This week we are going to be treated to a "major" hearing on reform of the GSE's - Fannie and Freddie - and an overhaul of the housing finance system in the United States.
In order to set the stage, we must look at what happened with these GSEs and why, and whether the current structure led to the crisis we are now in. The answer to the latter, on any sort of rational, objective basis, is "yes."
In 2004 Fannie was accused of widespread and intentional accounting falsehoods by the government's OFHEO, their purported "regulator." In 2006 101 civil charges were filed against Fannie's CEO Franklin Raines, CFO Timothy Howard and the former controller Leanne Spencer. The three were accused of manipulating earning to maximize bonuses (ed: where have we heard that before - and since?)
One of the issues in the backstory of Fannie Mae is that Barney Frank, chairman of the House Financial Services Committee, had a sexual relationship with Herb Moses, a former Fannie executive. More importantly, while Frank was not Chairman at the time, he was on the House Banking Committee, which is, among other things, charged with overseeing OFHEO. Conflict of interest and willful blindness? You decide.
There are a lot of people on the right who want to blame "The E-Vile Demoncrats" for everything related to this, of course, and the Fannie/Frank connection is a convenient whipping boy. But that connectivity doesn't an outrageous abuse (on it's own) make. For that we have to look at the so-called "free market" Repthuglicans. (ed: if I'm going to use "Demoncrats", it's only fair that I also use "Rethuglicans"!)
As Janet Tavakoli laid out this weekend in The Huffington Post (and I have chronicled for the last three years) Fannie and Freddie became Wall Street's garbage dump:
Congress twisted arms to make Fannie and Freddie buy more than $300 billion of phony "AAA" rated mortgage-backed securities from banks, not counting loans that didn't meet their stated requirements. Today Fannie and Freddie want banks to repurchase tens of billions of these loans, since they fail to meet representations and warranties, and the banks are fighting this obligation.
Top subprime lenders included Wells Fargo; Countrywide, purchased by Bank of America); Washington Mutual, now part of JPMorgan Chase; CitiMortgage, part of Citigroup; First Franklin (now closed), purchased by Merrill Lynch, which was purchased by Bank of America; ChaseHome Finance, JPMorgan Chase; Ownit, partly owned by Merrill Lynch, which was later purchased by Bank of America; and EMC, part of Bear Stearns, which was purchased by JPMorgan Chase. Most of the rest depended on massive loans from Wall Street. Many of these lenders were sued by states for fraud and paid billions in settlements.
Notice that all the big names are there. Every one. Bank of America, JP/Morgan Chase, Citibank. If you look a bit further you find Goldman and Credit-Suisse clearly in the middle of the pile as well.
Fannie and Freddie were convenient dumping grounds because they enjoyed an implicit government guarantee. But their was not only nothing explicit about that guarantee, it was in fact explicitly disavowed, as I have repeatedly pointed out:
That's on the face page of every offering prospectus, and it is both explicit and clear.
Nonetheless, the market believed there was a guarantee, which allowed Fannie and Freddie to borrow money at very close to the Treasury security rate, buy loans with that money, and then recycle it nearly-indefinitely, reaching peak leverage levels of 80:1 (and this only accounts for on-balance-sheet exposures.)
That leverage ratio, incidentally, means that a mere 1.2% decline in the value of those securities renders the firm insolvent.
The leverage allowed the bubble to be blown, and it also guaranteed the depth of the bust.
Bluntly: Fannie and Freddie's leverage ratios were the proximate cause of the false "appreciation" in "home values", which Americans were persuaded to extract and spend. The expansion of these false values and the depth of the bust that we must now suffer was caused by government policy.
But that's not the end of the bad news. In fact, it's just the beginning.
State and local governments, you see, believed that these "housing values" were real. It's their fault, as the evidence, including the leverage ratios, were right out in the open - if you bothered to look. They took that "appreciation" and built a tax base around it, and then levered that up with teachers, firefighters, cops and others, lavishing extravagant pension and benefit promises on their unions - all allegedly backed by the State Constitution. The unions were not only complicit in this fraud they were actively involved, in that they too could see the numbers - but didn't care, so long as they "got theirs."
Finally, there are all the people who bought the paper "secured" by these clown car organizations. They were duped too, but again, due to their own willful blindness.
All in all at least half, and likely more, of the so-called "asset value" of American Real Estate was false. Yet people didn't just have that "wealth" on paper, they borrowed against and spent it - at the individual, corporate, local, county, state and federal levels.
The actual value against which that borrowing took place, however, does not exist and cannot be made to magically appear.
The people involved in this scam knew what they were doing. All of them. They all knew, in the back of their mind at least (for the non-professionals) and objectively (for those professionally involved in finance, securities dealing and banking) that this was, in fact, a Ponzi Scheme and could not continue forever. It was predicated on ever-increasing leverage and always being able to find a bigger sucker to pay an ever-higher price. But that ever-higher price had to be paid out of stagnant or decreasing real after-tax wages, which of course is an impossibility. Nobody was seeing 10, 20, 30% annualized increases in their income in the 2000s.
Nobody.
So what can - and must - we do about this?
