Fannie Mae and Freddie Mac are on life support, and they can't stay that way forever. While Congressional action will be required to restructure the charters of the two government-sponsored enterprises, the current focus is on the Treasury Department, which has the lead role in identifying viable plans for their future.
In the spring, the agency requested public comments on a series of questions on the much larger, almost philosophical, issue of what government involvement in housing finance should look like. Now that regulatory reform legislation has been signed into law, Treasury Secretary Timothy Geithner says GSE reform is his top legislative priority. But he also says that no recommendations will be forthcoming until early next year at the soonest.
Tack on a few months of legislative wrangling, and a substantial amount of time to implement whatever plan is adopted, and it is hard to see GSE reform actually occurring any time before the end of 2011.
This is unquestionably bad news for Fannie and Freddie.
Operating in conservatorship under the Federal Housing Finance Agency, the only thing keeping Fannie and Freddie-and, by extension the residential mortgage market-alive is the explicit backing of the federal government.
But keeping the GSEs in an extended conservatorship, while it temporarily preserves the liquidity of the mortgage market, is liable to do permanent damage in the long run.
"Conservatorship cannot go on indefinitely," says Edward DeMarco FHFA's acting director.
"Our responsibility is to conserve and preserve the assets of the [companies], and that includes human capital and business platforms. But as uncertainty continues, it gets harder and harder to do that. Both staff and senior management want a clearer picture of their future; companies need to invest and develop."
Treasury can move in one of two directions then, either increasing government involvement in the purchase and securitization of home mortgages, or cutting some or even all of its ties with the GSEs, and letting the free market mold the face of housing finance.
In advance of Treasury's recommendation, there is no shortage of experts already putting forward proposals for the GSEs' future, including those who advocate a complete nationalization, and other, equally strong advocates of complete privatization.
Even regulators who once oversaw the GSEs have sharply different opinions.
James B. Lockhart III, the former director of the FHFA and now vice chairman of the investment firm WL Ross & Co., advocates privatization.
But Stephen A. Blumenthal, an attorney with Williams & Jensen in Washington, and the former deputy director and acting director of the Office of Federal Housing Enterprise Oversight, the FHFA's predecessor, argues that the private sector can't be trusted to rescue the housing market in the event of another crisis.
There's no shortage of ideas on what to do with the GSEs. Here are five of them.
The reason the government is being forced to prop up Fannie and Freddie is that there is no private entity in a position to step in and fill the securitization gap that would be left if they collapsed. And the reason for that is that Fannie and Freddie's implied government guarantee has for years stifled competition in the marketplace, allowing them to become increasingly dominant.
For Lockhart, the answer is to help build that market by reconstituting the GSEs as private insurers of mortgage-backed securities.
"We should try to resurrect the private market in this country; but it will take some kind of insurance and Fannie and Freddie could provide that," he says. "But it has to be done with a lot more capital behind it than it has in the past and that will raise the price of mortgages."
Lockhart concedes that privatized GSEs could not possibly function if they carried their existing $5.5 trillion in debt and their mortgage-backed securities portfolios. But he notes that those obligations are now viewed by the market as the U.S. government's responsibility.
"The U.S. government provided the senior preferred stock that is to keep them solvent forever," he says. "Anybody who has been buying their MBS and debt is buying that."
In Lockhart's vision, the reconstituted GSEs would be capitalized by private investors, or perhaps structured on a mutual model, where they are capitalized by the lenders who buy their guarantees. He says that they would need "countercyclical capital requirements" built in, so that as housing prices rise, capital requirements do also.
"Can you get there from here?" Lockhart asks. "I'm not sure. It is a reasonably long stretch at this point. It may require come sort of catastrophic reinsurance that is paid for by the government. It's not a pure privatization, but it would be a major step forward."
But Lockhart's solution has its share of detractors.
Blumenthal says that lessons from the recent past should teach us to distrust the private sector as a source of mortgage market liquidity.
