Fannie and Freddie likely to merge, but as public or private entity?

When Fannie Mae and Freddie Mac were seized by the government in September, most people assumed that these government supported entities (GSE) were likely to change dramatically. Now that heads of both GSEs are out or likely leaving -- Freddie CEO David Moffett quit in March and Fannie's CEO Herb Allison is the leading candidate to run the $700 billion U.S. bank rescue program -- leadership at the top is no longer an issue for making significant changes.

Rumors reported by Bloomberg indicate that executives at Fannie Mae, which is much larger than Freddie Mac, have started internal discussions about taking over Freddie's operations. That would certainly save overlapping costs and reduce administrative expenses.

Fannie's been around since 1938. It was created to help the U.S. rebuild its residential real estate market after the Great Depression. Freddie was created in 1970 to add competition to the U.S. mortgage market. Business -- and competition -- soared in the 1990s and early 2000s as banks couldn't lend fast enough. Many exotic private mortgages came to market, and as we know, imploded last year.

Today, Fannie, Freddie and Ginnie Mae back most of the mortgage loans on the market. Without them there likely wouldn't be mortgages available right now. In fact, that's their primary public goal -- to ensure cash is available for banks to make mortgage loans. Fannie and Freddie buy or guarantee securities for mortgage debt. Freddie and Fannie own or guarantee 56 percent of all U.S. home loans. Ginnie Mae does the same for FHA loans.

The key decider of Fannie and Freddie's future will be James Lockhart, who oversees Fannie and Freddie as the director of the Federal Housing Finance Agency. He said that Freddie and Fannie will remain under government control until the housing market recovers, with their primary focus being to help homeowners to meet mortgage payments.

Christopher Whalen, co-founder of Institutional Risk Analysis, told Bloomberg that, "The only way we're going to be able to manage them is if we squeeze every last ounce of savings out of the administrative side and just focus on trying to keep the loss number under control." Spokesmen for Fannie and Freddie declined to comment to Bloomberg on a merger.

Basically, there are three options for the future of Fannie and Freddie:

  • Remain under government control as Fannie was until 1968. If this happens Fannie and Freddie, whether one entity or two, would no longer invest in mortgage-back securities for their portfolio. That's the primary source of most of their problems. They'll again focus on their public mission of providing liquidity in housing without having to worry about a dual role of making money for investors. This could be as one or two entities, but likely would emerge as one to cut administrative costs.
  • Downsize the two or merge them into one, but leave them in tack and tightly regulated. Their primary role will be buying up mortgages, breaking them up and selling them as securities. They will continue their role as "buyer of last resort" to keep the mortgage market liquid. Right now Fannie and Freddie are about the only kids on the block, as most private mortgage money has dried up.
  • Sell them off and get the government out of the mortgage market. Conservatives have been screaming for this for years. They believe Fannie and Freddie should be broken up into smaller private agencies and sold off into smaller pieces, so one entity isn't "too-big-to-fail." But the big question I have with this scenario is what entity will take on the crucial role of Fannie and Freddie today: "buyer of last resort." If Fannie and Freddie were not doing that today there would be no one buying mortgages and that would greatly curtail any new lending.

Whatever is decided, Fannie and Freddie should not go back to being what they were -- GSEs with a dual mission of keeping the mortgage market liquid as well as trying to satisfy investors. If some portion of Fannie or Freddie does become public again, whatever it's called should not be faced with the same dual mission. The public entity must focus on building a solid company with its core focus on satisfying investors. The public mission should be left to the entity controlled by the government as Fannie was until 1968. This experiment in GSEs failed miserably and should not be tried again.

Lita Epstein has written more than 25 books, including The 250 Questions You Should Ask Before Buying Foreclosures.

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