With financial reform bills that already surpass the 1,000-page mark, it would be hard to imagine any subject left untouched by the effort on Capitol Hill to overhaul financial services.

But the White House and Congress are essentially ignoring the problem posed by Fannie Mae and Freddie Mac, which the government took over in the opening salvo against the financial crisis.

During the first half of 2009, the companies sucked $180.5 billion from taxpayers. By March the Federal Reserve Board plans to have purchased $1.25 trillion worth of MBS from Fannie and Freddie along with $200 billion of their debt.

Observers say that, while politically expedient, the decision by the Obama administration and congressional leaders to exclude Fannie and Freddie from their reform efforts could prove to be a bad call in the long run.

"Five years from now, we will have been better off if we had taken a completely different approach to reg reform that included bottom-line questions about housing finance and the government's role in housing finance," said Jim Vogel, the head of fixed-income research at First Horizon National Corp.'s First Financial Capital Markets Corp. "Reg reform that addresses our current focus without those bigger questions is just going to have to be redone at some later point."

Sen. Richard Shelby, the top Republican on the Senate Banking Committee, for years has warned of the risks that Fannie and Freddie pose. In October he said their fate "is a question that we ignore at our peril."

Leaving Fannie and Freddie out of regulatory reform legislation "is a grave mistake that will make it more difficult to reform our financial system," the Alabama Republican said. "The longer we wait, the more it is going to cost the American taxpayer."

House Financial Services Committee Chairman Barney Frank denied earlier this month that Democrats were neglecting the issue, and said his panel would tackle Fannie and Freddie in 2010.

"The Republicans make this big fuss," the Massachusetts Democrat said in a Dec. 10 interview.

"They are like, 'Oh you are ignoring Fannie and Freddie.' The answer is no, we passed a bill that let us put them in receivership. Right now they are sort of serving as a public utility for housing. We'll have to sort out the past problems, but it's not a problem going forward how to deal with them."

Maybe not, but passing GSE legislation has never been easy.

It took more than five years for lawmakers to agree on a reform bill signed into law in the summer of 2008 - too late to clamp down on the excesses at Fannie and Freddie and avoid their collapse that September.

The Obama administration is due to release its GSE prescription in February as part of its fiscal year 2011 budget proposal, but with the reg reform bill stalled in the Senate and midterm elections next November, it is unlikely a bill resolving Fannie and Freddie will be enacted next year.

Fannie and Freddie will be "in limbo for a long time," said Paul Miller, an analyst with Friedman, Billings, Ramsey. "There will be debates, but it'll probably be years before it is addressed."

"A lot of thought needs to be given to how these companies will look going forward," said Brian Gardner, an analyst at KBW's Keefe, Bruyette and Woods. "That takes a lot more time than the nine months they'll have before breaking for election."

Over the past year, three main visions have emerged for Fannie and Freddie: nationalization, privatization and a hybrid of those two extremes that would be regulated akin to public utilities. The Obama administration and leading lawmakers have yet to say what they prefer.

Each option carries plenty of downsides. If Fannie and Freddie are nationalized, their liabilities would likely need to be brought onto the government's budget, necessitating a higher national debt ceiling. Amid broader concerns about deficits, pushing the government further into the hole would be wildly unpopular.

Privatization, long touted by Republicans and likely to involve breaking Fannie and Freddie into smaller companies with no government support, took a hit in September when a Government Accountability Office report said private companies might not be able to support the modern mortgage market. Even if the private sector could, consumers would likely pay more for a mortgage, the U.S. Government Accountability Office (GAO) concluded.

"Lenders might be less willing to originate 30-year fixed rate mortgages due to the associated interest rate risk of holding them in portfolio," the report said. "Additionally, privatization or termination could result in a relative increase in mortgage rates, because private sector lenders might not have the funding advantages that the enterprises derived from their federal sponsorship over the years."

In the days before leaving office last January, then-Treasury Secretary Henry Paulson introduced the hybrid model into the debate. The idea is intended to get around the thorny issues raised by privatization or nationalization by turning Fannie and Freddie into private-sector mortgage guarantors regulated by a commission like public utilities.

The commission "would establish a targeted rate of return," Paulson said.