"The experience of 2008 demonstrated that during periods of crisis only the government has the resources necessary to provide liquidity to the mortgage market," said Blumenthal. "Consequently, any solution to the Fannie and Freddie issue that involves a private sector segment will fail-and it will fail at the worst possible time."
As profit-seeking entities, sellers of private-label mortgage securities are likeliest to pull out of the market when conditions are the least favorable, creating the same sort of stagnation in lending that we are fighting today."
This leads to Blumenthal's preferred solution for the GSEs.
Blumenthal's call for nationalization is really a plea to the Treasury Department to simply recognize both economic and political reality.
"It's time to just accept that providing liquidity to the mortgage market is a job for the government," he says. "I don't think the American public will tolerate a situation where for weeks and months on end banks are not lending, and the private sector will do that at times when interest rates and the economy are such that it is in their interest to do that."
Additionally, he says that expecting the private sector to step in and provide the funding to put Fannie and Freddie back on their feet is just naÃ¯ve.
"They are going to need an enormous amount of capital. Where is that going to come from?" he asks.
As badly burned as private investors were by the GSEs (shares that traded between $60 and $80 per share in the early 2000s now fetch about 30 cents), it seems unlikely that they will come flocking back-especially in the absence of an at least implied government guarantee of the companies' debt.
The government is the only entity in a position to recapitalize the GSEs and that fact, says Blumenthal, is only one more reason to support nationalization."It seems to me that if the taxpayers are going to come up with the capital, they ought to get the return on the capital," he said.
Before Fannie and Freddie began holding increasingly large segments of the MBS they created in their own portfolios, they ran a profitable business acting as agents between mortgage lenders and investors.
Blumenthal calls for a return to the GSEs' old, respectably profitable business model.
"Why shouldn't those profits inure to the benefit of the taxpayers?" he asks. "The future profits of Fannie and Freddie can go toward paying back what it owes the government."
Hold on, say others. Yes, the private sector is currently in no shape to support a robust MBS market. And yes, Fannie and Freddie were a key factor in that market's spectacular meltdown.
But should we be willing to forgo all the possible future benefits of a competitive MBS market in exchange for safety that might be achieved by some less dramatic changes?
No, say Donald B. Marron, director of the Urban-Brookings Tax Policy Center and a visiting professor at the Georgetown Public Policy Institute, and Phillip L. Swagel, a visiting professor at the McDonough School of Business at Georgetown University and director of its Center for Financial Institutions, Policy, and Governance.
"Whatever their flaws, Fannie and Freddie did boost liquidity in the secondary mortgage market. That liquidity made it easier for average Americans to get mortgages not only during normal economic times, but also in the depths of the financial crisis," they wrote in a detailed proposal for reform.
The Marron-Swagel plan, which looks to undo the flaws of the GSE structure while preserving the benefits of free market competition, would lead to another option.
Privatized GSEs, Nationalized Mortgage Insurance
"When we started thinking about this, we asked ourselves, 'What is the comparative advantage of the federal government?'" says Marron. "We decided that its No. 1 advantage was its ability to provide insurance against large macroeconomic risks."
The fatal flaw of the original GSE structure, Marron says, was the implicit government guarantee of the enterprises' debts. It created a de facto public backstop for private, profit-seeking behavior, and resulted in lower borrowing costs for the enterprises and excessive risk-taking.
"They weren't passing on the subsidy to borrowers, which makes no sense. There is no public policy rationale for that structure," says Marron.
His restructuring proposal would play to the strengths of both the enterprises themselves and the government, while doing away with the implied subsidy.
The GSEs both have the personnel and the infrastructure in place to support the securitization and sales of mortgage-backed securities, which Marron and Swagel propose they continue to do-as fully private companies in competition with others in the marketplace. At the same time, the government would offer to sell mortgage insurance to all mortgage securitizers, not just Fannie and Freddie.
"We want to make things explicit," Marron says. "You charge for the backstop that the taxpayer is providing-none of this implicit stuff. Whatever the government's role is going to be, let's write it down in black and white."
