MISMO evolution: the drive to establish industrywide standards for pursuing electronic commerce in the mortgage industry is having many ripple effects. Its impact is being felt on many levels as the housing sector processes record volume and provides crucial support for the U.S. economy.

THE SUBJECT OF TECHNOLOGY AND ITS IMPACT on economies, industries and firms tops the list of critical items to be understood by business and policy decision-makers in the U.S. mortgage lending industry. Housing and housing finance have provided significant support to the U.S. economic recovery due in part to the impact of technological change. $ Among the questions being been asked today is whether the productivity gains apparently born of that technological change are real and sustainable. $ I will touch on that timely question after addressing my main topic--the technology standards effort in the mortgage industry led by MISMO (Mortgage Industry Standards Maintenance Organization). But I think it makes sense first to consider why the housing and mortgage business managed to deliver such stellar performance recently when sectors all around it were moribund. $ My favorite headline of the last three years appeared in The Economist, and said, "Housing Saves the World." I have been encouraging mortgage lenders and their business partners to take a bow. $ I suppose I have to balance that by noting that The Economist recently featured a headline--"House of Cards"--in which it proposed that it will all be reversed by a house-price decline.

My disagreements with The Economist's latter assessment notwithstanding, there are challenges in the days ahead as industry volumes are expected to decline as refinancing drops away. I point lenders toward the continued work that must be done to improve upon past accomplishments by making their markets, products and processes more efficient. Much of this work is focused on expanding the role of technology in their industry.

There are three points I discuss in this article that describe the MISMO evolution and the backdrop against which it is occurring.

First, housing and real estate finance have been the central players in the U.S. economy since the onset of the recession and they remain strong.

Second, the development of standards is as much art as science. There seems to me to be an understatement of the degree to which political wrangling is part and parcel of standards development and shapes its final content.

Third, MISMO will provide tremendous efficiency and productivity gains to U.S. real estate finance. At center stage of the U.S. political arena today is the issue of data quality, privacy and transparency in the areas of consumer rights and corporate governance. In this article, I describe the benefits of the standards effort as well as the challenges it faces.

It's important to note that this standards effort is not about standards for the core technology, but rather of the application of alternative technology solutions to the conduct of the mortgage business and the structure of the markets in which it is resident.

I typically like to define terms anytime I address an audience so that we are starting from a common definition. So before I talk about U.S. mortgage market history, I want to make sure you know how I am using the word "technology."

My typical opening gambit is to ask audience members to volunteer a definition of the word "technology." This usually generates silence. I then follow up by asking that anyone in the room who has never used the word "technology" please raise their hand. No hands appear.

I now have them trapped. Since they have all admitted using the term, I then ask them what they meant when they used it. A lot of shifting in seats ensues.

We then have a bit of back-and-forth and arrive at the general sense that technology is a tool that offers an improvement in production; either it allows them to generate more output with the same amount of input, or the same amount of output with less input.

In an attempt to humor them, after the quiz I then relate that I grew up on a dairy in rural Minnesota where we burned wood for heat in our rather cold winters. I note that we had a pair of Clydesdale draft horses with which we transported the wood from the forest to our home. When I was about 10 years old we acquired a tractor. That was a significant change and improvement in technology. I note that it was particularly so for me, since I was in charge of emissions control on the Clydesdales.

My point is that we need to think rather broadly about the term "technology" and not be limited to the current thrust of technological change. I often make the case that up until now, arguably, the most important technological change in the U.S. mortgage industry has been the telephone, which enabled call-center and fax capability. However, the future of the mortgage industry is beginning to and increasingly will be affected by information and communications technology (ICT).

Basically, technology is a tool. Let's move on to its specific application in U.S. real estate finance.

Refi redux

My first point: The real estate and real estate finance sector has been the primary support for the U.S. economy since the onset of recession in 2000 and the subsequent slow recovery. The seeds for the sector's strength were planted earlier in the decade. Part of the story has to do with capital market funding, and contains a related technology story to which I will make reference. However, my central discussion centers around the practical aspects of mortgage finance at the industry and firm level.

The U.S. mortgage market has experienced three great waves of refinancing since 1990. Each had a profound effect on the economy and the industry. The 1992-1993 refinance (refi) boom occurred at the cusp of the introduction of computer networking capability and was thus largely a manually processed activity. The mortgage industry processed $1.3 trillion of residential real estate debt or more than 10 million loans.

Inevitably there were bottlenecks and delays in the paper processing necessary to effect the transactions. At the time, the rule of thumb for consumers to consider refinancing their loan was a market rate two percentage points or 200 basis points below their current contract interest rate.

Coming out of a sustained high-interest-rate environment, there was a massive move among consumers to improve the terms on their mortgage debt. The mortgage system reached maximum capacity as consumers saved billions and shored up their balance sheets and income statements.

