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Fannie and Freddie's extreme makeover

Maybe not tomorrow, but radical reform of the mortgage guarantors is on the way.

By Katie Benner, writer-reporter
Last Updated: July 15, 2008: 10:31 AM EDT

NEW YORK (Fortune) -- The government is opening the purse strings to prop up Fannie Mae and Freddie Mac, but obituaries may still be in order for the mortgage giants.

Sunday's announcement by Treasury Secretary Hank Paulson that the feds would make easy money available to the companies and may buy a big chunk of their stock made it clear that, for now, the feds consider the housing market too fragile and Fannie (FNM, Fortune 500) and Freddie (FRE, Fortune 500) too important to permit them to fail. The two own or guarantee about $5 trillion in mortgages - half the U.S. market.

It's hard to argue that the companies could go under tomorrow without a major disruption in the economy. But that doesn't mean they can continue doing business as usual. Major problems, like risk-filled books and tiny capital cushions, are symptomatic of Fannie and Freddie's structure: They're both government-sponsored and publicly-traded. And that model looks broken, possibly beyond repair.

"To focus on the current plan [to lend to Fannie and Freddie] and try to find good in it misses the point. They and the system that supports them are hurting the economy," says Michael Lewitt, co-founder of Hegemony Capital Management, which runs credit-oriented hedge funds. "They may continue to buy mortgages, but their ownership, funding, and structure will have to change."

Or, as Senator Jim DeMint (R-South Carolina) said in a statement, "Congress created this problem, and Fannie and Freddie must be dramatically reformed so American taxpayers aren't forced to bail them out time and time again."

Roots of the problem

A unique layer of implicit government protection has allowed Fannie and Freddie to increase the risks they take, but avoid the market consequences that come with bad bets.

The two government-sponsored entities (GSEs) were created by Congress to buy mortgages from banks, bundle, and resell them, which gave banks money to lend and made it less risky for them to do so. In turn, Fannie and Freddie received special perks from the government, were lightly regulated, and got to borrow money cheaply because they were treated like extensions of the U.S. government, which is the safest investment in the world.

To grow earnings and boost profits, the companies bet on all sorts of risky investments, including aircraft leasing, manufactured housing, and interest-only mortgages. They held lower-quality assets on their books to make money off the high interest rates these instruments paid. Like a highly-leveraged hedge fund, they used borrowed money (part of their total $1.5 trillion in senior debt outstanding) to magnify returns.

Some of these more speculative bets are falling in value, as are their mortgage portfolios. The use of borrowed money is amplifying the losses.

"When you mark their assets to market, they could fall below the value of their fixed obligations, which would mean the companies would have negative net worth and their capital would be wiped out," says Larry White, a professor at New York University's Stern School of Business.

And now the Paulson plan promises even more aid. But that plan and its explicit guarantee tie two high-risk balance sheets to the U.S. government, a move that isn't sustainable for long.

According to Peter Schiff, manager of Euro Pacific Capital, if such a perception lingers too long, the United States will have to offer higher interest rates on Treasuries to compensate buyers for loaning to a riskier nation. This would push rates higher on everything from auto loans to credit cards to corporate debt.

The worse case scenario: "Given the fragility of the economy, and its dependence on cheap credit," Schiff says, "higher rates will be the final blow that sends the United States into a severe recession."

How do you fix this mess?

So what happens to Freddie and Fannie, and to their investors? Here are three possible scenarios posited by analysts and investors, though it's not expected that big reform will come immediately.

Richard Bove, an analyst with Ladenburg Thalmann, says the companies should ultimately be dismantled and rebuilt as a Federal Reserve-like policymaking body, rather than as publicly-traded corporations. Fannie and Freddie's assets could be used to create another Federal agency whose job it would be to inject money into the mortgage market. Removing the profit incentive would take away the temptation to ratchet up risk.

Under this scenario, bondholders would be made largely whole and shareholders would get some money for their troubles.

Josh Rosner, a director at Graham Fisher, says that Fannie and Freddie's assets, many of them carried on the company's books at more than they're really worth, need to be re-priced for the overall good of the housing market.

To do this, Rosner proposes a "prepackaged reorganization plan." Investors who own the $3.5 trillion of mortgage-backed securities guaranteed by the GSEs would be promised 100% of their anticipated returns (since these bonds are backed by real housing assets and should see few losses over a longer period).

Investors who own their $1.5 trillion in senior debt would take a haircut large enough to create approximately $150 billion in new equity capital that would enable to the GSEs to buy, package, and sell mortgages without government support.

Subordinated debt holders and shareholders would be effectively wiped out - which is generally what happens to investors who support companies that pile on risk and lose the wager.

Activist hedge fund manager Bill Ackman, who is short Fannie and Freddie, unveiled a proposal Tuesday morning to restructure the two companies that is nearly identical to the Rosner plan, saying on CNBC that this plan will give the companies "a fortress balance sheet" so they "weather the perfect storm, which is what we have now."

But what if Fannie and Freddie don't really need to exist at all?

Despite the worry that the companies are too big to fail, Martin Hutchinson and Lauren Silva at Breakingviews.com suggest that they could be killed off, albeit slowly, by simply running them into the ground through higher fees to customers and reduced pay to their workers.

"Market forces probably would replace them within five years," they write, as banks that were pushed out of the mortgage securitization market by the Fannie Freddie monopoly come back. According to Hutchinson and Silva: "Politically it is an unlikely outcome, but by 2013 or so, it could be possible to close Fannie and Freddie - at least to new business - with scarcely a ripple."  To top of page

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