Image: John Schoen
By John W. Schoen Senior Producer
updated 7/15/2010 3:39:56 PM ET 2010-07-15T19:39:56

They're big, they're bad, they're sucking up billions of taxpayer dollars and they're not even addressed in the most sweeping overhaul of the financial system since the Great Depression.

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Two years after a wave of rogue mortgage lending sent the global financial system to the brink of collapse, Congress has put the finishing touches on a hotly-debated set of regulations to try to prevent it from happening again. The Senate passed the regulatory reform bill Thursday, paving the way for President Barack Obama to sign into law his administration’s third piece of major legislation.

Unfortunately, the new law has a gigantic hole in it — there's nothing in it dealing with struggling mortgage giants Fannie Mae and Freddie Mac.

“The essence of the problem was a real estate meltdown,” said Sen. Judd Gregg (R, N.H.). “The primary thing that we as a government should have addressed is Fannie Mae and Freddie Mac. The bill doesn't address that.”

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Call them the twin elephants in the room of financial regulatory reform.

Between them, the two so-called government sponsored entities own or guarantee more than 30 million home loans worth $5.5 trillion — or about half all mortgages outstanding. Already more than $145 billion in the hole, the government’s two giant mortgage companies are expected to need continued government life-support for the foreseeable future.

In the meantime, Fannie and Freddie continue to lose boatloads of taxpayer dollars; in the first quarter alone, Fannie Mae lost $8.4 billion and Freddie Mac burned through another $10.5 billion. They’re both carrying hundreds of billions of dollars worth of mortgages written during the boom years of 2005-2007, loans that continue to go bad. And as of the end of the first quarter, they had accumulated 164,000 foreclosed homes that will have to be sold at a loss.

“In a year or two they might return to profitability,” said James Lockhart, former director of the Federal Housing Finance Agency, which Congress created in 2008 to put Fannie and Freddie on a tighter leash. “But there’s still another big swing down before they get there.”

With taxpayers in revolt over mounting deficits, no one in either party is eager to see this uncapped bailout continue. But with private mortgage financing all but wiped out by the housing bust, the two GSEs are about the only place left to get a new mortgage.

Shutting off the taxpayer lifeline to Fannie and Freddie would almost certainly snuff out the feeble housing recovery — and further jeopardize a weak economic recovery.

“Our economy is very oriented toward homeownership,” said Howard Glaser, a mortgage industry consultant who served the Dept. of Housing and Urban Development in the Clinton administration. “So a smaller housing market is also a drag on the economy.”

Unless and until an alternative source of mortgage lending can be established to take up the slack, the government has little choice but to keep Fannie and Freddie on life support.

That’s why Congress and the White House have kicked this gigantic can down the road.

“If there was an easy solution they would have done it by now,” Stephen Blumenthal, a Washington attorney and former regulator of the GSEs.

Further complicating the government’s role in the mortgage market is the trillion-dollar lifeline provided by the Federal Reserve, which embarked on an unprecedented shopping spree for mortgage bonds in September 2008. That massive investment was supposed to jump-start private demand for mortgage bonds.

While the Fed’s move has helped keep mortgage rates low, it hasn’t produced the hoped-for restoration of private investment in new mortgages. Worse, the Fed now has a pile of mortgage bonds. If it were to begin unloading them back on the market, it could further depress private demand for home loans.

The whole idea of government-sponsored mortgages dates back to the Great Depression, the last time the housing market crashed and a new home mortgage was difficult to obtain. To get the market moving again, the government set up the Federal National Mortgage Association to buy mortgage loans from banks and other lenders. The new agency then sold those mortgages to investors, freeing up more cash to lend to more home buyers. By creating the first national mortgage market, the government also reduced the cost of borrowing to buy a home.

But in the 1960s, to help pay for the Vietnam War and spending on costly new social programs, Congress and the White House “privatized” Fannie Mae by selling it off to investors. (The nickname Fannie Mae came from the new stock’s ticker symbol, FNMA.) To create more competition, Federal Home Loan Mortgage Corporation, or Freddie Mac, was established in 1970.

That spin-off to private investors gave Fannie Mae a new, dual mission: promote affordable home financing while returning a profit to shareholders. That conflict lies at the heart of the current quagmire.

During the subprime lending boom of the early 2000s, as private mortgage lenders began loosening standards, Fannie and Freddie followed suit to avoid losing market share. When defaults began soaring in 2007, the ensuing housing bust sank many of those private mortgage lenders. Without a government bailout in September 2008, Fannie and Freddie would have toppled as well.

