Financial Reform forgets about Fannie and Freddie, but I didn't.

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So, the financial reform bill was passed, and now we can all breathe a sigh of relief. Well, not quite, because one of the prime causes of the financial crisis - the decline of the housing market, is still up in the air in terms of regulation. To be blunt about this, I ask the US government "what the heck's up with Fannie and Freddie."

For the most part, the financial reform bill seems like it will do good at identifying systemic risks, preventing it is another story. The genius of financial innovation always finds a way to create secondary markets. Either way, this is certainly a move to applaud. Among the plan of sweeping reform and regulations, a consumer protection agency will emerge, more disclosure, and government clearing houses for credit swaps. I especially favor the move to require banks and other financial players to take on some risk; for example, issuers of mortgage backed securities must retain a minimum of 5% of the credit risk associated with the underlying asset.

So, what to do about Fannie? For starters, here's some background info.



Fannie Mae and Freddie Mac actually provide a great benefit to homeowners and should not be fully blamed for the housing crisis. The bulk of Fannie and Freddie's portfolio holdings came from sub-prime borrowers in response to the Community Reinvestment Act. Providing affordable mortgage options to low income families who have the necessary means to qualify for such deals was able to continue because of institutions like Fannie and Freddie. Politicians wanted banks to serve the communities in which they operate, instead of taking deposits from the poor to finance the operations of the rich. However, the risk was that the residents in the community could not keep up with expensive mortgages. So, Fannie and Freddie helped to guarantee a portion of these mortgages by securitizing the asset to investors. These politicians who pushed hard for more sub-prime loans had good intentions that failed to make long term economic sense. As most loans had adjustable rates, borrowers began to struggle to make payments, and a default cycle rippled through the many markets that became the derivatives of the sub-prime investment scheme.

The systemic risk was caused by these secondary markets. Investors wanted to hedge, and sought more cash by sharing the pool of assets. With so many participants, and misleading ratings, and no real market value of these securities, the power of the home-owner is that much greater. The system was prone to collapse.

If we let Fannie and Freddie fail, a private player would have picked up the pieces, but the problem of politics will remain. For the many who sounded the alarm of regulating Fannie and Freddie by requiring reserves and oversight of their portfolio were dismissed in the Congressional chambers.



For a system so complex, I propose that the Federal Reserve adopt Fannie Mae and Freddie Mac. Now, this may receive some opposition from those who believe that the Feds have failed us. But actually, it's the fault of most politicians who place a gridlock on economic prosperity. The federal reserve is separate from politics for this reason, and for a system that provides affordability using such a complex framework, monetary experts should be involved. Home ownership and debt is crucial to our economic system, and with a grasp on this, the Federal Reserve will be better equipped on making better monetary decisions. Now, there's already a lot on the Fed's plate, but the work is best divided among their 12 regional branches. Picture a Fannie and Freddie board in each district with a specific grasp on community needs, reporting to the national Fed on the investment interest in the mortgage finance market, while adjusting the system for any type of secondary systemic risk.

The Treasury is set to hold a conference to discuss the outlook on the mortgage finance industry on August 7th. Clearly, they are undecided on what to do, so I hope some bright ideas come into play. I'll surely be listening very closely.

As for the housing markets -- the house price index posted a 4.6% increase in May, beating a forecast of a 3.9% rise. But the rise looks like a correction from the latest decline due to the expiration of home-buyer tax credits. Skeptics also say that home sellers are waiting for prices to rise, but then become desperate and offer bargains, causing a return to low home prices. There's also fears of a wave of pending defaults, certainly after 40% of home-owners dropped out of the HAMP program (government supported mortgage modification program).

The housing market got us into this mess, but a recovery can get us out.