The Need For Disruption: Building a Better Capital Market

Today’s private consumer credit capital markets don’t work.  

Take non-QM mortgage as an example.  Every lender has their own unique origination standards.  Lenders negotiate one-off loan purchase agreements (LPAs) with buyers, where no two LPAs are the same.  Once a lender delivers their contractual obligation of loans, they hope the buyer either re-ups for more loans or a new buyer takes their place – with yet another new and different LPA.  The resulting loan pools are bespoke, non-homogenous and illiquid. The only path to liquidity is frequently pledging loans into the capital markets for securitization.

Periodically – but with consistency – capital markets shut down.  When this happens, not only do buyers not re-up on new LPAs, they often stop buying outright - even with outstanding commitments to do so.  How do they do this when there is a contract in place to buy?  They delay wires, reject delivered loans or – as in 2008 – they say “sue me”.   

Lenders can’t turn off loan origination – doing so kills their business.  To manage inevitable capital market shutdowns and keep the loans flowing, lenders need to hold excess equity on their balance sheet.  How much equity varies by lenders, but what doesn’t vary is that equity is expensive and scales linearly (or worse) with production.  If a lender needs $100M of equity for $500M of monthly production, they need at least $200M in equity for $1,000M of monthly production.  Given the high cost of equity, lenders limit their production to keep required equity low.

Limiting production negatively impacts consumers.  Non-QM mortgages came to the market with great fanfare – offering flexibility a conforming mortgage couldn’t – but represented just 2% of 2023 mortgage production.  The lack of a persistent and deep capital market ultimately puts a limit on origination and results in restrictive terms and higher rates for consumers.  

Contrast this to the government sponsored entity (GSE) conforming mortgage market (e.g., Fannie Mae and Freddie Mac).  The same non-QM lender that needs to throttle monthly production due to the volatile capital markets and their own equity constraints can originate an unlimited amount of Fannie Mae and Freddie Mac loans, as the bid is always there.  GSE capital markets are liquid and don’t turn off.  Originate $10B of Fannie Mae loans in a month?  No problem – there is a bid to hit in any market.  Originate $10B of non-QM mortgages without billions of dollars in equity capital?  You won’t survive past a year.  

GSE Markets

How do the GSEs support such a massive, liquid and persistent market?  First, they standardize production.  Fannie Mae uses Decision Underwriter and Freddie Mac uses Loan Prospector to standardize underwriting.  There are single seller agreements for each GSE - not bespoke LPAs.  

Second, they support a to-be-announced (TBA) security market.  TBAs allow lenders to sell forward production, locking in prices and liquidity.  The GSE mortgage TBA market is the second largest market in the world – behind only US Treasuries – and trades $200B+ a day.  The New York Fed suggests mortgage TBA liquidity is worth upwards of 100 bps in bond prices versus the non-TBA mortgage markets.

Finally - and most importantly - the GSEs guarantee the cash flows of their pass-through securities.  While government backing was always implicit, it became explicit when the GSEs went into conservatorship.  Investors only take first order rate risk when buying Fannie Mae and Freddie Mac paper (with second order credit exposure to the guarantor).

The Story of Figure 

In 2018, Figure began originating home equity lines of credit (HELOC) in a very unorthodox way.  HELOCs were traditionally underwritten like most mortgages - with a human underwriter who reviews credit, income and property documentation to approve or deny the loan.  Since the mortgage crisis in 2008 the market doesn’t trust humans - so the third-party review (TPR) industry was catapulted to prominence.  TPR firms, as the name implies, review loans to ensure they were underwritten correctly.  Want to pledge a pool of loans to a warehouse?  The warehouse lender pays the TPR to review the loans.  Want to sell that same pool to a buyer?  The buyer pays the TPR firm to review all the loans - again.  Want to put the pool into a securitization?  You know where this is going.  But because of their guarantee and standardization, GSEs don’t use TPR firms - they are relegated to be yet another burden on the private capital markets.

Figure believes that the fundamentals of mortgage underwriting - credit, income and property - can all be captured electronically without any humans.  Figure built a loan origination system (LOS) and capital market to do this.  And to ensure the immutability of the data and our adherence to process, Figure put the loans and all of the underlying data on a public blockchain, Provenance Blockchain.  Figure secured warehouse lending in 2018, did the first securitization of its loans in 2020, and in 2023 did the first AAA-rated securitization of its loans.  Removing humans from the origination process and using immutable technology allowed Figure to dramatically reduce the TPR process - saving significant dollars on warehouse pledging, trades and securitizations.