Since then, lending standards have tightened considerably, along with the quality of loans being written, according to Edward DeMarco, the FHFA’s current acting director.

“What we're seeing in the mortgages that Fannie and Freddie are guaranteeing today is these are being made to borrowers with much higher credit score, much higher down payments,” he said. “And the mortgages themselves are mainly 15- and 30-year fixed rate mortgages.”

That means Fannie and Freddie’s financial outlook should gradually improve. But a lot depends on how quickly the housing market and economy recover. The longer that takes, the longer Fannie and Freddie will continue to bleed cash

“You have 25 percent of mortgages in this country underwater,” said Lockhart. “There’s a long way to go to get the kind of impact (from new loans) that will bring any significant improvement to offset the relatively bad three or four years (of bad loans.)"

That leaves Congress and the White House with several unappealing options. One is to have the government permanently take over the job of housing finance, effectively nationalizing the two mortgage companies. Proponents of that idea argue that without a government mortgage lender, access to homeownership will be subject to the credit cycles of the financial markets.

“The private mortgage market will exist only when it’s in the interest of the lenders to do so,” said Blumenthal. “Everyone likes markets rather than the government. But it’s not realistic to think that the free market will be available at all times. It will only be available when it’s in the lenders’ interest.”

So far, strong public backlash to the government bailout of the financial industry has made the idea of a full-blown takeover a political non-starter.

On the other extreme are proposals to turn over the job of housing finance entirely to private lenders. But even those who favor a free-market system of housing finance acknowledge that it will take years to restore enough confidence among private investors to replace Fannie and Freddie.

“Certainly the private label mortgage-backed securities that were issued in that period of years was a very ugly example of how the private market can go wrong,” said Lockhart. “That’s the dilemma.”

Other options fall somewhere between a fully public or fully private model. One solution would be to start over with a new version of Fannie and Freddie, with tough underwriting standards, and move their existing portfolios of loans into a separate entity. Over time, as those loans mature, the old GSEs could be shut down.

But the government would still face the huge cost of unwinding what could be hundreds of billions of dollars of money-losing loans.

Estimating that cost has further complicated the debate — a lot depends on what happens to the housing market and economy in the next few years. The longer the recovery takes, the more costly it will be to clean up the mess created by the boom in badly written mortgages.

“Sometime during the next Congress, they may get a bill out, but it could slip until after 2012,” said Glaser. “But if you think about the implementation that’s necessary to create and transition to a new system, my view that it’s very unlikely we’ll complete that process until 2016 to 2020.”

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Explainer: Background on the financial reform bill

  • Thursday, the Senate is passed a bill that would tighten the regulatory screws on banks and capital markets following the 2008-09 financial meltdown. Here are snapshots of the major reform proposals and players. The material comes from Associated Press and Reuters.

  • Sections of the bill

    The 2,300-page bill had already been approved by the House of Representatives. Upon its Senate approval, it goes to President Barack Obama for him to sign into law. Here are some of the major points covered in the bill:

  • Systemic risk

    A council of regulators chaired by the Secretary of the Treasury would be created to monitor big-picture risks in the financial system. The Financial Stability Oversight Council could identify firms that threaten stability and subject them to tighter oversight by the Federal Reserve. The Fed and the council could break up firms that have not responded to earlier measures and pose an urgent threat.

  • Ending bailouts

    Image: AIG
    Mark Lennihan  /  AP
    The bill would set up an "orderly liquidation" process that the government could use in emergencies, instead of bankruptcy or bailouts, to dismantle firms on the verge of collapse.

    The goal is to end the idea that some firms are "too big to fail" and avoid a repeat of 2008, when the Bush administration bailed out AIG and other firms but not Lehman Bros. Its subsequent bankruptcy froze capital markets.

    Under the new rule, firms would have to have "funeral plans" that describe how they could be shut down quickly.

    The Federal Deposit Insurance Corp.'s costs for running liquidations would be covered in the short term by a Treasury credit line, then recouped by sales of the liquidated firms' assets. In case of shortfalls, costs could be further covered by claw-backs of any payments to creditors that exceeded liquidation value, and fees charged to other large firms.

    The FDIC could guarantee the debts of solvent insured banks to prevent bank runs. But this could only happen if the boards of the FDIC and the Fed decided financial stability was threatened, Treasury approved the terms and the president activated a rapid process for congressional approval.

