Wednesday, February 9, 2011

FDR and the Reform of Fannie, Freddie and the mortgage-backed securities market

If FDR were president today, how would he reform Fannie, Freddie and the mortgage-backed securities market?

Using his framework, he would start by focusing on what the government should do.  It should make sure that all market participants can access all the useful, relevant information in an appropriate, timely manner when they invest in mortgages or mortgage-backed securities.

In the 1930s, FDR realized that it was physically impossible to convey all the useful, relevant information on a mortgage in an appropriate, timely manner to each investor.

Why?  21st century information technology including computers and the Internet had not been invented yet!

Instead, he created government entities as a substitute for providing investors with information on each mortgage.
  • These entities purchased the mortgages and collected all the information on them.   This allowed the entities to enforce standards for the types of mortgages that they were willing to buy.  Enforcement occurred because the entities used the data on the underlying mortgages to determine if the mortgages complied with their standards.  If not, the entities would force the originating banks to repurchase the debt.  
  • These entities could also issue debt that was backed by the government to investors. 
A Washington Post article on the recent ASF Conference, confirms the information substitution role of these entities: [emphasis added]
... participants at the conference warned that a government withdrawal from the market might scare off investors, who are the source of funds for banks that make loans to home buyers. Many investors are especially nervous after the financial crisis, when they took major losses on loans that weren't backed by the government. 
... Eliminating the government's role might also undermine the $5 trillion market for mortgage-backed investments ... In this market, investors are willing to trade in mortgage-backed investments regardless of whether they know what loans underlie them and whether those loans are overly risky.
Today, FDR would use 21st century information technology to convey all the useful, relevant information on each mortgage in an appropriate, timely manner to each investor (see here, here and here) and end the information substitution role.

With this data, market participants can analyze and value each mortgage by itself or as part of a pool backing a covered bond or structured finance security.

How can the mortgage market transition from where it is today to a 21st century information technology based market?


The government should make current asset-level reporting on an observable event basis mandatory for all mortgage-backed securities (both covered bonds and structured finance securities).  An observable event includes a payment, delinquency, default or borrower filing for insolvency.

For new securities, the cost of providing the data will be built into the deal.  For all existing securities, the government should pick up the expense.

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