service levels and risk management. While each of these is undoubtedly helping to mitigate some of the risks and eventualities which led to the meltdown, an analysis of the potential unintended impact of these regulations is also worth examining. The global financial system continues to increase in terms of size, depth, complexity and interconnectedness, and the US mortgage market is no exception. Regulators have attempted to protect the markets from risk through stress testing and increased stringency of compliance reporting. However, despite the laudable efforts to protect markets and consumers from systemic risk, the actions of the regulators have in many ways had the unintended effect of Balkanizing the leading financial services economy. 2 In addition, this can potentially create a situation in which a mass of regulations operating in silos has the same result as no regulations (at many times the cost of compliance and reporting). Enhanced regulations have also impacted operational costs for many organizations, including the cost of enhancing data, regulatory compliance reporting and adherence to different rules and standards. In certain segments of financial services that are heavily dependent on legacy infrastructure, the costs have been dramatic as new regulation has forced wholesale re-architecting of business processes and the systems that support them. The changes in housing finance regulations, in particular, should encourage organizations to think more strategically about their operational and technology investments. Although this task is by no means easy, it should include the following: Data Consolidation and Availability. A critical step is the increased investment in enterprise data integration programs to consolidate both structured and unstructured data. While most organizations have already invested in enterprise-wide data management, the consolidation and availability of data rather than its production is increasingly becoming the key to unlocking its potential. Standardization. Investments in standardized enterprise data transfer mechanisms and protocols whether through defining canonical data models for the enterprise or participation in key industry standards like those championed by the Mortgage Industry Standards Maintenance Organization (MISMO) are increasingly critical to reducing integration and change management costs to help drive these efficiencies. Partnership. The recent elimination of desktop underwriter fees to allow originators to run the same underwriting checks as the enterprises is an example of using partners to mitigate business risk. The ability of primary and secondary market parties to work with their technology partners and other enterprises to co-invest in solutions and share best practices would be of immense benefit to the overall housing finance ecosystem. Adoption. For many of these programs, the key success criteria is adoption, making investment in an enterprise-wide adoption and change management program critical. For example, a way to drive adoption across the firm could be through compliance scorecards with funding linked to quarterly goals for business units. It will be interesting to see in the next few years how technology and partnerships on both sides (regulators and market participants) may help reduce systemic risk and lower associated operational costs. With the right investments in technology and standards, regulators and organizations may be able to better integrate regulatory frameworks, dynamically access the right information and make more informed decisions proactively through the use of advanced analytics and visualization techniques. CROSSINGS: The Journal of Business Transformation

3 NEW PARTICIPANTS THE SIX-MINUTE LENDERS A recent study 3 by the Harvard Kennedy School analyzes the increasing role played in loan origination by non-banks (defined by firms unassociated with a depository institution). Given the regulations defined by the Dodd-Frank Act in conjunction with Basel III, the total volume of capital available to depository institutions for lending has been reduced. This has resulted in a non-bank boom in the lending space: the share of non-banks among the top 40 mortgage originators has increased from 16 percent to nearly 38 percent. This is validated by a recent study which listed regulatory factors (or reduced levels) as a lead competitive advantage for non-bank originators and servicers. 4 As a counterpoint, however, examination standards remaining consistent across the board and risk retention regulations put disproportionate pressure on non-banks as compared to larger depository organizations. $3, Fewer Depository Institution Originations Help Explain the Non-Bank Boom: Top 40 Mortgage Originators by Type ($ bil., ) $3, $2, % 18.0% 11.8% $2, $1, $1, % 82.0% 88.2% 9.7% 10.8% 10.0% 13.4% 18.3% 26.1% $ % 89.2% 90.0% 86.6% 81.7% 73.9% 37.5% 62.5% $ Depository Insitutions Non-Banks Figure 1: Increasing share of non-bank originations. The other change to the lending framework has been in the area of alternate lending. These non-bank players, also known as Six-Minute Lenders (referring to the ease of origination), include lending clubs and peer-to-peer lenders leveraging high-end technology platforms. Increasingly making their presence felt, participants in these new entities are no longer restricted to small venture capital-funded organizations. In fact, some of the biggest financial organizations (especially larger hedge funds) are getting on the bandwagon through conduits.