  • Supervising banks

    Image: Citibank
    Bill Sikes  /  AP

    The U.S. Office of Thrift Supervision, a financial regulator that was widely criticized in the run-up to the credit crisis, would be closed and most of its duties shifted to the Comptroller of the Currency.

    Banks would be barred from converting their charters to escape regulatory enforcement actions.

    The FDIC's deposit insurance coverage would be permanently raised to $250,000 per individual from $100,000.

  • Hedge funds

    Private equity and hedge funds with assets of $150 million or more would have to register with the Securities and Exchange Commission, exposing them to more scrutiny. Venture capital funds would be exempted from full registration.

    Investment advisers would have to manage assets of $100 million or more to be federally regulated, an increase from the present $30 million level. The change would shift some of the oversight for small firms from the SEC to the states.

  • Insurance

    A new federal office would be created to monitor, but not regulate, the insurance industry, which is now policed at the state level. The move would appease opponents of centralized regulation by keeping real power out of Washington's hands, while giving big insurers that want a single regulator a foothold they might be able to expand from in the future.

  • Volcker Rule and bank standards

    Image: Paul Volcker
    Cliff Owen  /  AP

    Under a rule proposed by White House economic adviser Paul Volcker, the bill would bar proprietary trading unrelated to customers' needs at banks that enjoy government backing, with some of the details of implementation left up to regulators.

    Banks could continue to invest up to 3 percent of their Tier 1 capital in private equity and hedge funds, not to exceed 3 percent of any single fund's total ownership interest.

    Private equity and hedge fund interests above the new caps would have to be divested over time, under the "Volcker Rule," named after former Fed chief and Obama adviser Paul Volcker.

    In addition, the largest banks' ability to expand would be limited by a new cap on their share of industry-wide liabilities.

    Non-bank financial firms supervised by the Fed would face limits on proprietary trading and fund investing as well.

    Bank holding companies within five years would have to stop counting trust-preferred securities and other hybrids as Tier 1 capital, a key measure of a bank's balance sheet strength.

    Firms with assets under $15 billion could count current holdings of hybrids as Tier 1 capital, but not any new ones.

    The bill would also require credit exposure from derivative transactions to be added to banks' lending limits.

    In addition, bank capital standards could not sink below those already on the books, and a 15-to-1 leverage standard could be imposed on firms that threaten financial stability.

    The bill would also make bank holding companies follow higher capital standards observed by bank subsidiaries.

    Analysts expect the Volcker rule and related changes to cut profit at firms such as Bank of America, Goldman Sachs, Morgan Stanley and JPMorgan Chase

  • Over-the-counter derivatives

    The bill would impose regulation for the first time on the $615 trillion over-the-counter derivatives market, including credit default swaps like those that dragged down AIG.

    Much OTC derivatives traffic would be rerouted through more accountable and transparent channels such as exchanges, electronic trading platforms and central clearinghouses.

    Banks would also have to spin off the riskiest of their swap-clearing desk operations, but could keep many swaps in-house, including derivatives to hedge their own risks, under rules drafted by Democratic Sen. Blanche Lincoln.

    Some end users of OTC derivatives would be exempted from central clearing requirements. Swap-dealers' ownership interests in clearinghouses would be limited.

    JPMorgan, Bank of America and other commercial banks could face structural changes from the bill, while it could boost business for clearing and trading venues such as the Chicago Mercantile Exchange, analysts said.

  • Payment, clearing and settlement

    Supervision of firms that settle payments among financial institutions would be broadened.

  • Protecting investors

    Image: NYSE traders
    Richard Drew  /  AP

    The SEC, after a study, could order brokers who give investing advice to follow a higher standard of client care.

    A new SEC office to regulate credit rating agencies would be created. The SEC would have two years to study the widely criticized industry. Afterward, unless it comes up with a better idea, the agency would have to implement a plan to form a government panel to match agencies with debt issuers for initial ratings of new structured securities.

    Rating agencies would also be exposed to more legal risk.

    On debt securitization, lenders that make loans and then sell them off as securities would have to retain at least 5 percent of the loans' risk on their books, unless the loans meet certain standards for reducing risk.

    The SEC's enforcement powers would be beefed up and its funding levels raised.

    On executive pay, shareholders periodically could cast non-binding votes on top managers' compensation packages, while their role in electing directors would also be enhanced.

    Corporations would have to allow claw-backs of executive pay if it was based on inaccurate financial information.

  • Protecting consumers

    Image: Swiping a card
    Elaine Thompson  /  AP file

    A new government watchdog would be established to regulate mortgages, credit cards and other consumer financial products.

