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Out of the 2,300 pages in the soon-to-be-law financial reform bill, none of them attempt to reform Freddie or Fannie – most say because F&F deserve their own reform bill and that will happen in 2011 after the U.S. Treasury completes its study. Fannie was created in 1938 to help buy mortgages from financial institutions and free up capital that could, in turn, be lent to consumers by banks, and Freddie was created in 1970 to do the same for S&L’s and to keep Fannie from being a monopoly. Investors – foreign and domestic – had the belief that loans backed by Freddie and Fannie carry an implicit US government guarantee. These two GSEs functioned as quasi-private companies that bought, bundled and securitized trillions of dollars of mortgages, in the form of mortgage-backed securities, and currently hold or guarantee more than $5 trillion of them. (There are others GSE’s – Government Sponsored Enterprises – like the Federal Home Loan Banks, the Farm Credit System, and Farmer Mac. Of course there is HUD & the FHA, and the VA program.)

The problem is, of course, that taxpayers, through the US government, have put up about $150 billion to keep them afloat, their value (and the value of the stock) has plunged, and analysts expect many more billions will be required to keep them solvent. The 25 basis point “guarantee fee”, added to the interest rate of the borrower, is not enough. Foreign investors who own their debt are concerned about the safety of their holdings, in turn requiring a higher return on their money for the additional risk – and to lower the risk we have effectively nationalized the two companies although their debt is not included on the government’s balance sheet. In fact, the Congressional Budget Office cannot audit either one, and if one combines the government bailout money of F&F with the existing budget deficit, it totals about $16 trillion, over 100% of our GDP.

Critics, taking a 30,000 foot view, say many countries have high levels of homeownership without the government playing such an important role in housing. Canada, not exactly a world economic powerhouse, does not have the equivalent of Fannie & Freddie, nor does it allow the deduction of mortgage interest from taxes. There has been no need for government bail outs of banks in Canada, which has 33 million people – about the size of Florida and Illinois combined. Fannie and Freddie could be combined – they are both under the auspices of the FHFA anyway – and then slowly liquidated with the securitization of mortgages going back into private companies. Or they could be kept in place, and charge a higher guarantee fee – like .5. Obama administration has already removed private intermediaries from the student loan business. No matter what happens, at this point, given the reliance of “the system” on Fannie & Freddie, it would require massive re-engineering of all of that and it’s by no means a straightforward thing to do.

From an investor point of view, many believe that the two will be combined, in which case investors will have to differentiate between the old bonds and the new bonds since a combination of the two would meld underwriting, remittance, servicing, etc., etc., and investors will want to know the “rules” for new pools and price them accordingly. The “accumulators” like Wells, Citi, Chase, and BofA usually sell to both, but often have strategic relationships with one or the other.

On a micro, loan originator level, when comparing Freddie versus Fannie many originators believe that Fannie is a better loan, with DTI capped at 45%, and no excess MIP charges to the borrower. But compared to a few years ago, the differences between DU and LP are much fewer. If they were combined, ironing out the differences at the production level might be relatively easy: figure out what servicing and underwriting characteristics gave them the lowest delinquency rates, and use those. Loans underwritten since the government takeover are among the cleanest in history. But consumers like a choice, probably more than just an FHA loan and a private bank’s loan product. No one expects the government’s work on Fannie & Freddie to shoot the US housing market in the foot, but we’ll have to stay tuned – everyone has an opinion.