How Blockchain Will Transform Residential Mortgages
In our previous piece, The Global Impact of Cheap Satellites and Launches, we talked about how there are very few trillion-dollar industries in this world. When you’re an entrepreneur, a trillion-dollar industry is pretty exciting because all you need to do is capture 0.01% of it and you’ll have $1 billion. Take the $1.7 trillion U.S. mortgage industry as an example. In 2006, when all those disheveled Lehman Brothers employees were carrying boxes of their possessions around Canary Wharf, it was because the U.S. mortgage market was crumbling. And crumble it did, leading to what’s hence been known as the subprime mortgage crisis. For today’s 25-year old millennial who was still a preteen when that happened, here’s a short history lesson for you. First, let’s talk a bit about how the residential mortgage industry operates.
Residential Mortgages for Dummies
If you’ve ever owned a house, you’ll understand just how painful the process of getting a mortgage can be. For John Doe consumer who is looking to buy a $250,000 home, they’ll need to work with a “Mortgage Originator.” That’s the entity responsible for collecting the 20 or 30 documents the future homeowner needs to provide which demonstrate their suitability for obtaining a $250,000 loan that will take around a third of a lifetime to pay back. What most people may not know is what happens behind the scenes. You see, the Mortgage Originator doesn’t actually go to their safe and pull out $250,000 in cash to give the existing homeowner in exchange for the title. Instead, the Mortgage Originator goes to what’s called a “warehouse bank” that provides a 30-day loan of $250,000. So, here’s what happens in a nutshell:
- Homeowner wants to buy home
- Originator verifies homeowner is suitable and presents terms
- Warehouse bank gives originator 30-day loan of $250,000
- Originator exchanges $250,000 for home title
- Originator sells mortgage to a buyer – a bank (like Lehman brothers) or perhaps a pension fund – after which they can repay the 30-day loan
As you can see, the terms of the loan are actually agreed upon before there’s even a buyer for the mortgage. Once that mortgage has been sold to Lehman Brothers, they might choose to hold it for a while before pawning it off on someone else. Alternatively, they can sell the mortgage – usually a batch of mortgages – to the two big buyers that purchase mortgages: Fannie Mae and Freddie Mac. Once the originator sells that mortgage, you can think of it as a discrete asset – a series of cash flows – that can be bought, sold, and traded by anyone. Now that we understand the basics, let’s talk about what went wrong back in 2006 with the subprime mortgage crisis.
The Mortgage Crisis of 2006
The subprime mortgage crisis began when President Clinton mandated that Freddie and Fannie were required to buy a certain percentage of mortgages issued to people who may not have been traditionally granted mortgages. These largely consisted of low-document loans where you didn’t need to prove your income. The idea was that home ownership would become more accessible to financially challenged people pursuing the American dream. There was nothing inherently wrong with the idea, as higher mortgage rates compensated for the additional risk. The problem arose when fraudulent transactions began making their way into the process.
This next part of the story is key to understand. Remember all those documents we talked about that the consumer provided at the time of origination? Those documents weren’t making their way through the process, so that once a mortgage traded hands a few times, there was absolutely no transparency into the details surrounding the origination. Still, the problem could have been resolved. The final gatekeeper in the entire mortgage process was the credit rating agencies who were supposed to apply risk ratings to these batches of mortgages. In theory, that should have worked. Agencies should have been able to detect the inadequate documentation that supported these lower quality mortgages, but they were too far away from the originator in the process. The egg couldn’t be unscrambled. To make matters worse, banks like Lehman began shopping for higher ratings, giving business only to those agencies that were willing to fudge the credit ratings a bit higher. Disaster finally struck, and the entire house of cards came crumbling down. That was the curse, and it also came with a blessing.
