The Revolution of Fannie Mae and Freddie Mac

If you have any understanding of the dynamics of the mortgage market, and Fannie/Freddie's role in it, then you agree with me (no I am not trying to be arrogant in an annoying way) and these two need to be privatized and broken up. For instance, here is what Steve Forbes recently said.

Treasury Secretary Hank Paulson should finally do to these two corrupt,mismanaged monsters what he should have done months ago and unveil a plan to break them up into 12 new companies. They should be recapitalized, which will require an initial outlay of more than $300 billion. Current shareholders should be able to exchange their existing paper for shares in these new companies. They won’t likely recover what they lost on Fonie’s and Fraudie’s common stock, but they’ll end up with a lot more than what these shares were worth before the government takeover. Preferred shareholders should be able to exchange their paper for similar securities in these new entities, with warrants attached for conversion into common shares.

To help beleaguered regional banks, which owned much of this stuff, these preferred shares should be called in at par in, say, 20 years or so. That way banks and other financial institutions shouldn’t have to take a massive write-down. The federal government should also have warrants in these new outfits so that taxpayers can ultimately get a part or all of their money back. In this way you could have a dozen competitive companies with no ties to Washington.

It isn't that I am an oracle, however when you have dealt with them as long as I have, the answer is obvious. However, privatization and break up is one of those things that redefines easier said than done. First, there is the price tag. Here is how Forbes estimates it.

They should be recapitalized, which will require an initial outlay of more than $300 billion. Current shareholders should be able to exchange their existing paper for shares in these new companies.

Just because Forbes throws out $300 billion as though it is pocket change that doesn't actually mean that it is NOT an enormous sum. Because they are now nationalized companies, this capital outlay will have to be done by the government itself. The enormous sum the government would be required to fund is only the beginning of the massive undertaking.

First, while Forbes suggests 10-12 new companies, there is still a great deal of debate internally just how many new companies there should be. This debate is not merely existential. Because there are only two companies, each is too big to fail. That said, if you were to break them up into too many companies, there would no longer be economies of scale.

Economies of scale may be utilized by any size firm expanding its scale of operation. The common ones are purchasing (bulk buying of materials through long-term contracts), managerial (increasing the specialization of managers), financial (obtaining lower-interest charges when borrowing from banks and having access to a greater range of financial instruments), and marketing (spreading the cost of advertising over a greater range of output in media markets). Each of these factors reduces the long run average costs (LRAC) of production by shifting the short-run average total cost (SRATC) curve down and to the right.

This concept of economies of scale as it relates to these two and the new companies they will form is also not merely theoretical. These two use their enormous size to drive interest rates lower. Keep in mind that any loan done by either has their core interest rate determined by them through the bonds they issue. If there are too many new companies each won't issue enough bonds to keep rates as low as they would be if there are fewer. If they aren't broken up into enough companies, then the new companies will continue to suffer from being too big to fail.

After the number of companies is determined, the real work begins. Keep in mind that these companies do everything: they securitize, they determine the rates, and they underwrite. They underwrite through three systems, Desktop Underwriter, Desktop Originator, and Loan Prospector. These are underwriting softwares that use very sophisticated formulas that essentially take the credit profile, income, property type, loan type, etc. and mix it up like a salad and then the software system determines if the loan is acceptable. Each of these new companies would have to develop their own systems based on what sorts of niches each would want to develop.

Furthermore, both Fannie and Freddie would then have to augment DO, DU, and LP because they are currently based their approval process is based on companies much larger than they will be. It is likely that each will have to make their requirements more stringent to deal with their new smaller size. Then, all of these new systems must be introduced to each and every bank. The underwriters at each bank must know how to use them.

Finally, there is the question of splitting up the employees and creating the right staff for all of these new companies. It is likely that each will have to hire all sorts of outside help. Still, the upper level management will have to come from Fannie and Freddie itself, or from folks that Treasury designates.

None of this is easy however it would be manageable if not for the big x factor. We are currently going through a mortgage crisis. Right now the mortgage market is going through chaos. If this is all done in a haphazard manner it will spin an already weak market out of control. With a slew of new companies, the entire industry will have to adjust to all new processes. Again, this would all be manageable if it wasn't done at such a trying time for the market itself.

Unfortunately, the alternative is even worse. These companies are in desperate need of reform. The longer they continue as two Government Sponsored Entities, the worse that is for the long term prospects of the real estate market. These two bohemoths have created a terrible deficiency in the mortgage market, and it is one we are now picking up the pieces of. If we don't reform them now, they will only continue to wreck havoc again. Unfortunately, there is no worse time for reform than now.