Figure started as a direct to consumer platform but quickly evolved to include a B2B2C model for third parties to use Figure’s automated LOS.  Since launch, Figure and its current 90+ third party partners have originated over $10 billion in HELOCs.  Because of the automation of the underwriting, all the loans are the same irrespective of the lender - a Guaranteed Rate loan is the same as a Figure loan. Figure’s LOS brought GSE-like AAA-rated homogeneity, transparency and certainty to the market. 

A New Capital Market

Figure recently facilitated a milestone transaction: the first   loan sale on the “Figure Connect” marketplace, with multiple buyers and sellers using a common LPA and leveraging Figure’s LOS for standardized origination.  The launch of Figure Connect – which connects originators directly with buyers for loan sales using common documentation, reps and warranties – was years in the making.  

First, Figure had to build a partner lender network on its common LOS.  Next, Figure had to convince loan buyers that (1) their unique differences across LPAs did not result in any performance improvement and a common LPA would work and (2) Figure Connect was their best opportunity to source collateral.  Concurrent to these steps, Figure had to prove we could achieve a highly competitive AAA-rated securitization takeout for a fully automated underwriting process.

The multi-buyer, multi-seller common LPA paradigm sets the foundation for a permanent capital vehicle that can buy loans from the marketplace, package those loans into an “guaranteed” pass through and sell to investors.  Figure is working with capital partners to stand up this vehicle to facilitate a TBA market for lenders and investors, and we are also working with sell-side banks that can make markets in both the TBA and the pass-throughs.  This ecosystem will leverage Figure’s LOS for homogeneity, efficiency and ratings and Figure Connect for liquidity.  The goal is to deliver a market first by year end 2024: an “always on” liquid GSE-like market for non-GSE credit.

The Role of Blockchain

The mortgage industry has had a warranted skepticism of blockchain.  However, without blockchain, Figure could not stand up and sustain this new capital market ecosystem.  There are two ways that blockchain supports this new marketplace.

First, blockchain displaces trust with truth.  The ability to capture data electronically and store that data in an immutable ledger dramatically reduces the need for TPR.  Remit and loan performance can be shown real time. The certainty of data reduces the guarantor cost of credit support.  And with loans, pass-through securities, remit data and the guarantor’s capital all recorded on  public blockchain, we can swap the opaqueness that took down the mortgage guarantors in 2008 with real-time, shared transparency that should keep access to capital open, when needed.

Second, blockchain facilitates frictionless markets.  Figure uses the Digital Asset Registry (DART) to record loan ownership on blockchain.  DART is different from the Mortgage Electronic Registry Systems (MERS) in that DART “listens” for transactions, updating the registry as transactions occur.  Unlike MERS in 2008, the record of ownership is never out of date.  Figure uses Figure Market’s ATS for the trading of pass through and TBA securities, allowing for 24x7x365 bilateral transactions with instant settlement.   

The Future

Freddie Mac’s recent interest in the second lien space has prompted many to question how the GSEs might impact Figure’s business. However, given the automation and lower costs that Figure has brought to the ecosystem, the right question is actually when will Figure impact the mass market mortgage business today dominated by the GSEs. 

The Figure HELOC process lowers costs by 80%. With its meaningful investment in artificial intelligence, this cost advantage will only grow. Figure’s modern loan settlement and payment infrastructure ensures loan investors get paid with significantly greater speed and accuracy vs. the status quo. 

While Figure launched its business on HELOCs - because we perceived the market to be relatively greenfield and open to disruption in the capital markets - we see Figure Connect’s value in ALL lending markets - not just HELOC.  

Fortunately, the Figure LOS that our partners use today not only originates HELOCs, it is designed to to originate everything from auto to first lien mortgage loans using the same automated processes.  We believe Figure Connect benefits from economies of scale and diversification of credit, while lenders capture a much lower origination cost coupled with certainty in takeout.  This combination makes every market - including conforming loans - open to change.

Next Steps

At Figure, we are challenging the status quo across the mortgage and capital markets ecosystems. If you are aligned to the vision of a more capital efficient, prosperous future that is better for borrowers and grows your business, we are excited to connect.