Treasury Secretary Henry Paulson on Wednesday said Fannie Mae and Freddie Mac should be eliminated and replaced by private-sector mortgage guarantors regulated like utility companies.

"Establishing a public utility-like mortgage credit guarantor could be the best way to resolve the inherent conflict between public purpose and private gain," Paulson said. "Under a utility model, Congress would replace Fannie Mae and Freddie Mac with one or two private-sector entities. The entities would purchase and securitize mortgages with a credit guarantee backed by the federal government, and would not have investment portfolios."

Speaking to the Economic Club of Washington, Paulson outlined several options for the future of the housing finance system, including allowing the Federal Housing Administration and Ginnie Mae to take on a greater share of the market for low-income and first-time homebuyers.
He said several alternatives were possible for Fannie and Freddie, including privatization, nationalization, or a restructured hybrid model of public ownership with government ties. But he said a utility model held the most promise.

Paulson said the entities should be privately owned, but "governed by a rate-setting commission that would establish a targeted rate of return, thereby addressing the inherent conflicts between private ownership and public purpose that are unresolved in the current GSE structure."

"The commission would also approve mortgage product and underwriting innovations to continually improve the availability of mortgage finance for a population to be defined by the Congress," he said. "In this model, continued safety and soundness regulation would be essential."

Other suggested models have flaws, Paulson said, including breaking up the companies and privatizing them.

"I am skeptical that the ‘break it up and privatize it’ option will prove to be a robust or even viable model of any substantial scale, without some sort of government support or protection," he said.

Leaving a larger company in private hands with no government ties is also problematic, he said.
"It is difficult to envision a sound, practical, private sector mortgage insurance business of any significant size that does not require large amounts of capital, and consequently generates only a modest return on capital," Paulson said.

Likewise, permanent nationalization of the government-sponsored enterprises would be a mistake, he said.

"While it offers the perceived advantage of explicit government support, it eliminates the necessary private-sector evaluations of credit risk and the private market stimulus to innovation," he said.

Paulson said returning to a hybrid model is possible. He said Congress could create a Ginnie Mae-like entity for non-FHA loans with a more explicitly defined government guarantee. But that may not be better than the current structure, he said.

"Developing risk-sharing parameters compatible with profit incentives would be as problematic, and potentially as inefficient, as in the current GSE structure," he said.


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