    The Consumer Financial Protection Bureau would be a separate unit within the Fed and funded by the central bank. It would consolidate consumer programs now dispersed across several agencies. Its director would be nominated by the president and confirmed by the Senate.

    The CFPB would answer, in some instances, to the Financial Stability Oversight Council. Car dealers, who fought for and won an exemption, would be beyond the watchdog's reach.

    Fees charged on debit-card transactions would be limited.

  • Federal Reserve

    Image: Federal Reserve building
    Karen Bleier  /  AFP - Getty Images
    The Fed's emergency lending would be exposed to congressional scrutiny, but not its decisions on interest rates. New limits would be placed on the Fed's so-called 13(3) emergency lending authority

  • Financial access

    Programs would be supported to help people who don't have bank accounts open them and to improve access to small loans and to enhance financial literacy.

  • Funding

    The costs of the reform bill would be met by funds raised from shutting down the $700 billion Troubled Asset Relief Program, or TARP, and increasing the amounts of money that banks must pay to insure their deposits.

    An earlier funding plan that targeted a new tax at large Wall Street banks and financial firms was dropped after some Senate Republicans complained about it.

  • Mortgage reform

    Image: "Sale pending" sign
    Justin Sullivan  /  Getty Images

    Mortgage lenders would have to assess borrowers' ability to repay before making a loan. Prepayment penalties against borrowers and bonuses to lenders known as "yield spread premiums" would be barred, with violators facing penalties.

    Other new protections would be set up for borrowers aimed at ending predatory and abusive mortgage lending practices.

  • The players

    Key people who have shaped the financial reform bill.

  • Barack Obama

    Image: Barack Obama
    Charles Dharapak  /  AP
    The president is determined to rein in the deregulated financial services sector and end a free-wheeling period blamed by some for the financial crisis behind the recession. Most Democrats in Congress, and a few Republicans, supported him on the issue.

  • Ben Bernanke

    Image: Bernanke
    Chip Somodevilla  /  Getty Images
    The soft-spoken chair of the Federal Reserve studied the Great Depression in graduate school, preparing him for today's crisis.

    Unlike his 1930s predecessors, Bernanke has turned on the money taps to flood the system with liquidity while slashing interest rates to spur the economy and fight deflation. He has also warned that big deficits would inevitably drive up interest rates.

    Before taking the reins at the Fed in February 2006, he briefly headed President George W. Bush's Council of Economic Advisers. Before that, he had three years of service on the Fed board, adding practical policy experience to his earlier theoretical work as an academic at Princeton University.

    A sober-sided "gray man" in appearance, Bernanke is plain-spoken, in contrast to predecessor Alan Greenspan, whose obscure policy pronouncements often perplexed his listeners.

  • Timothy Geithner

    Image: U.S. Treasury Secretary Timothy Geithner
    Jim Bourg  /  Reuters
    The Treasury secretary, who worked with his one-time boss Lawrence Summers to explain the administration's financial regulation reform proposals in a Washington Post op-ed, has a reputation of being cool under pressure. And there's plenty of pressure.

    He also has the unenviable job of helping the president keep down expectations of a quick recovery. Geithner told a New York audience recently that the financial system was beginning to improve but that unemployment will likely rise more.

    As president of the New York Federal Reserve Bank, Geithner was closely involved in the rescue of Citigroup Inc., as well as the bailouts of Bear Stearns and American International Group. But his reputation was tarnished by his involvement in the decision to let investment bank Lehman Bros. fail, a step blamed by some for plunging an already fragile financial system into a downward spiral.

    Previously, Geithner played a big part in shaping U.S. policy during the Asian and Russian economic crises in 1997-98, when he was in his late 30s.

    Geithner also worked at the International Monetary Fund, where he directed the Policy Development and Review Department from 2001-03. He studied Japanese and Chinese and has lived in East Africa, India, Thailand, China and Japan.

  • Lawrence Summers

    Image: Lawrence Summers
    Saul Loeb  /  AFP/Getty Images
    Summers, who co-authored the Washington Post op-ed on regulation reform, might have been Obama's treasury secretary but for an unfortunate 2005 comment, when he was president of Harvard University, that women have less innate ability in science than men. Instead, he heads the National Economic Council, a job that did not require Senate confirmation.

    Summers, who was Treasury secretary from 1999 and 2001, has a reputation for brilliance as well as not suffering fools gladly. He advised the president during the election campaign, and some had thought he might return to his old job at Treasury. Like Geithner, Summers is a time-tested crisis manager who gained experience helping direct the U.S. response to the Asian financial crisis in the late 1990s as the No. 2 Treasury official under then-Secretary Robert Rubin.

