Scott Simon, a managing director and head of mortgage-backed securities at giant bond buyer Pacific Investment Management Co., is bucking the conventional wisdom that says Fannie Mae and Freddie Mac need to be reformed to encourage private capital to move back into the housing market.

Simon argues that if the government were to play a lesser role in housing finance, credit standards would tighten, down payments would increase and interest rates would soar because investors like Pimco would demand higher yields.

Simon, whose Newport Beach, Calif.-based Pimco manages $2 trillion of assets, says that while he prefers smaller government, he sees no way to shift the government guarantee to private lenders without significantly raising the cost for borrowers.

Simon is retiring at the end of May after 13 years at Pimco. In an interview with American Banker last week, he made the case for why the GSEs, which were seized by the government in 2008, should remain significant players in the housing market.

Q: Should Fannie and Freddie be reformed?
Simon: I think it is absolutely convention wisdom that they need to be reformed. But how they are reformed is huge. I think they should not have investment portfolios, which is where they blew up in taking all this risk on non-agency subprime loans. I think they need to be run like a utility without an investment portfolio and the guarantee function should remain. If you take them away, housing will be lower in price, loans will be harder to get and rates will be higher.

You look at where we are now with well over 95% of mortgages guaranteed through the GSEs. I'm fiscally conservative and believe in small government. But the reality is that over the last 70 to 80 years, the government has been incredibly involved in housing since the Depression and massively involved since World War II. Since the agencies lost so much money, everyone went ape and said let's get them out of housing. We are where we are. The government runs housing and the capital markets are set up to be able to purchase interest rate risk and not credit risk with this massive amount of bonds. And that comes in the form of government or Treasury-guaranteed securities. Japan will only buy Ginnie Mae securities. Banks need to buy Ginnie, Fannie and Freddie.

What happens if the private market essentially replaces Fannie and Freddie?
The private market can make mortgages but they would trade at much higher yields and the down payments would be much higher because the private market cannot make competitive, fixed-rate mortgages with 20% or less of a down payment on the loans. Nobody will balance sheet those loans and no one will buy them.

Most of the people who think we should shut [the GSEs] down have a pure philosophical belief and they don't care what the outcome is. Or they simply don't understand anything about how housing finance works.

There are people that think money will flood into this to make mortgages. And I ask a simple question, who? If it's not the banks or the insurance companies, where is the magic $5 trillion going to come from? [Pimco] will go near it at a much higher yield, which translates into a much higher price for the consumer.

You cannot run the current housing system and keep housing prices where they are and keep mortgage availability without the agencies. It is devastatingly bad for the middle class.

By making the security guaranteed, the government can buy insurance and lay off the risk. I'm suggesting leaving the securities in the same form they are now. To make the homeowner have access to mortgages at a reasonable rate, we need the agency to sell it. If it's in a non-agency, triple-A security, banks won't want to buy it.

Does the profitability of the GSEs now change the equation?
I think so. The GSEs are on the verge of becoming obscenely profitable. They are going to make so much money over the next decade, it's ridiculous. Fannie just released nearly $60 billion to Treasury. Suddenly these guys are becoming a cash cow for the government.

Whether you spin these guys off or go private, it would be a very profitable business for the government to be in anyway. It is a hugely valuable thing for the government to own over time. If you spin them off, these entities have achieved the status similar to an electric company or the gas company, you have to run them like a utility, they are that valuable to the system. They would have to widely regulated. I'm a conservative but as a taxpayer I'd rather see the government run it, because they will make more money for the people. You don't need to sell it to a private-equity firm.

There are people on the Hill saying we can't get addicted to this money as opposed to the language of a few years ago that they were a black hole. Now the negative is we can't get addicted to all this money.

But, they used the one guarantee fee increase to pay for the payroll tax. They can do whatever they want.

You've voiced support for Ed DeMarco, the Federal Housing Finance Agency's acting director, who has received a lot of criticism for not allowing principal reductions on loans back by Fannie and Freddie.
Ed DeMarco has done a fabulous job, he is one of the true civil servants in Washington. But the problem with the job is it's set up so Congress can point over there and say that guy ruined your life, we didn't. He's a great whipping boy. It's so offensive to me. They don't want it to work, they want to have people to yell at when it doesn't work - it's all about some spin on the 6 o'clock news. When you can't get good people to serve, it's a disaster. This is a topic that directly impacts 65% of households.

Now I do understand that there's a public policy issue here. Given where interest rates are, if you can get a loan, it's unbelievable cheap versus your income and versus renting. But if you cannot get a loan, it's infinitely expensive. The credit box has gotten incredibly restrictive, which is why Fannie and Freddie are making so much money. These loans are unbelievable loans. Fannie's average is a 775 Fico score with a 31% down payment on a $285,000 loan.

If the government wants to guarantee loans with no down payments and Fico scores of 540, that's just not a prudent loan.

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