As Congress debates financial reform, an odd couple appears left out: Fannie Mae and Freddie Mac. Yet these two organizations manage nearly one-third of all U.S. consumer debt, are under government conservatorship and have a bill to the taxpayers already approaching $100 billion.

Today, Fannie and Freddie are acting as direct arms of the federal government's provision of massive aid to support and revive the U.S. housing market. At the same time, their operating structure is that of private companies operating under the conservatorship of the U.S. government with capital provided by Uncle Sam.

Though this arrangement has allowed them to support the housing market, we believe it is imperative as the mortgage crisis eases that these government-sponsored enterprises' future be addressed. If not, Fannie and Freddie will continue to create an unlimited government liability, possibly to the tune of $389 billion in government support, according to the latest Government Accountability Office estimate.

Many recommendations have been made for the GSEs' future, but a key ingredient missing from all of them is the capital issue. The GSEs currently have negative $98 billion of capital, so any plan for the future of these entities must start with recapitalization. Even if they become a government agencies similar to the Federal Housing Administration, Fannie and Freddie would require loss reserves. Further, the adoption of accounting rules in 2010 will produce a ballooning of their balance sheets, to $5.5 trillion from less than $2 trillion today.

In our view, the only viable option for limiting taxpayer expense and recapitalizing Fannie and Freddie is to set up a "Bad Fannie" and "Bad Freddie" holding the existing portfolios and a "Good Fannie" and "Good Freddie" as cooperatives of bank mortgage lenders, similar to the Federal Home Loan Bank System.

Here's how this approach would work:

  • The new GSEs would become monoline credit guarantors and no longer have meaningful balance sheets of loans or securities.
  • Any bank that originates an agency-conforming loan and wishes to sell it to the GSEs would be required to retain 5% of the loan balance as an equity investment in the GSEs. Thus, the new agencies would be recapitalized at a solid 5% level, and we believe that this capital level would be a significant buffer against potential losses.

If the capital level we propose had existed before the crisis, the GSEs' capital position would have been about $200 billion greater, allowing them to get through this slump without any permanent government support.
Though there has been criticism of the Federal Home Loan banks' financial performance, we note that they took no losses related to their core business of making collateralized advances. By limiting the new GSEs to being monoline credit risk guarantors, we believe risks could be similarly contained.

We believe that our recapitalization plan would be acceptable to the banks for three reasons: By participating as owners mortgage banks would generate significant fees; these banks could also leverage their investments so that the capital contribution would be one-twentieth of the investments' dollar amount, and since the new GSEs would have very limited retained portfolios, they would be leaving one of the primary areas in which they competed with the banks.

Under our plan, both the common and preferred equity of the GSEs would become worthless. Our "bad bank" analysis suggests that the companies would still owe the government nearly $100 billion by the end of year 10. Our proposed bad bank is not a traditional bad bank because neither the good bank nor the bad bank would have any equity. Rather, it would be a vehicle the government could use to run off the retained portfolio and guarantee portfolio.

Even if there are scenarios under which the GSEs could eventually repay their debt to the government, there is significant risk in letting these companies take more than a decade to run off these portfolios. Since they are running these businesses without capital, no mechanism would exist to protect against the next shock down the road. Therefore, we think it is important that these entities be wound down in our suggested 10-year time frame, if not sooner.

Finally, though our current proposal does not address this, ways exist to limit the new GSEs' risk further by materially tightening their underwriting standards. Such steps would help both to contain credit risk and to make room for more private capital in the mortgage business. However, our proposal addresses what in our minds is the key first step, creating well capitalized GSEs that can continue to support the mortgage market while significantly reducing the risk to the taxpayer.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.