Treasury Secretary Henry Paulson minced few words today in a speech discussing the status and Fannie Mae, Freddie Mac, and the likelihood of the two companies returning to their previous structures as government-chartered, private sector firms.

“The GSEs are playing a necessary role supporting the mortgage availability which is essential to eventually turning the corner on the housing correction, reducing the stress in our capital markets and returning to growth in our economy. This must continue to be our first priority,” Paulson said. “But we will make a grave error if we don't use this period to decide what role government in general, and these entities in particular, should play in the housing market. The public debate over the long-term structure of the GSEs is dramatically changed today – no one any longer doubts the systemic risk these entities posed.”

According to Secretary Paulson, that became painfully clear earlier this year, as the financial markets faltered. “Negative earnings announcements by Fannie and Freddie in August reflected those worsening conditions, and further roiled markets. Neither company appeared to have any reasonable prospect of raising private capital to allay those concerns in the foreseeable future, and our examination found capital to be inadequate--in terms of both the quality of capital and the embedded losses stemming from worsening mortgage market conditions,” Paulson said. “Confidence in the GSE model was largely shattered.”

In September, the federal government took over Fannie Mae and Freddie Mac, placing them in conservatorship to soothe investor worries, stabilize the financial markets, and mortgage rates.

But Paulson made it clear today that conservatorship is not a permanent answer to the question of Fannie and Freddie. Neither is returning to life as GSEs. “With the knowledge of recent experience, we have a responsibility to begin work now on a long-term GSE structure which avoids the dangerous mix of policy and market distortions created by the former flawed GSE model,” he said.

That will not be an easy task to accomplish. “Policymakers must decide if the GSE subsidy is a public policy priority,” Paulson asserted. “If the GSEs are to play a role, then, the debate is clearly framed: Government support needs to be either explicit or non-existent, and structured to resolve the conflict between public and private purposes. Any middle ground is a recipe for another crisis.”

In his speech, Paulson outlined four possible new structures for Fannie and Freddie, along with his thoughts on each one.

Turn Fannie and Freddie into government entities or fold them into an expanded Federal Housing Administration/Ginnie Mae agency, which would make their debts explicitly backed by the U.S. government. Paulson’s view? “I view the permanent nationalization of the GSEs, essentially expanding the role of FHA and Ginnie Mae, as a less-than optimal model. 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.”

Offer a partial government guarantee on non-FHA mortgages, which would limit potential losses for both investors and the Treasury. “While such a hybrid program would clearly define the extent of the government's guarantee, developing risk sharing parameters compatible with profit incentives would be as problematic, and potentially as inefficient, as in the current GSE structure,” Paulson said.

Privatize Fannie and Freddie, breaking the two mortgage giants into smaller pieces and eliminating any direct or indirect government support. This has often been suggested by anti-GSE advocates concerned about the systemic risk posed by the GSEs as well as those unhappy about Fannie’s and Freddie’s business advantages as government-chartered companies. But former Wall Streeter Paulson did not embrace this concept either. “As appealing as this alternative sounds, 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. … 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.

Borrow from the public utilities (gas, electric, water, etc.) model to create a private sector entity (or entities) that would take the place of Fannie and Freddie. This “housing utility” would purchase and securitize mortgages, review and approve mortgage products and underwriting practices, and be backed by the federal government. They would not maintain investment portfolios. This appeared to be Paulson’s preferred option. “Given traditional U.S. public policy support for marshalling private capital to expand homeownership, establishing a public utility-like mortgage credit guarantor could be the best way to resolve the inherent conflict between public purpose and private gain.”

Regardless of the option chosen, though, Paulson said the GSE’s new structure should meet three key objectives: “First, there must be no ambiguity as to government backing. It must be explicit or non-existent. Second, there must be a clear means of managing the conflict between public support and private profit. Third, there must be strong regulatory oversight of the resulting institutions.”

What will happen with the GSEs?  With a new American president’s inauguration just weeks away, it’s hard to know. But Paulson seemed to want to provide a framework today for those who may soon be evaluating the future of the GSEs and their complex operations and interactions with the economy and the housing market.

“The first step must be for policymakers to decide–in light of the recent housing bubble and the severe financial and economic penalty it has imposed on our nation–the role government should play in supporting homeownership,” the Treasury secretary said. “We cannot allow a repeat of the devastation this housing correction has wreaked on families and communities across the United States.” 
Alison Rice is senior editor, online, at BUILDER magazine.