Marron says that details of implementing the proposal would need to be worked out, including what premiums the government would charge and whether coverage would be simply for catastrophic events or be more comprehensive.
But, he adds, the government, which manages the Pension Benefit Guaranty Corporation, the National Flood Insurance Program and, not least, the Federal Deposit Insurance Corp., would not be moving into an area where it has no experience.
Advocates of both full privatization and full nationalization have issues with the Marron-Swagel plan.
Blumenthal argues that relying on the private sector to continue buying and securitizing loans will create the risk of lending drying up, regardless of borrowers' riskiness, in times when interest rate spreads reduce profit margins.
Advocates of full privatization, such as Lockhart, have allowed that federal insurance might be a necessary step on the road to full privatization of Fannie and Freddie, but never visualized a permanent federal program for insuring home mortgages.
So, is there a way to shove the GSEs out of the federal nest without risking that the securitization market dries up at the first sign of economic stress?
Public Utility Model
A few months ago, House Financial Services Committee Chairman Barney Frank made headlines in the business press with his statement that Fannie and Freddie had become "the public utility that finances housing in America."
His point was a simple statement of fact, noting that under conservatorship, the GSEs were being used as an instrument of public policy to extend liquidity to the mortgage market at a time when no other institutions would.
But the statement may also have foreshadowed the enterprises' future. Both Geithner and his predecessor, Henry Paulson, have suggested that restructuring the GSEs as public utilities might be the most sensible course.
Under this model, the GSEs would be owned by private investors, but would operate under strict federal supervision. They would continue to buy and securitize mortgages, but would not be allowed to hold them in portfolio (except for a small amount kept for making necessary adjustments to the composition of securitization bundles).
The GSEs' fees for providing guarantees and other costs would be limited by Congress or a federal regulator, risk-taking would be severely constrained, and they would be required to pay regular shareholder dividends. The government role in overseeing the operation of the GSEs would include requiring that they serve all segments of the mortgage market that fall within certain "conforming" parameters.
Still, despite the expressions of interest from Geithner and Paulson, many remain deeply suspicious of the public utility model.
Former Reagan administration Treasury official Peter J. Wallison, now a fellow at the American Enterprise Institute, warns that allowing Congressional influence over guarantee fees is a recipe for another public bailout.
"Political forces will suppress guarantee fees, thereby preventing the utilities from being compensated appropriately for the risks Congress will require them to take," he wrote in an AEI report earlier this year.
"With these fees too low for the risk involved, regulated utilities will eventually become insolvent, and, ultimately, the taxpayers will pick up the losses," he predicted.
Back To The Future
While no solution to resolving the Fannie and Freddie problem is going to make everyone happy, there is at least one outcome guaranteed to make nobody happy: status quo ante.
Republicans and Democrats in Congress have rarely seen eye to eye on the issue of the GSEs, and the potential for any legislation involving them to devolve into a partisan fistfight is high.
But as DeMarco, the acting FHFA director, has made clear, a failure to act is sure to result in disaster. Perpetual conservatorship will drive off experienced employees who will be needed to implement future restructuring of the GSEs, and simultaneously prevent Fannie and Freddie from investing in the systems and technology they need to remain effective.
While letting the patient die on the table isn't acceptable, said DeMarco, absent Congressional action, there is currently only one treatment available.
"The only outcome that the statute today could conceptually allow would be to reconstitute the companies as they were," he said. And of all the options out there, he said, that's the one nobody wants.
Unfortunately, according to some observers, it may be hard to avoid.
"I think it is the most likely outcome," says Wallison of AEI. "Without some sort of agreement on something else, it is going to be required that Fannie and Freddie stay in place to continue to finance housing in the U.S., and as long as they are there, other sources will not develop."
Wallison says that Republicans in Congress don't want another federal agency financing the housing market, while Democrats are likely to remain opposed to privatizing the function.
"Stalemate means they remain in place," Wallison says. "Unfortunately, this is the course of least resistance and Congress frequently does take the course of least resistance."