A recent story on Bloomberg reported that Treasury officials are leaning toward a specific option outlined in 2011's white paper on the future of the GSEs. While their preferred option is impractical and unworkable, I believe that Fannie and Freddie can be restructured to serve as the foundation for a new mortgage system backed by private capital.

Aside from reducing the government's role in housing finance, any GSE reform effort should avoid disrupting the mortgage and housing markets while maintaining and supporting the operations of the MBS market; despite the financial crisis and its aftermath, it has performed well over the last five-plus years. In particular, the TBA market is a crucial asset; maintaining its integrity and functions should be a priority for policymakers.

The Treasury's preferred option advocates a "[p]rivatized system of housing finance" with "catastrophic reinsurance behind significant private capital." The white paper specifically describes one approach in which

...a group of private mortgage guarantor companies...would provide guarantees for securities backed by mortgages...A government reinsurer would then provide reinsurance to the holders of these securities, which would be paid out only if shareholders of the private mortgage guarantors have been entirely wiped out.

Unfortunately, the mortgage insurers are not remotely capable of taking over the government's credit enhancement function. The industry continues to work through its legacy assets, and many firms remain unprofitable. In addition, the MI business is fundamentally different from the GSEs' guarantee function; MI companies typically insure only a portion of a loan's value, while Freddie and Fannie insure loans' entire principal value. A simple infusion of private capital will not be sufficient to create a financially viable alternative to government guarantees.

Moreover, the mortgage insurers' operations are not nearly large enough, in terms of staffing and overall operational capabilities, to take over the GSEs' guarantee function. A (very) rough estimate suggests that the industry currently writes policies on about $150 billion in mortgages per year. As GSE monthly issuance has averaged $48 billion for the last year, the MI companies' total insured loans comprise about three months of conventional loan volumes. The chaos and difficulties encountered by lenders and servicers after 2006 should serve as a cautionary tale for anyone who would contemplate rolling out poorly organized and understaffed mortgage operations.

The fastest and most rational way to create a substantially privatized system of housing finance would be to restructure and privatize the GSEs. Despite their disastrous history, they house the infrastructure that continues to facilitate the mortgage and MBS markets. Once they are privatized, reorganized, and separated from their legacy exposures, they can serve as the foundation for a new housing finance system that can evolve without disrupting the housing market.

The strengths of each enterprise should be utilized to create maximum efficiencies and economies of scale. In order to take advantage of Fannie Mae's superior liquidity and market presence, its pooling and capital markets operations should be kept intact. The loan guarantee functions of the two firms should be combined into a single and distinct operation. Both entities would be backed by the type of catastrophic government reinsurance envisioned in the white paper. Superfluous assets and operations, including their retained portfolios, should be spun off or otherwise liquidated.

In their prior existence, the GSEs were an unprecedented disaster for the housing market and the country. Nevertheless, they contain unique operational assets that would be virtually impossible to replicate without years of effort. It is in the country's interest to salvage the useful parts of the GSEs to help create and structure the housing finance market of the future.


Bill Berliner is Executive Vice President of Manhattan Capital Markets. He is the co-author, with Frank Fabozzi and Anand Bhattacharya, of the recently-released second edition of Mortgage-Backed Securities: Products, Structuring, and Analytical Techniques. His email address is bill_berliner@manhattancapitalmarkets.com.

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