With the number of foreclosures nationally jumping 47 percent in March from a year ago, lawmakers are weighing whether new lending rules are needed or whether the market is already self-correcting.

Last week, Sens. Charles Schumer, D-N.Y.; Sherrod Brown, D-Ohio; and Bob Casey, D-Pa., introduced a bill that would mandate tougher federal standards for mortgage lenders, even as Senate Banking Committee Chairman Christopher Dodd, D-Conn., was emphasizing that increased regulatory oversight and voluntary reforms by lenders are preferable to legislation.

The mortgage industry, in general, has argued that reform could restrict lending in the near term, hurting low-income borrowers -the intended beneficiaries.

Big financial institutions have in recent years increasingly bought home loans in bulk from lenders and bundled them into securities to be sold to investors, theoretically spreading risk and helping provide more funds for lending.

Critics say the creation of this secondary market in mortgages caused housing lenders to be too lenient in evaluating high-risk or subprime borrowers.

Consumer advocates say investors in bundled or pooled mortgages should be held legally accountable for encouraging lax lending practices.

Found here.

Bernanke began with a nice summary of what we’re talking about:

The subject of my remarks today is the regulation and supervision of two large financial companies: the Federal National Mortgage Association (known familiarly as Fannie Mae) and the Federal Home Loan Mortgage Corporation (or Freddie Mac). Fannie Mae and Freddie Mac were created by acts of the Congress and are thus known as government-sponsored enterprises, or GSEs. The Congress chartered these two companies with the goal of expanding the amount of capital available to the residential mortgage market, thereby promoting homeownership, particularly among low- and middle-income households. Although they retain their government charters, Fannie and Freddie were converted (in 1968 and 1989, respectively) to private, publicly traded, for-profit companies….

Fannie Mae and Freddie Mac each run two lines of business. Their first line of business involves purchasing mortgages from primary mortgage originators, such as community bankers; packaging them into securities known as mortgage-backed securities (MBS); enhancing these MBS with credit guarantees; and then selling the guaranteed securities….

The GSEs’ second line of business is the main focus of my remarks today. It involves the purchase of mortgage-backed securities and other types of assets for their own investment portfolios….Beginning in the mid-1990s, the GSEs began to rapidly increase the quantity of mortgages and other assets that they purchased and retained in their portfolios. From the end of 1990 until the end of 2003, the combined portfolios of Fannie Mae and Freddie Mac grew more than tenfold, from $135 billion to $1.56 trillion, and the share they hold of outstanding residential mortgages increased from less than 5 percent to more than 20 percent. Moreover, to finance their own holdings of MBS and other assets, in 2005 the two GSEs together issued almost $3 trillion in debt. Today, the two companies have $5.2 trillion of debt and MBS obligations outstanding, exceeding the $4.9 trillion of publicly held debt of the U.S. government.

On December 6, 2006, Fannie Mae filed its 2004 Form 10-K with the SEC. The filing provides consolidated financial statements for 2004, and a restatement of previously issued financial information for 2002 and 2003 and the first two quarters of 2004. As a result, investors and others should not rely on Fannie Mae’s annual and quarterly financial statements issued prior to December 2004 nor should they rely on financial information issued prior to December 2004 that may be contained in Fannie Mae’s earnings releases, Annual Reports, Form 10-Ks, Form 10-Qs, Information Statements and Quarterly Supplements, Form 8-Ks, Form 12b-25s , Monthly Summaries, and Business Activity Supplements.

That a publicly traded company is unable to provide accurate and up-to-date annual reports for shareholders is to me astonishing. Usually, a company that is more than a year delinquent in filing its annual report would be delisted from the New York Stock Exchange. That we are in this situation for an institution with such a huge financial footprint is quite alarming. These problems, however, are not those addressed by Bernanke, who instead raised the following issue:

This line of business has raised public concern because its fundamental source of profitability is the widespread perception by investors that the U.S. government would not allow a GSE to fail, notwithstanding the fact that– as numerous government officials have asserted– the government has given no such guarantees. The perception of government backing allows Fannie and Freddie to borrow in open capital markets at an interest rate only slightly above that paid by the U.S. Treasury and below that paid by other private participants in mortgage markets. By borrowing at this preferential rate and purchasing assets (including MBS) that pay returns considerably greater than the Treasury rate, the GSEs can enjoy profits of an effectively unlimited scale. Consequently, the GSEs’ ability to borrow at a preferential rate provides them with strong incentives both to expand the range of assets that they acquire and to increase the size of their portfolios to the greatest extent possible.

This kind of problem and its solution are very well understood by economists. There are strong incentives to gamble whenever you’re playing with somebody else’s money. The way to solve this problem is to raise capital requirements. If you have none of your personal money at risk, then the upside when you gamble with somebody else’s capital is all yours, and the downside is none of your concern. But if the GSE’s equity were 10% of its mortgage portfolio, then when there is a 10% loss on the mortgage portfolio, the loss is entirely borne, as it should be, by GSE’s stockholders, who could then be relied on to pressure management to minimize the risk of such an outcome. To meet toughened capital requirements, Fannie and Freddie would have to use some combination of raising more equity from new share offerings and selling off existing mortgage holdings. The latter would perhaps also involve narrowing the mission of the GSEs to target a specific policy objective, such as helping low-income households achieve affordable housing. Any such changes would significantly reduce the GSEs’ contribution to systemic financial risk. Hence Bernanke’s recommendations:

First, the GSE regulator should have the broad authority necessary to set and adjust GSE capital requirements in line with the risks posed by the GSEs. Second, the GSEs should be subject to a clear and credible receivership process, a process that would establish that both shareholders and debt holders of a failed GSE would suffer financial losses. Third, the GSEs’ portfolios should be anchored firmly to a well-understood public purpose approved by the Congress.

Very sensible suggestions from the Federal Reserve Chair. Let’s hope that Congress has enough sense to adopt them.

Found here.