But the GAO noted that regulation of public utilities is often inefficient and has led many states to deregulate these industries. It also saw little benefit to be gained from this hybrid model.

"It's not clear that the public utility model is an appropriate regulatory structure because, unlike natural monopolies such as electric utilities, the enterprises have faced significant competition from other providers of mortgage credit over the years," the report said.

Moreover, a hybrid model could revive the conflicts Fannie and Freddie faced in the years before their conservatorship when they had to square the needs of shareholders against their public mission.

"The hybrid structure to my mind ... is just an atrocious model," said David Reiss, a professor at Brooklyn Law School. "It's the worst of both possible worlds."

Some observers said they do not expect much from the administration when it makes its proposal in February.

"I have grave doubts that the proposal will be a very serious one," said Peter Wallison, a longtime GSE critic who is now on the Financial Crisis Inquiry Commission. "It will be more like what we've seen in the past, with a set of principles."

But even that could help renew debate over the future of Fannie and Freddie, said William Longbrake, executive in residence at the Robert H. Smith School of Business at the University of Maryland.

"A high-level piece will sharpen and focus the debate without prejudging the details," he said.

Whichever path the administration ultimately chooses should include measures for Fannie and Freddie to raise capital in a countercyclical fashion, said James Lockhart, the former director of the Federal Housing Finance Agency, who placed the GSEs into conservatorship.

"In good times, have the financial institutions, including Fannie and Freddie, reserve more or put up more capital as house prices get off trend and start to increase," said Lockhart, the vice chairman of WL Ross & Co. "We need some sort of discipline there that would cause financial institutions to sort of rein in bubbles."

But siphoning off money that would otherwise support housing is never popular, Lockhart acknowledged.

"There's lots of congressional pressure not to do it," he said. "Everybody supports housing. Everybody likes the economy to be booming and for people to have houses."

Still, those who rely on Fannie and Freddie to stimulate local housing markets say they do not care how the administration proceeds. They just want a decision that would clear up the uncertainty surrounding the mortgage markets.

Fannie and Freddie "are such big players in the market that a decision will help others know where they can go," said Christopher Hunter, who chairs the real estate practice at Morgan Miller Blair in Walnut Creek, Calif. "When a decision is reached, you'll have that and the entrepreneurial guys can fill in the gaps."

The uncertainty fuels the question of just how long Fannie and Freddie will operate under the government's thumb, a question policymakers have refused to answer. But it has become increasingly clear that a swift resolution is not in the offing.

Wallison said the administration has little choice but to keep them under government control, since Fannie and Freddie have become central to the White House's efforts to modify troubled loans.

"While that is going on, you can't really think about what you're going to do to the housing finance system in the future," he said. "We have no alternative."

Perhaps the most likely scenario for more immediate action on Fannie and Freddie is if public anger at the status quo swells.

"Making taxpayers more aware of the large and growing cost of rescuing the GSEs would help Congress see the wisdom of starting to slim the biggest elephants in the crisis avoidance arena," the Shadow Financial Regulatory Committee, a group of public policy experts, said in a Dec. 14 statement.

Though it is easy to carp about all the money Fannie and Freddie are bleeding from the taxpayers, Mark Zandi, the chief economist and co-founder of Moody's Economy.com, said the companies could ultimately turn a profit for the public.

"My sense is that three to five years down the road, once they work through these problem loans, they'll become more profitable again and there will be more pressure to spin them off," he said. "It will probably be a decade, but my guess is 10 years from now, the federal government will make money."

Policymakers face big choices in 2010 related to Fannie and Freddie. The Fed must decide whether it will keep its word and end its debt and MBS purchases in March, a move that could increase mortgage rates. The Finance Agency must decide whether to begin shrinking Fannie's and Freddie's mortgage portfolios by 10%, as they said they would when the conservatorship was announced in 2008.

Each of these decisions could have enormous impact on a mortgage market that is still shaky. But despite the uncertainty the conservatorship has caused, Lockhart still says it was the right choice.

"The conservatorship was extremely important," he said."The amazing thing is we couldn't have done that without the legislation that was passed only 40 days or so before. The whole housing market and the whole economy would have gone under."

Heather Landy and stacy Kaper contributed to this story

(c) 2010 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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