The Mortgage Industry Today
In order to tell this story, we sat down to talk with John Pellew, CEO and Founder of a startup called Othera, which promises to transform the mortgage industry using technology. Mr. Pellew spent the last five years speaking to more than 500 companies operating in the residential mortgage market to figure out what problems needed to be solved. While many startups right now are focused on force-feeding some blockchain architecture down their clients’ throats, Othera is focused on taking a technology-agnostic approach to an industry that’s riddled with disparate entities that all share one thing in common. They all operate in a highly regulated industry as a result of the 2006 crisis. Regulation means standardization, and as every techie knows, you need standards in order to adopt a solution across an industry. That’s where Othera sees a billion-dollar opportunity.
Which Blockchain Do We Use?
Mr. Pellew told us about how a C-level technology executive once told the Board of Directors he was trying to figure out “which blockchain they should use.” Anyone with a modicum of technological competence knows how flawed that statement is. Choosing the technology before figuring out what the problem is something a freshly minted MBA might try to do. It’s back asswards as they say. The right way is to figure out the problem first. And we know the problem now. All those documents that are assembled at origination – regardless of their quality – need to be moved up the food chain so that the quality of a mortgage can be assessed at any level, at any time. Regardless of what the rating agency says, anyone who holds a mortgage should be able to assess the quality of that mortgage by interpreting the underlying documentation in any manner they see fit. That’s where Othera comes in.
Earlier we talked about how documentation wasn’t following the mortgage as it changed hands, not in a form that could be analyzed readily. Additionally, there was no way of verifying a document’s authenticity. This is where blockchain technology can be applied. At the point of origination, any document can be converted into a PDF, and then cryptography can be used to create and embed a hash in the document in a blockchain that allows anyone to verify originality. If John Doe’s W2 is attached to the mortgage, anyone in the process, with the right authority, can quickly tell if the document is still original. Originators can simply create PDFs of all the documents – whether right or wrong – and then anyone can always look to make sure the documents are the same as when the origination took place. The mortgage itself – along with all the accompanying digital documentation – is then represented by a token so that ownership can be assigned. What Othera has built is a platform that supports whatever blockchain solution companies want to use.
When it comes to competing blockchain solutions for real estate, Mr. Pellew talked about how everyone seems to think the outcome is like the Highlander movie – “there can only be one.” The techies like to use the old “VHS vs. Beta” example, but it’s more like Microsoft vs. Apple. There will be multiple winners, each addressing different use cases and capturing different degrees of market share. Othera’s platform consists of a distributed network of blockchains where every single user will use whatever blockchain they like with a single method in place to enforce security across each individual blockchain. After spending years meeting with stakeholders in every corner of the mortgage industry, Othera realized that three things are needed to create a solution for the residential mortgage industry. Coincidentally, that’s exactly what Othera’s blockchain-based solution solves for – interoperability, privacy, and security.
The Way Forward
Othera’s plan just isn’t confined to the whiteboard. They’re weeks away from deploying the first component of their platform. This ambitious startup had already partnered with a co-op that represents over 150 mortgage originators that generate in excess of $230 billion in mortgages per year. The first thing they’re planning to address is something called “volume-based pricing,” and that’s about where we’ll stop today. The basic idea is that the buyers of mortgages don’t want to deal with multiple parties as that drives costs up. Dealing with a single party that aggregates a pool of mortgages is much easier and will command a better price for originators. That’s the tip of the iceberg when it comes to what Othera has planned. As for competition, they’re technology platform agnostic. While competitors expect the originators to adopt some expensive technology solution, Othera doesn’t. If you’re an originator that knows how to create PDFs, you’re all set.
Nowhere in the world – except perhaps Japan – will you find a residential mortgage industry with such standardization than in the United States. The subprime mortgage crisis was both a blessing and a curse. On one hand, it erased loads of value, and on the other hand, it led to standards being put in place that paved the way for solutions like Othera is building. With an experienced leadership team at the helm, Othera has positioned themselves so that they don’t have a dog in the race. All stakeholders throughout the process stand to benefit from implementing the solution, and Othera remains an objective third party that just wants to make things better for everyone, while possibly making their investors very wealthy in the process.