The Definition of Insanity Is...

"But you and I
We've been through that
And this is not our fate
So let us not talk falsely now.
The hour is getting late, hey."

-Jimi Hendrix

Finally, the discussion of what to do with Fannie and Freddie has kicked off!

In testimony before the House Financial Services Committee last week, James Lockhart, Director of the FHFA, which oversees the twins, laid out the checkered history of these entities as well as a menu of potential solutions going forward. While I disagree with much of what was said, the fact anything is being discussed on Capitol Hill is a huge step toward our economic recovery.

For 268 days, Congress did its best to avoid facing difficult questions regarding the twins, including their role in creating the current financial mess and any potential restructuring/dismantling of them as entities. But now, the issue is finally on the table for discussion.

Enough congratulations, let's get to resolution.

First, let's realize the twins played an important role in perpetuating the current crisis. By Lockhart's own figures, the mortgage market more than doubled from 2000 through 2008 when the twins were left with over 50-percent market share. Industry-wide loose lending standards along with return demands from shareholders forced them to innovate with the rest of the mortgage market in order to remain competitive. The innovations of the last 10 years are widely accepted as the cause of the current mortgage meltdown, and the twins were right in the mix.

So, what does the head regulator of the twins suggest as resolution? Unfortunately, his solution seems to be to retain the status quo in the two most important areas.

First, he believes they should retain the goal of promoting "sustainable mortgage options for low- and moderate-income families and neighborhoods." Setting aside the many potential meanings of the word "sustainable" in this sentence, has the head regulator of Fannie and Freddie failed to read a newspaper in the last 18 months? The widespread loan availability to those who cannot afford to make the required payments got us into this mess and renewing this initiative (indeed, it has been ramped up since the crisis began) will only perpetuate a cycle destined to end in extreme bust. If it is desired to subsidize these potential borrowers, a more straightforward approach of putting the government on the hook for part of their payment would be less likely to create a moral hazard.

Instead, the twins should be used to continue a standardization of mortgage structure and terms in order to promote liquidity and investor participation in the market. To be fair, Mr. Lockhart mentions this, but only as an ancillary goal.

His second, and most troubling, recommendation is to allow the twins to remain government-sponsored enterprises (GSEs). Instead of having public stock outstanding, the entities would operate as a co-op, owned by individual banks across the country. At first blush, this seems quite similar to the structure of the Federal Home Loan Bank.

However, a deeper dive reveals that we will be left with the same inherent conflicts between the owners of the newly restructured twins and their regulators that got us into the current mess. For decades after going public in 1970, the pull of two divergent masters led to great confusion by internal management about which master to serve at what time. To satisfy the desire of their shareholders for growth, the twins entered a multitude of new product areas armed with the assumed guarantee of the U.S. government. It was this guarantee combined with a profit motive that drove them off the cliff.

The entities were able to secure congressional approval (under both Republican and Democrat control) by siphoning a portion of their profits into legal lobbying efforts. Of course, I can understand the desire by congressmen to keep these cash cows alive (which the above recommendations will certainly accomplish), but I can also see how this sets the stage for a sequel to today's economy.

I am extremely pleased this debate has kicked off, but we need fresh ideas on how to promote housing instead of recycled stanzas of our past failures. Clichés exist sometimes because they are true, and the old adage that "those who forget the past are doomed to repeat it" certainly rings true.

Key Developments

In the "less bad news equals good news" category, job losses declined only 345,000 in May versus expectations of a 520,000 drop. In the 2001 recession, the peak monthly job loss was only 325,000 versus our recent experience of six months at north of 500,000 job losses. This data certainly supports the idea that the recession is lessening, but the economy has a long way to go before achieving recovery status.

April's personal income and spending report was, at the headline, a reflection of the government's stimulus efforts with indications of an underlying slower economy. The 0.1 percent decline in consumer spending was the second monthly decline in a row and much of the 0.5 percent rise in income was caused by government transfer payments.

The bankruptcy at GM notwithstanding, total vehicle sales in May surprised to the upside, coming in at a 7.3 million annual pace, up from 6.9 million in April. Though sales are down some 29 percent from a year ago, the April improvement was fairly widespread among automakers and nearly equal between cars and trucks. In any case, until consumer lending availability and employment growth returns, it will be difficult for auto sales to rise much from here.