Fixing Fannie Mae and Freddie Mac: The Debate Begins

The Obama administration acknowledged Tuesday that major changes must be made to mortgage giants Fannie Mae and Freddie Mac, but indicated that it supports continuing government guarantees in the mortgage sector. Is that a good idea?

Speaking at the start of a White House conference designed to foster public comment on the fate of Fannie and Freddie, Housing and Urban Development Secretary Shaun Donovan said: "Given where we are today, our footprint needs to be smaller."

But Donovan also told CNBC that the government was playing an "important role in stabilizing the mortgage market during the current downturn." He added that Fannie's and Freddie's financial problems don't lend themselves to easy solutions.

"A Carefully Designed Guarantee in a Reformed System"

Fannie and Freddie, which were seized by the government in 2008 to avoid a collapse of the mortgage market, are already holding $148 billion worth of bad debts from loans guaranteed before they were placed under conservatorship -- debts that will now fall on U.S. taxpayers to repay. A total of $5 trillion of guaranteed mortgages are still outstanding, and the amount of bad loans is expected to grow substantially in the coming months as more people who bought homes during the housing boom default.

Treasury Secretary Timothy Geithner, the host of the conference, made it clear that the administration has not abandoned the Fannie-Freddie model of backing loans.

"I believe there is a strong case to be made for a carefully designed guarantee in a reformed system, with the objective of providing a measure of stability in access to mortgages, even in future economic downturns," Geithner said.

But he came out in favor of the government stepping back from being the primary mortgage lender in the U.S. "We need to begin the process of weaning the markets away from government programs and make room for the private sector to get back into the business of providing mortgages," Geithner told the conference.

Strictly Securitization?

But the issue of whether or not to continue providing mortgage guarantees has prompted serious debate about what role government should play in what used to be an entirely private sector business.

Lawrence J. White, an economics professor at New York University's Stern School of Business, says Fannie and Freddie should be turned into purely private companies that carry out securitization -- the bundling of mortgages into bonds that are then sold to institutional investors.

"If their brand name and their systems and their collections of personnel have value in the marketplace, then they will survive," White says. "If it does not, then the market will eat their lunch."

White says he can see no reason for continuing government guarantees of mortgage securities. He says the private securitization market is sophisticated enough to provide the necessary guarantees to investors. But he acknowledged that the private market is dead at the moment because of the financial collapse and may take several years to recover. Therefore, he says, government backing for Fannie and Freddie can't end immediately as some critics have demanded.

He added that there may be a continuing benefit to having the Federal Housing Authority help low-income borrowers become first-time home owners, but that would not require the continued existence of either Fannie or Freddie.

A Role for Low-Income Borrowers

Linda Couch, deputy director of the National Low Income Housing Coalition, says she favors a continuing role for the federal government in issuing mortgages, as long as that help is limited to the lowest-income households.

"It is our hope that this whole reform process results in a mechanism to help people at the lowest income levels afford homes or spurs the development of affordable rental housing," Couch says. "If that happens through government backing of securities, then that might be the way to go."

But Couch was clear in her view that the government should stop guaranteeing mortgages for wealthy people. Fannie and Freddie currently limit the size of "conforming" mortgages -- those that they will buy from lenders -- to $417,000.