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Tuesday, September 9, 2008

McCain/Palin and the Fannie/Freddie Mess: Platitudes and Half Measures

Today, the Senator and the Governor wrote an editorial in the Wall Street Journal about their plans for the two troubled giants. Anyone who has read my work knows that I favor both of them for the Presidency and so you can rest assured that the upcoming attack on their plan is not partisan. While I support the two, I must report what I see not what I would like to see. Their plan is full of nice sounding rhetoric, half measures, and sadly I don't believe the truly yet (though I am available for consultation) understand the nature of the mortgage market and Fannie/Freddie's role in it. First, here are the highlights and then I will give my analysis.

Enduring reform of Fannie and Freddie is a key first step. We will make sure that they are permanently restructured and downsized, and no longer use taxpayer backing to serve lobbyists, management, boards and shareholders.

Treasury has broadly followed the McCain plan, outlined months ago, and gets at the short-term heart of the problem. That plan reinforces the federal commitment to meet our obligations and get this mess behind us. It replaces management and board members. It requires that shareholders take losses first. It puts taxpayers first in line for any repayments. And it terminates future lobbying, which was one of the primary contributors to this great debacle.

Along with the commitment of taxpayers' dollars, we should make market reforms to help ensure that we do not face this problem again. We will make sure the marketplace understands its obligations. Homeowners must be able to understand the terms and obligations of their mortgages. In return, they have an obligation to provide truthful financial information, and should be subject to penalty if they do not. Policies must be in place to ensure that homeowners provide a responsible down payment of equity in the initial purchase of a loan. In the future, Fannie, Freddie or any government organization should never insure a loan when the homeowner doesn't have enough of his or her own capital in the investment.


Lenders who initiate loans will be held accountable for the quality and performance of those loans, and strict standards must be required in the lending process. Every lender must be required to meet the highest standards of ethical behavior, with recourse if they do not perform.


We will push the nation's top mortgage lenders to provide maximum support to help cash-strapped, but credit-worthy customers. Lenders should do everything possible to keep families in their homes and business growing.

What is startling is how both of them, much like all of Washington (and I am sure Barack Obama is no different) really don't understand the nature of the mortgage market today.

Back when things were really booming, the mortgage market was fractured. Sub prime was a booming industry. Those loans were securitized and underwritten by a significant group of Wall Street investors that bundled those loans and turned them into bonds. Alt A was another thriving niche of loans. These were loans that each indvidual bank underwrote itself and would, initially at least, hold in its own portfolio, or they would agree to sell it to another bank that had the same loan in its portfolio. Today, all those niches are almost entirely non existent.

The only niches that exist today are loans underwritted and securitized by Fannie Mae, Freddie Mac, and FHA. I will say it over and over, both Fannie and Freddie don't merely securitize loans but underwrite and price them as well. Any loan backed by one of these two, and that is now almost all loans, is entirely directed by these two. So, when McCain/Palin say they will minimize Fannie/Freddie's role in the mortgage market they are dreaming unless their restructuring is combined with breaking the companies up into a group of five to ten such companies.

Both of them correctly point out that these two companies must be fully privatized (as opposed to their current structure as private Government Sponsored Entities), however if there are still two of them, their privatization will continue to be largely ceremonial. That's because, fully private or not, if the two of them continue to dominate the market, they are still too large to fail. As long as these two continue to combine to securitize 80% of the loans funded, as they do now, their will be an implicit backing of the federal government of these two giants. They will continue to be too large to fail, private or not.

The two of them are correct that lobbying by both corrupted their business. I would support wholeheartedly their plan to outlaw lobbying by both. Unfortunately, those sorts of anti lobbying, anti corruption measures will have limited effect if these two continue to dominate the mortgage market. Influence can be created in all sorts of ways and as long as there is a need to influence the companies will find one. Because both will continue to be too large to fail under their CURRENT plan (one I hope they will update), these two companies will continue to have way too much influence on politicians.

The most troubling aspect of their plan is here.

Lenders who initiate loans will be held accountable for the quality and performance of those loans, and strict standards must be required in the lending process. Every lender must be required to meet the highest standards of ethical behavior, with recourse if they do not perform.

This paragraph completely misconstrues the manner in which the mortgage market works. All loans aren't merely securitized by Fannie and Freddie but underwritten by them through three systems, Desktop Underwriter, Desktop Originator, and Loan Prospector. All the banks do is verify that all the information entered into this sytem is true and accurate. If banks are held to account because Fannie and Freddie's software system approved a loan it shouldn't have, the whole system will be in chaos.

The two of them speak in Obama like soaring rhetoric about restructuring, cleaing up the system, and making it work for the borrower, and yet their plan misses one vital element. Unless these two are broken, their structure will remain flawed. McCain/Palin have accurately assessed that both need to be fully privatized, however without breaking them up after they are privatized, the job is not done. Unless McCain/Palin realize that Fannie/Freddie currently have a monopoly on the mortgage market, their plan is destined to fail.


Naftali2 said...

I'd agree with you if you thought the key to McCain and Palin's plan was simply a matter of downsizing government and trying to restructure a bureaucracy.

But that's not the crux of the plan.

This economy has been scrambling for some time to find a direction for tangible investment. After the internet bubble, the money moved into real estate--which on the face of it is very tangible, and the returns were quite impressive. Not only were there subprime loans, but there were loans that were not subprime, folks investing and buying several houses to flip and rent. You can see the immediate limitations of such a market. Eventually rents and prices raise to shock the market.

However, the crux of the McCain/Palin plan in energy--the new gold--and energy technology. There is no ceiling on this market, that is the demand will not go down, and the US ability to produce such energy will infuse this economy with the OPEC treasure.

I think you know enough about economics to picture this ripple effect.

mike volpe said...

First of all, that is a lot of soaring platitudes. It's great that they want to transform our economy based on domestic energy. That doesn't mean they will do it. Let's leave that to the side. Let's say you are right. Let's say that energy drives our economy. So what.

These two dominate mortgages. They do everything. They control pricing, underwriting and securitizing. Neither banks nor mortgage brokers ever do anything unless that is all right with Fannie/Freddie. Every single file I send to a bank is run through one of their systems. It is their conditions. Whether or not the economy is revolutionized, they will still dominate housing. If one of them, or both, is on the brink of failure again years from now, they will have to be bailed out since they dominate the mortgage market. Since they dominate the mortgage market, they are vital to housing. No matter how revolutionized our economy is, we can't survive without housing. There is the rub.

If fannie/freddie dominated the gummy bears market I wouldn't care, but they dominate mortgages. Unless you want a housing market in which all transactions are done for cash, their continual dominance of mortgages presents a problem that needs to be resolved.