4 Given technology s ability to disrupt existing business processes, it is very likely that non-banks will continue to play a critical role in changing the dynamics of the mortgage market. Naturally, the presence of these non-bank institutions creates another potential area for systemic risk one not necessarily accounted for in the current regulatory framework. However, just as technology has served as a force for disruption in the market, this may be an opportunity to again leverage technology to ensure that post-crisis mitigation measures are enhanced to effectively address current and future scenarios that were not anticipated. Technology has made rapid strides in the combination of data and analytics. By running big data analytics, organizations are able to analyze a mix of structured, semi-structured and unstructured data in search of valuable business information and insights a key technology differentiator from REPORTING AND DATA It is widely recognized that inconsistent and ambiguous terminology and poor data quality exacerbated the crisis through inaccurate classifications and reporting. One example of this is the classification of sub-prime loans as prime, based on their acceptance by enterprises, even though these were accepted by lowered underwriting standards as part of the affordable housing program. Post-crisis regulators, industry groups and market participants have acknowledged the need to increase data quality, including the clear definition of regulatory reporting guidelines and the consistency of definitions and attributes at loan, borrower and security levels. Most players have recognized that good quality data is a benefit to the market because it will allow for improved correlation analysis and predictive modeling, which in turn improves efficiency. Most would agree that the volume of data and the velocity of its creation will only increase. However, there is no guarantee that the increasing amount of available data will necessarily help investors correctly value what they buy or allow regulators to properly measure systemic risk. Market participants must develop clear strategies for ensuring data availability and quality in their organizations data consolidation and adoption, strategic prioritization on modeling initiatives and an overhaul or consolidation of reporting frameworks and tools are all steps in that direction. A development that will be keenly followed will be the Regulation AB II standards around asset level disclosure. An organization s ability to develop early warning signals based on historical trend analysis would be a definite competitive advantage. The market is at the beginning of a long learning curve on understanding the effective use of data. Although the boom-bust economic cycle seems inevitable, the promise represented by technology s ability to help draw meaningful conclusions from increasing volumes of data will be a crucial factor in mitigating systemic risk and industry participants ability to adapt to changing market conditions. RISK MANAGEMENT CHANGING SHAPE AND FORM Risks are inherent to financial systems. While regulations and processes do help manage risk, they will never completely eliminate risk. Risk changes form and evolves in response to any action given the high degree of interdependency in the modern financial ecosystem. Since 2008, several steps have been taken to manage credit risk, such as the launch of credit risk transfer initiatives to distribute risk across investors, lenders and insurers and the defining of documented standards and guidelines for counterparties like insurers and servicers. Similarly, interest rate risk management for the portfolio of loans enterprises retain on their books has also seen several advances to manage both extension risk as well as pre-payment risk. However, with the high focus on partnerships in terms of risk distribution, the counterparty risk in terms of exposure and the number of counterparties has significantly increased. The improvement of risk model sophistication, regular disclosures, defined guidelines and frequency of stress testing and reporting have been put in place to manage causes that led to the 2008 crisis. It remains to be seen if these measures adequately manage systemic risks. Moreover, the Housing Bubble 2.0 will be impacted by CROSSINGS: The Journal of Business Transformation

5 other factors that were non-existent seven years ago, such as the composition of the portfolio shifting toward nonbanks, the role played by regulators, spiraling operational and compliance costs for lenders, and an increasingly complex market in terms of volume, leverage and stakeholders and their interactions. It is impossible to quantify the element of risk in today s housing finance market and measure it against the market as it was seven years ago. However, it is fair to say that while regulators, housing finance organizations and their technology partners have invested significantly in mitigating known risks, the true test will be the ability to anticipate and mitigate against the yet-unseen risks posed by new players, the direct and indirect consequences of regulations and disruptive technology. CONCLUSION Financial markets, whether organized and separated by asset class, geography or other factors, are more interconnected than ever before. No one can predict when the next bubble will burst, but the boom-bust cycle will likely continue and the interconnectedness of markets is sure to result in difficult-to-predict ripple effects. Markets will inevitably evolve faster and in less predictable ways with the entry of new players who leverage new technologies to disrupt old businesses. To combat this disintermediation, incumbent participants must have clear strategies as well as the will to boldly execute those strategies. Further, the ability of technology to outstrip the bounds of regulation is readily apparent from the rise of non-bank financial entities. Regulators must likewise develop proactive strategies that leverage technology and data as a means to mitigate systemic risk when guidelines fail to do so. The ability of the housing finance market to absorb a potential Housing Bubble 2.0 may depend upon two key factors. The first is a market participant s ability to individually invest in long-term strategic initiatives that address the foundational issues of enterprise data. Risk management at an individual level is a first step toward mitigating risk at a more macro level. It will be a challenge for market participants to do this without getting distracted by more tactical and reactionary goals. The second is the market s ability to create value networks through partnerships between regulators, primary and secondary market parties and their technology partners. These value networks have the potential to mitigate future financial crises through a combination of risk frameworks and regulatory measures backed with advanced analytics technology. Financial markets have generally shown an inclination toward integration (e.g., swaps clearing process), and if properly executed, there is a possibility that the housing markets could benefit from this. In any event, technology and the power of data will be key factors in either helping spark a Housing Bubble 2.0 or making it just a passing reference in the history of housing finance.

6 Resources 1. Zero Hedge, Mark Hanson Is In Full-Blown, Black- Swan Lookout Mode For Housing Bubble 2.0, Cato Institute, Regulatory Fragmentation, the Balkanization of Financial Markets and the Competitiveness of the American Financial Services Sector, regulatory-fragmentation-balkanization-financialmarkets-competitiveness 3. Harvard Kennedy School, What s Behind the Non- Bank Mortgage Boom?, content/download/76403/ /version/1/file/ Final_Nonbank_Boom_Lux_Greene.pdf THE AUTHORS Hans Godfrey is a Vice President within Sapient Global Markets. In this role, Hans leads Sapient Global Markets engagements in the mortgage and securitization space, partnering with industry stakeholders to deliver next-generation infrastructure. Hans has over 20 years of business experience and has worked with governmentsponsored enterprises, multilateral development banks, regulatory agencies and commercial groups to deliver business value through technology enablement. hgodfrey@sapient.com Adi Ghosh is a Washington, DC-based Director focused on the primary and secondary housing finance market. He works closely with key industry participants to increase operational efficiency and bring strategic alignment in the housing finance space through technology solutions and value-driven partnerships. Adi has over 15 years of product development and business advisory experience across mortgage-backed securitization, loan origination, servicing and delinquency management. sghosh6@sapient.com CROSSINGS: The Journal of Business Transformation

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