The Obama administration turned its focus squarely on a $5 trillion question Tuesday: What to do with Fannie Mae and Freddie Mac, the giant financiers of US home mortgages that fell into a bankruptcy-style conservatorship two years ago.
These two corporations together own or guarantee about half the mortgage debt in America. What happens to them will affect the ability of the economy and the housing market to recover. It also has big implications for US taxpayers, who could foot even higher bailout bills if the mortgage-insurance business isn't fixed.
"We will not support a return to the system where private gains are subsidized by taxpayer losses," said Treasury Secretary Timothy Geithner, in remarks Tuesday that opened a day-long conference on how to reform these so-called government sponsored enterprises (GSEs).
Mr. Geithner cited the possibility of giving Fannie Mae and Freddie Mac an "elegant funeral." But that wouldn't mean a government exit from its prominent role in America's housing market. In fact, it could mean that the government agrees to stand explicitly behind the GSEs' obligations, while also putting in place a new system designed to ensure that mortgage credit is available even during recessions or a banking crisis.
"'Without such support, the risk is that future recessions could be more severe because the financial system would not have the capital to support mortgage lending on an adequate scale," Mr. Geithner said in his prepared remarks.
Other panelists at the conference echoed that view.
"The hit to the economy [from the recession] would have been measurably greater" without the GSEs and the Federal Housing Administration, said economist Mark Zandi of Moody's Analytics. By guaranteeing or insuring mortgages, these agencies enabled credit to keep flowing for typical home loans even as home values were falling and the private-sector channels of mortgage finance had dried up.
The Obama adminstration hasn't outlined its approach to GSE reform, which was notably missing in the financial-reform law the president signed recently. The conference represents a first step, at least in public view, toward developing a proposal.
The battle in Congress, expected to ramp up early in 2011, will reflect a sharp partisan split that's existed for years. Republican lawmakers emphasize the importance of scaling back government's role in the housing market and limiting taxpayer exposure to losses. Many Democrats emphasize the risks of providing too little support for the housing market, given housing's prominent role in family wealth and in the economy's ups and downs.
Both sides of this debate were represented in Tuesday's panel discussions. Many participants from the private sector – including Mr. Zandi – said the government should eventually scale back its role in the housing market significantly.
At the same time, many said government mortgage guarantees should continue to be available in some carefully managed forms.
At least one participant, bond-fund manager Bill Gross of the investment firm PIMCO, suggested that government guarantees should apply to virtually all mortgages. He said this results in mortgage interest rates that are about 3 percentage points lower than if the only mortgage insurance came from the private sector.
Whatever role the governemnt takes in the future, policymakers must also decide on a transition plan to get there.
Many panelists urged that Fannie and Freddie should not be reconstituted in something similar to their pre-crisis form: profit-seeking private corporations that, at the same time, have a government-chartered mission and implicit taxpayer backing.
An exit strategy could involve adding Fannie and Freddie's roughly $5 trillion in obligations, in effect, to a federal balance sheet that already includes $13.3 trillion in federal government debts. The GSE obligations would be a different animal, because those liabilities would need to be covered by taxpayers only if things went bad in the housing market.
But the nation has just seen things go bad in the housing market.
During the financial panic of 2008, investors who held GSE debts became increasingly worried about the solvency of those corporations. The Bush administration felt impelled to put Fannie and Freddie into a conservatorship, to avert a possible bankruptcy and to keep mortgage markets moving.
The companies weren't holding enough capital in reserve to cover likely losses.
As of March 31 this year, 6.3 percent of mortgages held by Fannie and Freddie are either seriously delinquent or in foreclosure. Although that's down slightly from the figure three months earlier, it represents a big one-year rise (from 3.9 percent in early 2009).
In the end, losses to Fannie and Freddie related to the financial crisis may cost taxpayers $305 billion, according to one estimate recently published by Mr. Zandi and Alan Blinder of Princeton University. But that figure could rise or fall depending on what happens with the economy – and with government policies on housing.