The Fannie/Freddie Conundrum Has Few Good Answers

Within the next 90 days the White House is expected to release its blueprint on what to do with the nation's money-losing - but much needed - congressionally chartered mortgage giants, Fannie Mae and Freddie Mac. If you think the answer to this dilemma is going to be an easy one then I have some AIG bonds I'd like to sell you.

First, let's state what might not seem so obvious: Fannie and Freddie are really giant savings and loan institutions. They hold liabilities and assets. Instead of using deposits they tap the capital money markets using short- and long-term debt. Most of their assets aren't whole loans, but mortgage securities backed by residential whole loans.

Together, they have $1.6 trillion of on-balance-sheet assets and off-balance-sheet guarantees of $3.6 trillion for a total exposure of $5.2 trillion. And even though both operate under federal conservatorships (with Treasury pumping money into them to keep their net worth positions north of zero) Uncle Sam has yet - technically- to put his "full faith and credit" sticker on them.

To novices, the full faith and credit issue might seem silly but it's not, really. If the U.S. says explicitly that it stands behind their debt obligations that means Uncle Sam's debt load just increased by $5.2 trillion. And as most of us realize - except, perhaps, Nobel Prize winner Paul Krugman - the U.S. has much too large of a debt load. Then again, as Mr. Krugman has argued, our debt problem is secondary to turning around the U.S. economy.

Mr. Krugman is much smarter than me and I hope that ultimately he's right. As for Fannie and Freddie, anyone who thinks they should be shot in the head doesn't understand how the U.S. mortgage market functions. If they disappeared overnight which institutions would fund mortgage demand in this nation? Wells Fargo? Bank of America? JPMorgan Chase?

I'm not talking about merely originating loans. All three already do that - with a combined market share north of 55%. But where would all those freshly originated loans reside? On the balance sheet of the big three or would they turn around and securitize residential loans using the private label MBS market? Oh, that's right. There is no private-label MBS market any more. And if Sen. Chris Dodd and Rep. Barney Frank get their way, private-label funders would have to retain a 10% risk piece on all new securitizations.

Let me put it in plain language for you: there is no easy solution to filling the void that would be created if Fannie and Freddie got shot in the head. The Federal Home Loan Bank System? That might be a start but let's first ask how Fannie and Freddie got into trouble in the first place. The answer is this: The two bought $400 billion in alt-A and subprime loans/securities without paying much attention to credit quality. Who sold them this crap? The Masters of the Universe on Wall Street: Bear Stearns, Merrill Lynch, Lehman Brothers, take your pick.

Why didn't we know they owned so much junk in the first place? Well, we knew bits and pieces of the story, but for years Fannie and Freddie had a weak and underfunded regulator with all the punching power of a bantamweight. Plus, any time Fannie and Freddie didn't want something to happen that would hurt their business they poured money into the coffers of politicians on Capitol Hill (both parties) who did their bidding. They spent millions on lobbying and political donations. But does that mean the GSE model is broken? I'm not sure. An argument can be made for their survival as closely regulated mortgage utilities which, by law, are barred from lobbying government officials and regulators.

Paul Muolo is executive editor of both National Mortgage News and Mortgage Servicing News. He can be e-mailed at Paul.Muolo@SourceMedia.com.

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