As we enter the third year of the conservatorships of Fannie Mae and Freddie Mac, it is well past time to seriously reconsider their fatally flawed structures and how we want the U.S. mortgage market to be structured in the future. The enterprises with $5.5 trillion of mortgages (60% of all U.S. mortgages) were the twin biggest casualties of the financial crisis, but their conservatorships have been critical to supporting the housing market, buying 75% of all mortgages made.

One option, as Bill Gross, the co-CIO of Pacific Investment Management Co., suggested is to continue the "nationalization" of the housing finance system because we cannot go cold turkey to get off the narcotic of government support. I disagree. Just because we cannot afford going cold turkey now is no reason to create another giant government program on top of the enormous deficits of Medicare, Social Security and Medicaid among others.

It is time for the U.S. housing finance system to grow up. Congress finally tried in July 2008, but it was much too late and too little. The place to start is with what went wrong. Depressingly, my list today of what went wrong at the enterprises is similar to the first list of problems that I highlighted in 2006 when I became their regulator:

  • Capital requirements were much too low as they were allowed to have only 1% capital.
  • Affordable housing goals were pushed too high to be safe and sound, which combined with the drive for profits resulted in the GSEs lowering their underwriting standards.
  • The congressionally mandated weak powers of the regulator were compounded by the implicit government guarantee, which resulted in a lack of discipline from the credit markets.
  • The massive portfolios, which we capped in mid-2006, increased the GSEs' credit risk, but also diverted managements' attention to managing complex interest risk using derivatives.
  • The unique GSE structure allowed Congress to have too much influence over the GSEs and, unfortunately, vice versa.

It is often said that the enterprises socialized losses and privatized profits. Actually they privatized losses as well. According to the FHFA, they lost their entire $78 billion in shareholders' equity in 2008 and have cost taxpayers $148 billion through June 2010. Even worse they failed in their missions of providing stability and liquidity to the mortgage market, which helped cost homeowners trillions of dollars. The No. 1 goal of mortgage reform is to never let that happen again.
We need to create a liquid, safe, efficient and transparent mortgage system that produces reasonable-cost single-family and multifamily mortgages with minimal risk to the taxpayer. There needs to be a clear demarcation between the risk assumed by the government and private sector so that there would be some real discipline from buyers of their securities.

The successors to Fannie Mae and Freddie Mac should not be GSEs, but rather federally regulated and licensed packagers and insurers of mortgage-backed securities. These new private-sector MBS insurers, which could include "new" Fannie Mae and Freddie Mac and others, would be mutual or shareholder-owned companies. The "old" enterprises with their outstanding debt and MBS protected by the Treasury senior preferred stock would be run off over time.

Unlike the present Fannie Mae and Freddie Mac MBS, the new insured MBS should have common terms to promote liquidity and complete transparency on the underlying mortgages. The MBS would be backed by realistic down payments, private mortgage insurance, the insurer's capital and lastly, catastrophic government reinsurance. A risk-based premium should be charged for the government reinsurance and held in a fund. In case of conservatorship or receivership of one of the MBS insurers, holders of up to $250,000 of that insurer's MBS would be protected. To instill market discipline by having "skin in the game," holders above $250,000 would suffer a 5% loss before receiving the benefit of the government reinsurance.

Any debt issued by the MBS insurers would be junior to the claim of the MBS holder and the government reinsurance. Portfolios should be limited and used primarily for liquidity purposes. Instead of affordable housing goals that are subject to ever-escalating congressional and administration pressures, an annual fee to fund a government-managed affordable housing program should be paid as part of the insurance premium.

Higher minimum and risk-based capital requirements set by the regulator are critical. They should be countercyclical so that when housing prices get too far above historical norms, the capital requirements would automatically increase to dampen the boom-and-bust housing cycle.

Gross is right that mortgage rates may rise somewhat, but nowhere near the 300 to 400 basis points he suggests. A properly structured and priced, insured MBS market, importantly, will allow the re-emergence of a sound, private noninsured MBS market over time. The bottom line is the U.S. cannot afford to permanently socialize the housing finance sector.

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