    He earned a Ph.D. in economics from Harvard in 1982 and taught there and at the Massachusetts Institute of Technology. Summers was the World Bank's chief economist from 1991 to 1993.

  • Mary Schapiro

    Image: Mary Schapiro
    Jim Young  /  Reuters
    Schapiro came on board to lead the Securities and Exchange Commission facing the prospect of shuttering of it amid criticism that it mishandled the gravest financial crisis since the Great Depression.

    That idea has since been pushed aside, and Schapiro, a former SEC commissioner who has spent more than two decades advancing through the U.S. financial oversight bureaucracy, may oversee the SEC's expansion. She has called for more oversight of asset-backed securities, credit default swaps and other, less-regulated pools of capital. Geithner has said the administration would like to give the SEC power to give shareholders more say over executive pay.

    Schapiro has also chaired the futures-market regulating Commodity Futures Trading Commission. She most recently was chief executive of a brokerage watchdog group, the Financial Industry Regulatory Authority. Schapiro came to the job with plenty of critics. Some said she was not a reformer, beholden to too many in a broken system, while others said FINRA had a mediocre enforcement record.

    The fact that she worked at both the SEC and CFTC led some to speculate that Obama planned to merge the two regulatory agencies — an idea that has been kicked around for years.

  • Sheila Bair

    Image: FDIC Chairman Sheila Bair
    Jonathan Ernst  /  Reuters
    As financial regulators were skewered last year for going too easy on regulation, Sheila Bair emerged as an unflappable figure with a tough-love approach to the banks she supervises as head of the Federal Deposit Insurance Corp.

    A self-described moderate Republican and former academic, she clashed with the Bush administration by pleading for more federal help for troubled homeowners in the mortgage crisis and openly criticizing the banking industry. In 2008, Forbes magazine ranked her as the second-most-powerful woman in the world — a distinction she thought was a mistake when she got a phone call about the citation.

    The Kansas native, whose term ends in 2011, was a university professor before coming to the FDIC. Previously she worked in the Treasury Department and for the New York Stock Exchange.

  • Gary Gensler

    Image: Gary Gensler
    Christinne Muschi  /  Reuters
    A former Treasury undersecretary, Commodity Futures Trading Commission Chairman Gary Gensler is expected to play a key role in efforts to regulate the over-the-counter derivatives market. Ironically, Gensler was part of the Treasury Department when it helped get a law enacted that exempted credit default swaps from tougher regulation.

    Gensler was a partner at Wall Street giant Goldman Sachs by age 30 and has been a critic of mutual funds.

    He advised former Maryland Democratic Sen. Paul Sarbanes on the post-Enron Sarbanes-Oxley corporate governance and auditing reforms. He was a senior adviser to New York Democratic Sen. Hillary Clinton's presidential campaign.

  • Christopher Dodd

    Image: Christopher Dodd
    Charles Dharapak  /  AP
    Christopher Dodd, the silver-tongued, white-haired chairman of the Senate Banking Committee, faces a tough re-election race for his Senate seat in Connecticut.

    After more than a quarter-century in the Senate, few know better than Dodd the inner workings of an institution known derisively by some as the place where bills go to die. Dodd knows the markets and banking well, coming from a state loaded with headquarters of hedge funds, insurance companies and other giants of the financial services industry.

    Dodd is known as a centrist who can steer a bill to the Senate floor. Whether he can overcome Republican opposition there to Democratic reforms will be crucial to efforts to tighten a financial oversight system in crisis.

  • Barney Frank

    Image: Barney Frank
    Evan Vucci  /  AP
    Rep. Barney Frank, chairman of the House Financial Services Committee, is an oddity among the well-dressed, conservative banking lobbyists who carefully parse their sentences as they come before his powerful committee.

    It's not just because of his rumpled clothes, his short temper or his sharp tongue. A lawyer and feared debater, Frank is an unabashed advocate for activist government and has more intellectual heft in his field than any other member of Congress. The Massachusetts Democrat is a power player on Capitol Hill. He often appears side-by-side with leaders to field nitty-gritty financial policy questions from the press.

    He has long argued the mortgage crisis, the credit crunch and the recession show the danger of taking a hands-off approach to the economy and Wall Street. With Obama and the Democrats in power, a more hands-on approach has arrived.

Data: Interactive timeline examining the global financial crisis


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