In 1994, the Federal Reserve raised the target Fed funds rate in tightening monetary policy, economic growth strengthened significantly and mortgage rates rose roughly 225 basis points--ending the refi boom and revealing significant excess capacity in the mortgage finance industry.

This led to a major consolidation among lenders (e.g., 19 of 24 public stock companies were acquired). It also prompted stepped-up efforts to alter the fixed-cost structure of the industry to make it more variable through the use of technology tools as a substitute for labor. Further, technology began (but only began) to be used to support the inflow and outflow of temporary employees to match staffing levels to cyclical volume changes.

Though not the central point of this article, it is also important to note that this excess capacity among prime mortgage lenders encouraged them to set about attempting to understand the business being conducted in the nonprime or high-risk credit market. That market, at the time, was the province of a few finance companies with relatively little competition. Technology would eventually play a role in increasing competition in and expanding credit access in the non-prime market as well, through the enablement of broad-based analysis of consumer risk patterns to improve risk-based pricing. But that is a story for another time.

By the time of the next refi boom in 1998 (which produced $1.5 trillion in mortgage volume and about 12 million loans), computer-based risk analysis of consumers, called "automated underwriting," had been introduced. It was not yet dominant, but the refi boom provided a testing ground for its refinement on a large-scale basis. Ultimately, it would emerge as an industry staple, supplanting the time- and paper-intensive manual underwriting process. It did not, however, begin the automation of the back-office activities.

Another feature of this refinance boom was an increase in the number of kinds of mortgages available to consumers. Automated payment calculations and the development of software designed to ensure consumer protections enabled lenders to start tailoring mortgage products to individual borrower needs. This trend continues today, with some lenders offering more than 350 mortgage product variants compared with perhaps 30 just 10 years earlier.

The third major refi boom lasted from the beginning of 2001 to mid-2003, and we are still experiencing the trailing edge of that boom. It has been during this refinance boom that the impact of technological change has been felt most greatly. By the end of the boom, consumers had recognized that the technological improvement in the processing of mortgage data and consumer and back-office documents had reduced borrowers' cost of exercising their option to prepay to nearly zero.

Consumers were refinancing with rate declines of as little as 40 basis points. The boom was augmented by the growth in housing equity as home values rose more than 50 percent in a six-year period. Consumers began to actively manage their household balance sheet, of which the mortgage was simply one part on the liability side.

The household balance sheet, at minimal cost, could be restructured to alter cash flows, restructure debt or gain access to accrued equity for consumptive purposes. This activity has been good for the economy and good for consumers, and will have a sustained positive effect in years ahead.

The volume of loans completed in 2003 is likely to exceed $3.3 trillion, or more than 18 million loans in one year--a number that would have been physically impossible in 1993. The unprecedented transaction volume was enabled by the technological change that had taken place in the intervening years. Still, there have only been a handful of experimental, purely electronic mortgage transactions, and that is where MISMO points to the future. The full automation and integration of processes in a standardized format are still ahead of us.

The art of MISMO

My second point is that this industry's standards effort is as much art as science. The formation of MISMO officially occurred in 1999. I was assigned responsibility for MISMO in 2000 and did what any good economist would do--recognize that I am not an engineer. So I hired some engineers to address the challenges ahead.

One challenge was to manage the inherent imbalance in the abilities of the primary and secondary mortgage markets to accrue the investment funds needed to effect structural technological change. At a recent gathering I heard a reference to Joan Robinson, and want to identify my one theoretic connection to her that stems from my describing the U.S. secondary mortgage market as being dominated by duopsonists. "Duopsonists" is the term Robinson used to describe two firms that purchase all the output of a given industry, which is essentially the case with Fannie Mae and Freddie Mac and the conventional conforming residential loan market.

Excess returns on a risk-adjusted basis in the oligopolistic secondary market make available investment funds not present in a purely competitive primary market. This raises the potential that a few large secondary market firms could dominate the technical-solution set for the entire industry, both primary and secondary markets. This would not result in an optimal outcome for consumers.

We felt a strong need for the Mortgage Bankers Association (MBA) to take on a central role in the standards development efforts. MBA's involvement could help balance the interests of all segments of the market by representing the purely competitive primary market's interests--including those of consumers--by working on the interface between the two markets. The engineers we hired have the technical knowledge and experience to lead the industry in that role. Our economics division balances the technical side by evaluating whether what is technologically possible is economically feasible.

The next step was to observe what changes technology was making in the industry and give oversight suited to the nature of those changes. In the U.S. mortgage industry there are two types of change under way: market-structure change and product and process change.

New and different types of companies are entering the business, even while old companies are consolidated out of business. Simultaneously, new ways of conducting business and product alterations are proceeding apace. To further complicate matters, MBA's residential and commercial members have similar, yet unique, technological needs.

