How the Web will transform big finance

“In the past 180 years, the U.S. housing finance system (HFS) has evolved from an informal/communal institutional arrangement to one of the most well-functioning and extensive financial intermediation systems in the world.” 

So begins a report commissioned in 2006 by the U.S. Department of Housing and Urban Development (HUD). The authors continue on to laud our achievements in institutionalizing, securitizing and automating this “HFS.” Our system was so well developed, they said, that other nations should look to us for how to build their own.  

{mosads}Of course, as they wrote, they could not have known of the troubles that lay right around the corner. Perhaps unwittingly, an unkind fate had the report published on April Fools Day. 

The failures in 2008 of our financial system and the consequent collapse of liquidity, and with it lending and borrowing, have been well documented. In many ways, we are still feeling the effects and will be for a long time to come.  

Meanwhile, our nation’s response, coordinated through private enterprise and government intervention, amounts to more of the very same that got us here in the first place. There are new regulations and new regulatory authorities. And there are many of the very same institutions who were “too big to fail” then, but who now present a united front of newfound financial chastity. 

So what have we learned? 

It’s worth looking back to history to discover new solutions to old problems.  

The very first institutional mechanism to fund housing in the United States originated in the 18th century. “Terminating” Building Societies consisted of local groups of citizens who banded together to fund the construction of houses for their members. It was a small-scale, local and social, and very practical approach to finance, and it worked, mostly. To ensure the recycling of community capital, loan terms were short. Balloon payments loomed under the threat of foreclosure. Home ownership, home size and home cost were therefore limited. 

Over time, economic shocks have brought in their wake new efforts to intermediate or  alternatively to disintermediate housing finance. For example, following the Great Depression, government got involved to reduce the incidence of foreclosure and expand homeownership. The Federal Housing Administration created the 20-year amortizing mortgage as one solution to those problems. This began a cycle of institutionalizing housing finance through public and private means, which in time gave rise to its securitization. As we now know, housing finance became a multi-trillion dollar business, for Wall Street and Washington alike. Main Street, for its part, voraciously consumed all that the symbiotic duo offered. 

The information technology revolution of the 1990s quickened the pace and expanded the scale of what had been set in motion decades before. The shocks came faster, and were felt more broadly. As Michael Lewis retells the tale, our HFS (particularly the web of mortgage backed securities) became so complex that no one could really understand it in its totality. 

What one cannot understand, one certainly cannot control. A heavily mediated system requires control. Human nature and the nature of our institutions being what they are, the result of 2008 was probably inevitable. 

Enter: Internet 

We need a new approach to financing houses in America. In fact, it’s already on the way into the mainstream. The future of finance lies in using the architecture of the Internet and how people have learned to utilize it over the past three decades. 

In consumer lending, the most advanced example so far, consumers have raised over $7 billion in loans via the Web, starting the trend to replace bank lending. The market has been inspired by Lending Club and Prosper in particular as marketplace-based approaches to reformatting finance. My company applies this concept to real estate, but there are many other examples of startups doing this in small business lending, student loans, payday loans and other fields. 

Could the Web succeed in replacing a system that has grown too big to fail (at least, that is, to fail itself), with one that’s too distributed to be decimated again? If it does, the impact on savers, investors, builders and communities will be transformative.  

This new system will need to leverage technology as the old system has. But it should do so in a way that brings us back to where we started, free of dependence on large institutions, government intervention and black-box finance. The Internet has always been a mechanism that increases transparency, encourages the open flow of information, and gives voice to the individual. Finance needs that today, more than ever.  

We’ve seen the Internet deliver the Schumpeter treatment to insurance, auto sales and wireless, among many other industries. Early indicators in finance suggest a similarly profound effect is well on the way.  

What does the future of housing finance look like? It looks more like democracy, where everyone can vote with their dollars, and where the benefits flow more evenly to everyone as a result. Self-forming, ad-hoc communities of people will self-determine the level of risk they individually want to bear. The centrally-managed fund with its high priesthood of finance will fall away. Fund managers will cultivate followings not as masters of financial resources they aggregate, but as influencers people choose to follow, or not. When they do, the booms and busts of a heavily mediated financial system will level out.  

Now is the time for that change to happen in finance. Communities have never been broader, more far-reaching and diverse, or more well equipped to share information efficiently. People have never been so connected. A new generation is rising that mistrusts central authority, large institutions, and Wall Street in particular.  

The motivated among us have the power, knowledge and capacity to do without the old intermediaries. In fact, we prefer it.

Dally is the co-founder and CEO of GROUNDFLOOR, the first micro lending community for real estate.