First, we have to recognize that perverse systems like this, where government backstops a thing and then starts literally sleeping with the people it's supposedly regulating, always leads to corruption. When that perversity includes the taking of leverage it always leads to some sort of Ponzi Finance and ultimately a collapse. It cannot be otherwise.
Therefore, we cannot have this in the future. It simply must go away.
By the same token we cannot just turn off Fannie and Freddie like a switch. It's tempting, but we can't do it, and everyone knows it.
But what we can do is put forward a plan to dismantle these two hotbeds of conspiracy and corrupt practice. Thus, the following recommendations:
Announce that Fannie and Freddie will be closing for all new loan intake as of 12/31/2010. This must be a date-certain, and in the reasonably-current time frame. Four months is enough.
In the interim period, there will be a 50 basis point cumulative upcharge assessed on all Fannie and Freddie loans, starting with September 1st, increasing to 100 basis points October 1st, 150 November 1st and 200 December 1st. The intent is to make Fannie and Freddie paper expensive on an incremental basis, thus discouraging people from using it. We need a private lending market for home loans, and the only way to get one is to stop subsidizing their issuance!
Formally run down Fannie and Freddie's portfolios, and remove the backstop. On January 1st 2011 place them both in runoff, as they are no longer accepting any new paper. Within a decade their portfolios will be insignificant. Whatever losses are accrued will be absorbed by the holders of the paper, but these losses will be spread over a decade's time. We have already pumped over $100 billion into these enterprises, and there is likely $200 billion or more of additional hidden losses in their portfolios. However, those losses, over a decade, are manageable - even if they are five times higher than estimated (that is, even if 20% of their paper is worthless, which it likely is not.)
Accept that home prices will contract to sustainable levels. Bill Gross says he will not buy paper without 30% down. Ok. There are others who will - but not at zero, and probably not at 5% down. At 10% down there are likely buyers at a higher interest rate. At 20% down the rate is likely reasonable, and then there is Bill Gross who will buy all you care to emit at a very favorable rate - with 30% down. This is how it should be - you pay for additional risk profile, and the less you put down, the more risk there is!
Keep the VA program for veterans and the FHA, but make the FHA program entirely-self-funding by law, with floating MIP payments linked to actual default costs. That is, no fixed-cost insurance - it adjusts annually. Yes, this will make FHA loans expensive. They should be expensive. I would keep the VA program simply because it is a benefit that is linked to military service, and even if it loses money, I believe it is a reasonable program with a reasonable return on investment in support of our service men and women.
Investigate and, where it can be shown that banks or others proffered loans to Fannie and Freddie that did not in fact meet underwriting guidelines, prosecute. We simply must get rid of the "freebie" for scamming the people via the government, even if the government is colluding with you. 1,000s of people need to go to prison as a consequence of the immense damage done to our economy. None of this was an accident. If government needs someone to lead this charge, I recommend Bill Black - he did it the last time and would be the "go to" guy to do it again.
Inform state and local officials that the bubble is both dead and that they must adjust, which means contracting their budgets to pre-bubble levels. They won't like it. Neither will their unions. It doesn't matter. The money isn't there, the asset valuations never really existed, they never will in the future and you can't wave a magic wand and make them appear. Those promises made based on fraudulent data cannot be kept and are void under the general common law rubric of fraudulent inducement. Unions that refuse to accept this must be broken and replaced.
Accept that the economic adjustment that must take place will be painful, it will result in millions of bankruptcies, both personal and business, but that it should and that doing so will clear the system. Protect nobody except depositors with FDIC insurance coverage. Everyone else remains fully exposed, and if this means they go under, that's fine. The economy will suffer a temporary setback but where there is a demand for a service or good and a void, someone will fill it. This is called "capitalism" and we need to start practicing it.
Extend the PBGC to cover state and local pensions and void, by Federal Law, any standing or claim upon a State beyond the PBGC for these plans. The unions will howl. It doesn't matter. The PBGC both caps pension payouts and has a legal mandate to guarantee self-funding of the plans it takes over. States should be able to discharge their plans into the PBGC - indeed, they should have always been able to. This can be fixed with a relatively simple statutory change, and needs to be - right now, today. With this problem solved the State fiscal crisis disappears and their funding gaps become manageable. This change will also restrain future demands for excessive pension and retirement compensation, as the unions will be well-aware that should they push too hard they won't get what they negotiated - they'll get what the PBGC can pay from their plan assets. While this may sound harsh it is the only means by which state and local pensions can be brought under control.
Encourage a private mortgage bond guarantee system with explicit leverage limits within the firms of no more than 8:1. There is no reason that a handful of private companies cannot, and will not, arise to fill the need for securitized loans that are backstopped by a larger pool - that is, insurance in the purest form. By mandating a no more than 8:1 leverage limit the aggregate loss in the pool will not be able to exceed 12% before the insurer will fail. This will put an immediate stop to high-risk lending in securitized paper, but at the same time it will permit "good risk" lending to be bundled, pooled, and underwritten. With no government backstop investors in said paper will be forced to do their own diligence and monitor what's going on - or suffer the consequences.
If you want solutions, here they are. They're not a "free lunch", but there isn't one. There also isn't a way to "conveniently" resolve these problems without pain and hardship, at least in the short term.
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