GSE Reform – A Fast, Practical Solution – By Rick Baron

We don’t need to re-create the wheel nor do we want throw the baby out with the bath water. We only need to change and repair the business model.

It’s as if we spent 25 years building a state-of-the-art computer to connect lenders to investors and enhance market liquidity. But like most folks in the ‘90’s, we forgot to install a firewall or any anti-virus software. When we plugged into the internet, Congress hacked into the system and infected it with sub-prime viruses and Alt-A malware disguised as Affordable Housing Programs. There was no firewall (or law) to prevent them from doing it. They corrupted the system.

Then the shareholders & CEO’s of Fannie and Freddie looted the corporate treasury. Then they handed over risk assessment (loan decisions) to software that assumed Real Estate values would always go up, and they don’t. The software also could not tell if you were lying to it. Human beings were no longer held accountable for responsibly assessing risk.

Then we handed securitization over to Wall Street, and handed originations over to unemployed and unlicensed computer nerds and twenty-year-olds. Soon anyone with a computer and an internet connection could get in the mortgage business and get rich, and here we are. Duh.

The system has not failed; it’s just been corrupted, infected and damaged. The system crashed in 2008, but we managed to reboot in Safe Mode. It’s still functioning, but just barely, and now we want to unplug it and scrap it.

We need to convert Fannie Mae into a Non-Profit Corporation. This would remove pressure from shareholders to take undue risks for the sake of profits. We need to build a legal firewall to keep Congress out of it completely. They should never be able to dictate credit quality or meddle with its money or its purpose. The Non-Profit Corporation would exist BETWEEN the government and the private market, not UNDER either one or both. The Non-Profit Corporation is the only business structure that can insulate the system from both government and private corruption. The Non-Profit Corporation is totally transparent and easy to regulate responsibly.

We need to put HUMAN BEINGS back into the risk assessment business and hold them ACCOUNTABLE, but also allow them to override software findings (when it makes sense and they document and justify their reasons).

All net profits (currently averaging over $10bln/yr) should then be BANKED as an AGENCY GUARANTY RESERVE FUND (not a government guaranty) and built up over time to make it the Fort Knox of mortgage banking.

We need to turn Freddie Mac into a second RESOLUTION TRUST CORPORATION (FRTC). Shift all of Fannie’s sub-prime securities (B Paper) over to Freddie, and all of Freddie’s prime loans (A Paper) to Fannie.
Then systematically modify ALL of the sub-prime loans that it owns outright to new 30 year fixed rate loans at 1% above current Fannie Mae 30 year fixed rates, no questions asked. None of these people qualified in the first place, so trying to make any of them qualify for a lower payment is just foolish. That’s why the modification programs tried so far have failed.

Give FRTC the rest of TARP money and a line of credit with the Fed to buy any and all B paper from any and all interested parties for .50 cents on the dollar of original value. Paying .50 cents on the dollar would help banks restore capital reserves and get the viruses off of their books and quarantined inside the FRTC. They could then go back to normal lending.

Once the U.S. owns them as the investor, systematically modify all of them as well. Then intensively counsel all of them on how to manage their money and live within a budget that works.

On the Pay Option ARM’s, systematically modify all of them to fully amortizing 3/1 ARM’s with 2/6 caps at Wall Street Prime plus a half-percent.

Once the loans show a history of performing, repackage them into MBS and sell to investors at a profit and recoup most of the money spent. That’s why the rates need to be set at 1% above the current FNMA rate – to offer an attractive yield to investors. If the loans are modified to below market rates, they will likely remain illiquid, especially when market interest rates rise.

Systematically modifying the loans to lower rates and payments will immediately create an enormous economic stimulus and give the borrowers a fighting chance to keep their homes.

Turning Fannie into a Non-Profit Corporation would prevent what went wrong from ever happening again, and the reserve fund would return us to an ever growing AGENCY guaranty instead of a Government guaranty. However, the GOVERNMENT BACKSTOP IS THE FULFILLMENT OF AFFORDABLE HOUSING GOALS because it keeps mortgage interest rates well below private market rates and competitive with long term Treasury yields.

This solution is a good idea. It will work. It will repair and continually strengthen the financial system and allow lending and credit standards to return to a more normal level. It will stimulate the economy and job growth as a result. It’s easier to implement and could be accomplished more quickly than the other proposals. It restores our mortgage and financial system to a state that we know works well, and will protect it from being compromised or infected ever again.

My faith in Congress doing the above, which is workable and makes sense, is zero. I’ve been lobbying Texas agency heads and politicians to create a non-profit corporation for Texas to function as a Frannie in case of emergency. We could put additional ones in each of the Federal Reserve Districts to take the pressure off of Fannie, diversify risk and be in a better position to respond to regional market changes quickly.

Common sense has left the mortgage industry, and we’re so risk-averse now we’re choking the industry out of business. If rates spike, we’re dead in the water. The small banks and credit unions taking all the “approve/ineligible” loans will get caught in the S&L trap of the late ’70′s/early ’80′s (higher cost short term money with lower yield long term loans) and they have no ready-made secondary market . Can you say “Systemic Risk II“?

Right now we’re observing a massive train wreck in slow motion, and we’re in the car floating end-over-end through the air assuming Congress will fix everything before we hit the ground. Pull your heads out, people. We need smart, swift & bold action and we need it now. The above could be implemented quickly and cheaply, would stimulate jobs and the economy, and would put the mortgage finance and banking system on a sustainable path. We should have done this in 2008 with the original TARP. We can still do it. All other options I’ve seen will take too long and will likely make everything worse.

Can anyone tell me why this will not work? Will someone please help get behind this idea? I’ll be happy to put this all together for us for a two year consulting contract and a seat on the Board of Directors (so I can make sure no one screws it up). Just let me know. rb