By Ronald D. Orol

Almost one year after Fannie Mae (FNM) and Freddie Mac (FRE) were effectively nationalized in the midst of an expanding economic crisis, policymakers in Washington have still yet to come to a conclusion about what to do with the quasi-governmental mortgage giants.

This has Republican lawmakers steaming about the companies, which they believe should be reformed right away.

Democrats - including those in the White House and Treasury - have put the issue off until after their current bank restructuring endeavor is completed, which in itself is a momentous undertaking that is only scheduled to be wrapped up by year-end.

"Fannie Mae is something we will take seriously, study and take our time and come back to folks next year," said Treasury Assistant Secretary Michael Barr.

Nevertheless, with the Obama administration's bank regulatory reform proposals out the door, key Treasury Department officials can begin thinking about expanding on options for the entities it released in June guidelines. Possible reform ideas involve nationalization, privatization and a series of hybrid approaches.

The mega-institutions became a symbol of the financial crisis when they were taken over by the government in a conservatorship in September as the crisis expanded.

Government regulators took over Fannie Mae and Freddie Mac because they believed their collapse would have had an even more wide-ranging explosive impact on the markets than the failure of Lehman Brothers.

Fannie and Freddie purchase whole loans, and package them as a means of ensuring that capital is available to banks and other financial institutions that lend money to home buyers. They either hang on to the mortgage securities or sell them to investors with a government guarantee.

So far, Fannie Mae has received $34.2 billion in taxpayer-funded bailout money, while Freddie Mac has received $51.7 billion. Taxpayer investments may go up as defaults on home mortgages swell. It's unclear how high their losses will be but the government recently expanded a regulatory limit of $100 billion in losses the entities will accept to $200 billion each.

Nevertheless, there are growing reasons to reform the entities, which have become almost the sole provider of mortgage financing in the United States. Legislation approved in 2008 gave the Treasury the authority to purchase Fannie Mae and Freddie Mac securities through Dec. 31, 2009.

Christopher Whalen, director of Institutional Risk Analytics, said he expects lawmakers to draft legislation extending this authority, which would allow the government's conservatorship of the entities to continue through 2010.

The debate about what to do with troubled assets of Fannie Mae and Freddie Mac is part of a broader discussion about the two mortgage giants.

Bad Bank?

Charles Horn, partner at Mayer Brown LLP in Washington, said there are calls for the government to reduce the size of the entities, perhaps by requiring that they wind down their assets over a period of time.

One possible approach to achieve this would be to create a "bad bank" taking hundreds of billions of dollars of Fannie Mae and Freddie Mac bad loans off their books. The bad bank would seek to collect as much of the debts as possible.

Fannie Mae securitized roughly $94.6 billion of whole loans held for investment in its mortgage portfolio in the second quarter of 2009. It had total non-performing loans of $171 billion as of June 30, up from $144.9 billion in March and $119 billion in December.

A second part of this approach, which is one of many under consideration by the White House, would be to privatize by creating new quasi-governmental corporations or "good banks" that would resemble the old entities with public offerings that accept private equity and debt investments.

Public Option? Break Up?

However, Whalen doesn't believe restoring their previous hybrid quasi-public-private status is in the cards.

"I think losses at Fannie and Freddie will be so high in both of these entities that by the time we get into next year, Congress won't be interested in privatizing Fannie and Freddie," Whalen said. "I cannot imagine a rational argument to have private equity investors in these entities. The only role for private capital should be in bonds."

However, Dwight Smith, partner at Alston & Bird LLP in Washington, said there are advantages with a public model - in particular funding from shareholders and creditors - if it can be structured in a way that limits the possibility that their collapse could cause massive damage to the markets.

Smith argued that a public model with a government guarantee could work if Fannie and Freddie were dissolved into many smaller public companies, a prospect that is also under consideration by Treasury.

"If Fannie and Freddie were to have failed, that would have thrown the entire residential market into incredible turmoil," Smith said. "However, if you have 10 or 12 smaller Fannies, then, if one of them were to fail, it doesn't mean that the others would fail as well. If investors know they can't rely on government to bail out a mini-Fannie that would restore market discipline."

Ginnie Mae To The Rescue?

However, Whalen said that a more useful approach would be to merge Fannie and Freddie, as many expect to happen, and create a Ginnie Mae type-structure out of the entities, known as Government Sponsored Enterprises. Unlike Fannie and Freddie, which buy whole mortgage loans and mortgage securities from financial institutions, Ginnie Mae only provides government guarantees for mortgage securities. The agency currently guarantees $771 billion in mortgage securities and it has guaranteed roughly $2.9 trillion in assets since its inception in 1968.

Whalen argues that having a Ginnie Mae-type entity is important because it creates a secondary market for banks by giving them an option have their mortgage securities receive a government guarantee.

Before Fannie and Freddie become a Ginnie Mae-type entity they would need become smaller, which would happen "if the government is disciplined" and pays off the massive debts that exist to support their retained portfolios of loans and securities. A substantial size reduction is necessary, Whalen added, because it would limit their "too-big-to-fail" quality.

However, Smith argues that such an approach would limit Fannie and Freddie's flexibility in the mortgage market. By only guaranteeing mortgage securities and not whole loans, a new consolidated Fannie and Freddie could hurt struggling smaller financial institutions that rely on the entities to prop the market for whole loans.

"Originators who now sell whole loans to Fannie or Freddie would be left out, leading to further industry consolidation," Smith said.

Smith added that he was worried that an entity that only guarantees high-quality mortgage securities would not be in a position to limit the fallout from a financial crisis, unlike the Treasury's current program that includes purchases of subprime mortgages and problematic mortgage securities.

"Treasury purchases would have a smaller impact," Smith said.

Utility Model: Good Or Bad?

Treasury also may restructure Fannie and Freddie into public utilities, where government regulates their profits, sets fees and provides guarantees for their assets.

The approach has pros and cons. Smith said that with a utility model, regulators could prevent abuses in advance in a way that the current model can't.

"In this environment, mortgage lenders have shown that when they compete they do a bad job and impose billions of dollars in costs on taxpayers. The government needs to be sure that this business is managed much more closely and on a day-to-day basis," Smith said. "However, a utility model would represent the most intrusive government regulation of all the options and would reduce the flexibility of lenders to offer mortgages."

-Ronald D. Orol, 415-439-6400; AskNewswires@dowjones.com