This process of change was rather nicely captured in a comment by Angelo Mozilo, chairman, chief executive officer and president of Calabasas, California-based Countrywide Financial Corporation. He said, "There are consumers and there are investors, and the rest is friction." Standards reduce friction.

The primary art in standards development, it seems to us, is finding the space in which parties with powerful proprietary interests can be shown that the net value of cooperation in creating a standard exceeds the net value of not participating. Part of this is economic, part technological and part political.

Incidentally, I have concluded that my discipline, economics, was fooling itself when it changed its name from "political economy" to "economics." I recently hosted the Russian counterpart of the U.S. Department of Housing and Urban Development (HUD) Secretary Mel Martinez for a luncheon. I related the story of President Ronald Reagan hosting Soviet General Secretary Mikhail Gorbachev for a Memorial Day parade in the United States. After all the battalions, divisions and companies of the military passed, there came seven men in black suits. When Gorbachev inquired who they were, Reagan replied, "Oh, those are our economists. You've no idea of the damage they can do." My Russian guests seemed to have an outsized appreciation for that joke.

Realizing we would need full participation, but not dominance, of our two large residential and multifamily secondary market companies--Fannie Mae and Freddie Mac--in order for there to be hope of adoption of a standard, we opened negotiation. They were both already participating in the formative stages of the standards effort, but we desired some formal objectives. In 2001 we announced a public agreement between MBA and Fannie Mae to develop, adopt and implement standards in three areas: data structure and definition, electronic mortgages and secure identity.

The fact that the larger of the two duopsonists has made public commitment gives some reasonable expectation that the second firm will also participate with seriousness, and in fact continues to do so. Also, the technology vendor community, which provides the tools that construct the electronic business process, are crucial and are well-represented on MISMO.

With the simple mechanism of MISMO as a wholly owned, nonprofit subsidiary of MBA funded by participant subscriptions, we have developed standards cooperatively, and they are now in the implementation phase. More than 250 companies and 1,000 individuals in more than 30 workgroups are involved. The benefits will emerge over the next five years or so. What are those benefits?

The payoff from standards

There will be significant efficiency and cost reductions in real estate finance as a result of the standards. These efficiency gains will accrue to lenders as reduced costs and compressed time from loan application to closing; to borrowers as lower upfront costs in mortgage acquisition; and to investors as improved data and investment analysis quality. The process of realizing these gains in the industry will exact a price in the form of structural change to the mortgage food chain.

We have already seen benefits from the automation of non-standardized processes through application of technology. For example, the CEO of a small mortgage company recently showed me that over the course of the most recent refi boom he was able to increase output by 127 percent while increasing staffing by only 42 percent, and part of that staffing increase was from temporary help.

(Let me note here that federal productivity statistics show that productivity gains in the nonbank financial sector have not been as great as in the bank sector. It is my view that there are significant mismeasurement problems with that data. If corrected, I believe we would see significantly higher measured productivity gains in the nonbank financial services sector.)

Standards-setting

MBA is leading efforts in the development of industry standards for the mortgage finance industry. The first, and oldest, effort is MISMO itself. MISMO develops common data definitions and transaction structures to eliminate the need to write custom interfaces between each pair of business partners. It is available and being used for implementation on the MISMO Web site (www.mismo.org).

MISMO has created a data dictionary that defines more than 3,400 unique terms used in the residential mortgage industry, and a second dictionary for the commercial and multifamily business. The dictionaries also describe the dimensions of the data storage so that everyone who uses a term defines it the same way and stores it in the same structure. The data is presented and managed using extensible markup language (XML).

By using common data definitions and XML transactions, a lender can reduce or eliminate the need to rekey data into disparate back-end systems, thus eliminating the attendant cost of finding and correcting human errors. Such errors are commonplace today because often there are six to 14 such systems within one organization.

Further, there are at present perhaps 48 different firms providing loan origination systems for the consumer interface. This can create significant possibility for error in cross-firm commerce. Consumers benefit from the reduction in errors born of the standards, receiving better assessment of consumer credit quality and more accurate risk-based pricing as well as broader product-selection options.

Data standardization increases transparency and, combined with data-quality improvement, helps clarify performance results attributable to management. This, in turn, improves corporate governance accountability and, as a result, also improves investor confidence.

E-mortgages

The second industry standards effort is the development of guidelines and specifications for electronic mortgages. A true e-mortgage is very different from the online originations being done by the high-tech lenders of today under the term "e-mortgage." A true e-mortgage is originated, closed, recorded and delivered to a secondary market investor entirely in electronic form, using electronic or digital signatures.

I should note that the usual procedure in explaining this part of the standards effort is the presentation of one or more incomprehensible flow charts. I am happy to make several such flow charts available in the event you feel it will enhance my credibility on the subject. My engineers are not sharing this byline, however, so I will leave the charts out.

