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The Winners and Losers in a Changing Mortgage Market

Increased regulation could advantage high-tech disrupters and firms with economies of scale, says Morningstar's Jim Sinegal.

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Matt Coffina: For Morningstar StockInvestor, I'm Matt Coffina. I'm joined today by Jim Sinegal, who is a senior analyst on our financials team. We're going to talk about the mortgage market.

Jim, thanks for joining me.

Jim Sinegal: Thanks for having me.

Coffina: To get us started, could you briefly explain how the U.S. mortgage market works? What is the role of originators, servicers, securitizers, and investors?

Sinegal: Basically, financial-services companies have specialized over time. Whereas banks used to make loans and hold them on their balance sheets, now those roles are filled by a variety of parties. First, you have the originators, the party that actually makes the loan. But instead of holding it, now those loans are mostly sold off to be securitized. The securitized loans are sold to investors, and the actual collecting of payments and disbursing of funds to investors is done by the mortgage servicers. So now, there are four parties at least fulfilling those roles, whereas in the olden days it used to be just one.

Coffina: So, the key securitizers for residential mortgages are Fannie Mae and Freddie Mac. These two organizations have been in conservatorship since the financial crisis. Has that reduced their role in the mortgage market?

Sinegal: No. Actually, they have gained share since they were taken into conservatorship. Basically, the two of them are functioning as arms of the government now, and it's very hard for private players to compete. So, we're seeing Fannie and Freddie guaranteeing about two thirds of all mortgages originated right now. They are raising their fees, and the private market is starting to come back; but as I said, it's very hard to compete with them with the full backing of the federal government at this point.


Coffina: So, there has been a variety of proposals to restructure the mortgage market, mostly aimed at reducing the role of Fannie and Freddie. Can you walk us through a few of the main proposals that are out there?

Sinegal: As you might imagine, there is a wide variety of opinions on how the mortgage market should look going forward. Fannie and Freddie have dominated it since the 1930s, basically, when Fannie Mae was created, and now people aren't exactly sure how things are going to look going forward.

There are a lot of proposals out there. Some would like to see them eliminated altogether; some would like to see the government maintain a large role, but not so much Fannie and Freddie. I think there are two main sources of debate. The first is around who is going to own the securitization platform. Will it be a public utility? Will the government still own that? Or will the securitization platform itself be owned by other financial institutions? And second, who is going to hold the credit risk and in what form?

I think some people would like to see the government provide a backstop after private investors take the first loss piece. Another proposal envisions something like the FDIC [in which] participants would pay into a fund, and that would guarantee the quality of the mortgages rather than the government itself or arms like Fannie and Freddie.

Coffina: I know it's very much up in the air right now--a lot of uncertainty about what, if anything, is actually going to pass. But if you had to take a stab in the dark here and guess what is the mortgage market going to look like five or 10 years from now, what do you think are going to be the major differences versus today?

Sinegal: [As organizations, I personally think] Fannie and Freddie did work very well throughout much of their history, but now both parties seem to agree that they should go away. So, I'll be surprised if they still exist in 10 years. I think the major thing that's going to affect investors is the increased regulation. We've already seen that. There are now new standards for servicing; all of the servicers have to hold certain standards. There are new standards for originating mortgages. And I think in a lot of markets when you essentially have firms bidding on a standardized contract, there's not a lot of room to compete and basically low-cost production becomes much more important. I think that's what we're going to see going forward.

Coffina: So, from an investor's perspective, who are the winners and who are the losers?

Sinegal: It's somewhat ironic in that, as the market becomes more standardized, that actually encourages large players, too-big-to-fail players, because there are big advantages, economies of scale in financial services. So, I do think the large firms are going to continue to do well--the firms like Wells Fargo (WFC) that now maintain a large portion of the origination-servicing market.

But I think, on the other hand, as cost becomes more important, there is a big role for disruptive players--maybe more high-tech players. We've talked a lot about firms like Discover (DFS) and how they have a low-cost advantage over traditional banks. Now, their mortgage business is off to a slow start; but I think that's the kind of firm without the legacy costs of a branch network, with huge investments in technology that could be a much bigger player in the mortgage market going forward.

Coffina: Thanks for joining me, Jim.

Sinegal: Good talking with you.

Coffina: So, in conclusion, a lot of changes [afoot] in the mortgage market, a lot of proposals to restructure Fannie Mae and Freddie Mac or perhaps eliminate them altogether. We think the mortgage market will look significantly different 10 years from now than it does today. And most likely, that's going to benefit the low-cost players--either those with scale like Wells Fargo or perhaps some higher-technology kinds of players that traditionally didn't participate in this market like Discover Financial Services.

For Morningstar StockInvestor, I'm Matt Coffina. Thanks for joining us.

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Matthew Coffina has a position in the following securities mentioned above: WFC, DFS. Find out about Morningstar’s editorial policies.