I just had a real interesting chat with Armando Falcon, who was Fannie Mae and Freddie Mac's top regulator for six years. He now argues that the two mortgage finance giants should be nationalized. He walked me through how such a process might take place. Excerpts:
What are the chances that the government will take more serious steps to stabilize Fannie and Freddie?
"They will need additional capital. They will not be able to do that through raising funds from the capital markets—their share price reflects the unwillingness of the markets to give them any more capital. So it's just inevitable. It's a matter of time before they become undercapitalized, and then the combination of the Treasury and the new housing regulator will take some action to resolve the companies.
What form will the intervention take?
"Treasury could try to provide the companies with additional funds through the line of credit, but the companies rely on the capital markets buying their debt for liquidity. The minute the markets see that the companies are unable to fund themselves through the normal debt operations, then Treasury and the new regulator have to figure out how to deal with them without creating a panic in the debt and equity markets.... You can't go in for just a dime, you have to go in for the whole kit and caboodle.
And that's when I think [Fannie and Freddie's new regulator] will have to take some action to force the companies to once and for all recognize all of their losses . . . [and] then the government takes over the companies."
What would that look like?
"This is like a typical bank resolution. They are shut down on a Friday—or taken over right at the close of business on a Friday—[and] a pass through receivership happens. They open up on Monday as a new [entity], let's say Fannie Mae II. This time they are owned by the government. The government has wiped out shareholders—preferred shareholders, subordinated debt holders—and the government decides what to do with senior debt holders. And there they could decide to force them to take a haircut on what they are owed, or more likely, they'll just say, 'OK, we'll back all of the debt you've got that Fannie and Freddie previously issued.' And that's probably the smart thing to do."
"That's the way it happens. So on Monday it opens up, there are no disruptions to the housing market because this happens in a seamless transaction, just like a bank resolution. Fannie and Freddie II would open up on a Monday and they continue to either buy mortgages, they continue to issue mortgage-backed securities, [only] this time they are backed by the full faith and credit of the government."
But they wouldn't actually be on the government's balance sheet?
"It would be done through [Fannie and Freddie's new regulator]'s receivership powers. So [the new regulator] would appoint a receiver, or let's say a conservator, of the new Fannie Mae II. The bad debt of the companies would be left in the old Fannie and Freddie, and everything else would be transferred to the new entity."
How does the government create a conservator?
You literally create a new charter and transfer all the assets and liabilities to the new charter. The agency would figure out what transfers and what doesn't, and generally they would probably transfer the senior debt and then wipe everybody else out in the old company."
So stockholders would be wiped out, but the debt holders would be OK?
"Senior debt holders [would be OK]. There is a small amount of subordinated debt that both companies have issued that would probably either get completely wiped out or suffer some serious haircut."
So the new companies—once nationalized—would continue performing their role of adding liquidity to the mortgage markets?
"Yeah. And some people have worked themselves up into a frenzy, and say, 'Oh, my God, the housing market!' But actually, the companies that open on Monday continue to function just as they did before, just now they've been taken over by the government.
And I would argue that this brings some much needed stability to the housing market. You remove the uncertainty of what's going to happen with these two companies, and you've actually, I think, begun to lower interest rates on mortgages. Freddie paid a 113-basis-point spread over treasuries in their recent debt offering. If the government is now issuing the debt to fund the companies—the Fannie Mae II operations—they are not paying that premium, so the savings could get passed on to the consumer in the form of lower interest rates."
When do you expect this to happen?
"It could happen as soon as the end of September...I think it probably would happen before the end of the year."
Then what? Would the government spin them off or bring them onto its balance sheet?
"Then it's a policy question for the government. Do they turn them into an agency and have the government take over their roles? Or would they just slowly wind them down and sort of transition them to a scenario where the private sector starts to take over the functions of these two companies?"
Do you think the private sector can do that?
"Sure. They were before the boom in the housing market. The private sector had over 60 percent of the market share in mortgage backed securities, and they could certainly take over that function again."
Would you like to see them wound down entirely, or do you think there is some role for them in the future?
"They can't go back to the way they were before. I think that is just not even an option because it is clear the government will step in and bail out these two companies, which they regard as too big to fail. And if they were allowed to remain in their current condition...then you have two private shareholder companies issuing debt backed by the U.S. government. That's just a dangerous situation."
Should they be spun off as entirely private companies?
"I wouldn't do that. What should happen is when the government takes them over it should slowly wind down. Shrink and almost get rid of the retained portfolio. Some portion of it may be essential for illiquid affordable housing, but that is a very small amount of the portfolio. Shrink and almost get rid of the retained portfolio. Very targeted in what they would do.... They would be a government agency, and at that point the government could decide if they want even that part of what they do fully privatized.... The end result has to be to get to a minimal government role and a highly competitive private market taking over."