Our Take: Revamping the U.S. Mortgage Market

The fate of the mortgage securities business rests on more than the path taken by home prices and credit spreads. It also rests to a great extent on decisions that will be made in Washington by a post-Bush administration and the Congress.

The federal takeover of mortgage giants Fannie Mae and Freddie Mac closed the door on one long-running national policy debate, only to open the door on another that's likely to be just as contentious. To wit: now that it is proven that the business model the two companies pursued in recent years was not viable without government backing, what form should they molded into once Treasury's "conservatorship" ends?

Whatever answer carries the day will have a large and lasting impact on the quantity and content of jobs for traders, structurers, portfolio managers and everyone else involved with mortgage-backed securities. As outlined in a recent New York Times story, Washington's main players seem to line up behind one of four alternative visions for Fannie and Freddie's future:

- Private companies constrained by regulation to concentrate on providing mortgage guarantees rather than buying and selling large quantities of mortgage bonds.

- Pure government agencies - in effect, re-nationalized, since Fannie Mae began life as an arm of the U.S. government.

- Laissez-faire: liquidating the companies and relying instead on fully private institutions and market forces to structure the secondary mortgage market.

- An eventual return to the status quo ante.

No More Gambling With Taxpayer Funds

The old debate concerned whether it was prudent to maintain the government's statutory commitment to lend a relatively small amount to Fannie Mae and Freddie Mac in case of crisis. Armed with the credit subsidy that grew out of that seemingly symbolic government backing, the two firms leveraged up their balance sheets. They bought and held some $1.5 trillion of whole loans and mortgage-backed securities packaged by themselves and other institutions. Until recently, this strategy generated what looked like easy arbitrage profits from borrowing at sub-Libor rates to invest in higher-yielding mortgage paper.

While both shareholders and executives at Fannie and Freddie got rich off indirect taxpayer subsidies, congressional Democrats were happy to divert a portion of the resulting profit streams to support the social goal of "affordable housing" - liberal-speak for rental or home-purchase subsidies to low-income families. Those lawmakers pressed the mortgage giants and their regulator to continually step up their involvement with lower-income borrowers, less affluent neighborhoods, and rental housing.

Critics have long contended that all of this amounted to gambling with taxpayers' money. Recent events have proven the critics right. Yet, even now, key lawmakers with jurisdiction over Fannie Mae and Freddie Mac - House Financial Services Committee Chairman Barney Frank (D-Mass.) and Senate Banking Committee Chairman Christopher Dodd (D-Conn.) - are demanding a return to the good old days when the government-chartered mortgage giants could do what they pleased and grow as large as they liked, with Uncle Sam as their silent partner.

What Comes Next?

Rules of the conservatorship announced on Sept. 7 lean in the opposite direction. Treasury Secretary Hank Paulson's plan allows the companies to enlarge their so-called "retained portfolios" over the coming year, to help prevent skittish mortgage markets from pushing up borrowing rates. Starting in 2010, however, the plan would force Fannie and Freddie to steadily reduce their holdings by 10 percent each year.

The rub, of course, is that the current plan is merely a fiat of the Bush administration. When enacting homeowner relief legislation in late July, Congress authorized the Treasury to assist or take over Fannie and Freddie at its discretion, but did not mandate any specific measures. So the structure set out by Paulson is likely to be overhauled once a new administration takes office.

If you work with fixed-income securities, therefore, you would be wise to scrutinize the proposals about what to do with Fannie and Freddie that will emanate from Washington after Nov. 4. Start with the ideas voiced by the next administration's nominee for Treasury Secretary (whoever that turns out to be), and work your way down from there.