The Nerve to Say No

FAIR GAME
The Nerve to Say No
By GRETCHEN MORGENSON
Published: December 11, 2010

DECIDING what to do with Fannie Mae and Freddie Mac, the taxpayer-owned mortgage giants that helped set the financial crisis in motion, will be a huge job for Congress next year.
On Capitol Hill, Joseph A. Smith Jr., the Obama administration's nominee to lead the Federal Housing Finance Agency.
The man in the middle of that melee is likely to be Joseph A. Smith Jr., the commissioner of banks for North Carolina since 2002. In November, the Obama administration nominated him to head the Federal Housing Finance Agency, Fannie and Freddie’s regulator.

Last Thursday, Mr. Smith’s confirmation hearing took place. Beyond prepared remarks, Mr. Smith said little at the brief and sparsely attended hearing. Richard Shelby of Alabama, the ranking Republican on the Senate Banking Committee, questioned Mr. Smith about his plans for the agency and asked him to reply in writing. On Tuesday, the committee will consider the nomination.

Mr. Smith’s bona fides are many. He has both industry and regulatory experience: before he became commissioner, he was a lawyer in private practice and a general counsel for Centura Banks, now a unit of RBC Bank.

When he has testified before Congress in recent years, he has shown a keen interest in saving taxpayers from institutions that are too large and interconnected to be allowed to fail.

In March 2009 for example, he told the Senate Banking Committee: “As we work through a federal response to this financial crisis, we need to carry forward a renewed understanding that the concentration of financial power and a lack of transparency are not in the long-term interests of our financial system, our economic system or our democracy.”

Amen.

If this Mr. Smith goes to Washington as head of F.H.F.A., he will face a monumental challenge at a crucial time: how to protect taxpayers from even greater losses incurred by Fannie and Freddie as Congress considers what to do with the companies. Since they collapsed into conservatorship in September 2008, Fannie and Freddie have received $151 billion in taxpayer assistance. More will almost certainly be needed.

Because subsidizing housing through Fannie and Freddie is a time-honored tradition in Washington, Mr. Smith is sure to encounter enormous political interference as he walks the tightrope of overseeing the mortgage giants and working with Congress to determine their fate.

Through a spokeswoman, Mr. Smith declined to comment last week on his plans for the two companies because the confirmation process is still going on.

This year, Edward J. DeMarco, the acting director of F.H.F.A. and a career public servant, has done an admirable job of trying to minimize taxpayer losses generated by the companies. He has been forceful in demanding that banks buy back dubious loans they sold to Fannie and Freddie during the mortgage mania.

Mr. DeMarco’s agency also issued subpoenas last July to institutions that packaged mortgages into securities that were sold to Fannie and Freddie. Although the materials received through those subpoenas have not been disclosed, the subpoenas themselves made it clear that Mr. DeMarco was eager to go after anybody who might have offloaded sketchy loans onto taxpayers.

Mr. DeMarco is staying on at the agency as its chief operating officer after the new director arrives. And if Mr. Smith becomes the director, it is imperative that he also keep applying Mr. DeMarco’s buyback pressure on the banks.

MR. SMITH would also do well to follow another of Mr. DeMarco’s leads: pushing back against the growing chorus of groups arguing for an explicit government guarantee of all mortgages going forward. After what we have been through, isn’t it incredible that anyone could argue for government guarantees of all mortgages? Yet that’s just one of the many perverse “solutions” that have been floated in the aftermath of the crisis.

“The proposals are all similar,” said Edward Pinto, former chief credit officer at Fannie Mae in the late 1980s and a real estate finance consultant and resident fellow at the American Enterprise Institute, a conservative think tank. “They say the private mortgage market cannot exist without some type of explicit guarantee, that the government will be the catastrophic backstop and that it will be well-capitalized. But the problem with guarantees is the private sector ends up benefiting from the gains while sticking taxpayers with the losses.”

In addition to shielding taxpayers from having to backstop an ever-expanding financial safety net for errant bankers, we also need protection from ballooning losses at Fannie and Freddie. This will require the F.H.F.A. to take other crucial steps.

Janet Tavakoli, president of Tavakoli Structured Finance, a consulting firm in Chicago, has provided a to-do list for officials at F.H.F.A.

In a presentation to the agency’s supervision summit meeting last Wednesday in Washington, Ms. Tavakoli said that if the agency hoped to determine the credit risk lurking inside Fannie and Freddie, it needed to ascertain two things: the probability of default on those loans and the loss rates when probable defaults actually occur.

“They have to do their own statistical sampling of their portfolios to get a realistic idea of what those numbers are,” Ms. Tavakoli said in an interview. “And it has to be rigorous because we don’t know what kinds of impairments to expect from risky new mortgage products combined with a damaged economy and housing market.”

The F.H.F.A. cannot rely on estimates from the credit ratings agencies about the extent of those losses, Ms. Tavakoli said. “The whole idea of relying on third parties has not worked,” she said. “Once you feel better about the quality of your information, you’ll feel more confident about making your next decision.”

She also advised the F.H.F.A. to conduct a thorough fraud audit on the portfolios held by Fannie and Freddie to identify any improprieties that may have been involved in the loans the companies purchased.

“Fannie Mae and Freddie Mac have inherited a system that is hostile toward them fixing this mess,” Ms. Tavakoli said. “They need to stand up to the pressure they are going to get from Congress to give imprudent loans to people to provide a fake stimulus to the economy. But it didn’t work before and it won’t work now.”

In an interview Friday, Mr. DeMarco said: “I recognize that the policy discussion about the future of housing finance will be difficult and may take a while. If there were easy answers, we would have put them out there by now. But the key job for F.H.F.A. is to ensure that the functioning of the enterprises in conservatorship continues and that new business they take on is safe and sound while this takes place.”

IT could not be clearer that should Mr. Smith win the leadership of the F.H.F.A., he’ll have to stand up for the taxpayer. That also means he will have to stand against increasingly powerful banks that — despite the magnitude of the crisis — have managed to avoid, circumvent or co-opt policy makers, law enforcement officials and regulators.