The e-mortgage effort takes slightly different structures on the commercial versus the residential real estate finance sides, due to consumer protection regulations on the residential side. Both residential and commercial mortgages are dominated by paper documents that are more costly to create, transmit and store than virtual documents. They also include new disclosures as mandated by the laws that make them possible: the Uniform Electronic Transactions Act (UETA) and the Electronic Signatures in Global and National Commerce Act (E-SIGN).

Thus, the eventual emergence of virtual documents will again reduce costs, although substantial upfront investments are required to build the alternative architecture to achieve fully electronic document processing capability. For example, an electronic note (the security instrument) can be 100 percent identically reproduced, which raises the question of identification of the authoritative copy in a court of law.

To solve this problem, the concept of an e-note registry has been developed by MBA with broad industry participation. The e-note registry is an industry utility that will uniquely identify the location and controller of the authoritative copy of an electronic note. This most importantly eliminates the problem of who has the "real" e-note, since it is very easy to make an exact copy of any digital file (such as a Microsoft[R] Word document). The standards for both the e-mortgage and the e-note registry are in place, and implementation has begun.

Data security and encryption standards

The third major standards effort is in secure identification and public key infrastructure (PKI) encryption standards, which provide the underlying infrastructure for e-mortgage process flow and the e-note registry operation. In an era where consumer privacy, data security and identity theft have become broad-based public policy concerns, the ability to establish the identity of trading partners in a secure environment has become essential.

However, rather than choose a single provider of such services, the strategy of the standards development effort has evolved to one of establishing minimum business use requirements and auditing service providers for meeting those minimums. The market will then sort among the best mechanisms, including interoperability between providers, for providing the security service itself. There are currently five interested identity issuers in the pipeline for accreditation, with one approved issuer and one approved auditor.

I want to make two brief asides before summing up. First, it is impossible to overstate the difficulty of achieving consensus on the nature, content, rights, responsibilities and liability assignment associated with intellectual property rights in the standards-setting process. It is the single most time-consuming activity at the outset, and all else awaits a compromise solution.

I say compromise, because there is a negotiation that takes place among the corporate counsels, the economists and the engineers to find an optimum or near-optimum solution. The thrust of technology development and change has outpaced public policy regarding the definition of property rights in this area. In order for our efforts to continue, we had to negotiate intensely regarding a working solution with which all could live. This, too, was evidence of the aspect of standards-setting that is art rather than science. A great deal of value could be added to the public debate by some interdisciplinary work within the university research community on this point.

Second, I made an oblique reference earlier to capital markets developments and technology. The U.S. real estate finance market has made a major transition from being funded by local depository institutions in local markets to being funded by global capital markets. The ability of the investor community to access ICT-based analytic tools to revalue financial investment alternatives in real time has supported the expansion of access to global capital by U.S. real estate markets.

Additionally, it has led to instantaneous price responsiveness at the U.S. consumer level to changes in global capital markets. For example, if European banking authorities conclude their institutions are over-invested in U.S. mortgage debt and enact a sell-off, this can immediately lead to a widening of yield spreads over U.S. Treasuries. The ripple effect moves down the food chain extending an interest rate increase to U.S. consumers overnight. Technology plays an important role in this process.

Final word

Technology is altering the structure, products and processes of the U.S. real estate finance system. Getting back to the question of whether productivity gains are real and sustainable, you will find me in the camp that believes economists are people who see things happen in reality and wonder whether they can happen in theory.

In the 11 years I have been at MBA, 17 of the 25 largest residential lending firms in the industry when I arrived are gone from the business. Further, the second-largest firm in the industry today (Wells Fargo Home Mortgage, then called Norwest) was not in the industry in 1990.

The U.S. housing finance system remains a leading support for the recovery of the U.S. economy and will help strengthen it going forward. Both household behavior and the economy have likely been permanently altered through the changes that have occurred in the real estate finance system.

The technology standards development process in the U.S. real estate finance system--while not pure to the taste of either engineers or economists--is working. But it is as much art as science. This will continue to be the case due to the structural imbalance between primary and secondary markets. The ability of the government-sponsored enterprises (GSEs) to generate risk-adjusted rates of return well above competitive market levels means they will continue to have excess capital to plow back into technology relative to what is available in the purely competitive primary market.

Finally, the standards are up and running, and companies are implementing them today in both the primary and secondary markets. They will produce tremendous benefits for consumers, lenders and investors, and ultimately the economy, as their adoption becomes broad-based. The fully electronic mortgage requiring no data re-entry--while ensuring the protection of consumer, lender, and investor rights and eliminating paper from the process--is coming. It is restructuring the value chain as we speak.

Douglas G. Duncan is senior vice president and chief economist with the Mortgage Bankers Association (MBA) in Washington, D.C.