Do Fannie and Freddie Need a 'Bad Bank?'

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"I think they just decided to go the route of bailing out everybody who was big, which was easier than setting up the structure of bad banks," says Campbell R. Harvey, a professor of international business at Duke University's Fuqua School of Business.

Indeed, for the shakiest banks, separating bad assets from good assets might have made it abundantly clear how short of capital they were. "It doesn't really solve the problem of institutions with negative capital," says Phillip Swagel, a visiting professor at Georgetown University's McDonough School of Business and a former assistant secretary of the Treasury under Henry Paulson. "You somehow have to add more capital or take existing debt and turn it into capital."

So far, the government capital infusions, followed by private investment, seem to have done the trick. Some banks—Goldman Sachs (GS), JPMorgan Chase (JPM), and Morgan Stanley (MS) among them—have already repaid their TARP funds, and most of the other big banks have shown strong earnings in recent months. "We did the right thing by recapitalizing the banking sector. The financial system is nearly at pre-Lehman levels," says Daniel Clifton, a Washington policy analyst at Strategas Research.

Prime Defaults Could Eat Up Gains

But that could change if the housing market continues to tank. In announcing its second-quarter results, Fannie Mae appeared to forecast a grim future for the housing market, with high unemployment pushing more homeowners toward foreclosure, including those with prime, or high-quality, mortgages. Some fear that financial institutions could see their newly raised capital rapidly eaten away. "It really is not beyond the realm of possibility that our big banks could come to the trough again," Harvey says. "Prime [mortgages] could be the doomsday machine."

As for Fannie and Freddie, it comes down to a question of how the government wants to structure them when they come out of conservatorship. Dividing their assets into good and bad banks makes sense if the government wants to keep a "quasi-private institution," says Albert S. Kyle, a finance professor at the University of Maryland Smith School of Business. The government-sponsored entities are so "deeply insolvent" that they'll need to divide the assets to attract investors, he says. "As long as it's done as a part of comprehensive reform and designed in a way to make buyers and sellers participate, it can't do any harm."

The White House said on Aug. 6 that it continues to mull its options, and that it's too early to call any one strategy likely. But clearly, the Administration believes any restructuring of the GSEs can wait. The Treasury doesn't plan to release a specific plan for Fannie and Freddie until February 2010, when the 2011 budget is due.

Plus, Swagel notes, the Administration needs control of the GSEs to execute its housing policy. Using Fannie and Freddie, the Administration can keep more people in their homes by guaranteeing their mortgages—essentially subsidizing refinancing by the banks. And perhaps most attractive of all, they can maneuver with limited political interference, Swagel says. "They're using the GSEs to write checks to people without having to ask Congress."

Craig is a reporter for BusinessWeek in Washington, D.C.