Do Fannie and Freddie Need a 'Bad Bank?'

As the Obama Administration mulls ways to reorganize the mortgage giants, the idea of creating a "bad bank" to hold toxic assets is back, but drawbacks remain

As the Administration weighs options for reorganizing Fannie Mae (FNM) and Freddie Mac (FRE) in the wake of their dismal financial performance, a strategy that spawned a lot of chatter but little action earlier in the financial crisis may be back on the table. Months ago, policymakers and outside experts weighed the benefits of creating a "bad bank" to hold commercial banks' toxic assets, but the idea never gained traction. Now, some suggest, the concept could help to restructure the mortgage giants—but the hurdles that caused commercial banks to adopt a different solution remain.

Fannie Mae said on Aug. 6 that it lost $14.8 billion in the second quarter and plans to draw down another $10.7 billion from the federal government to balance its books. That brings to $85 billion the amount of funds that it and Freddie Mac have received from Uncle Sam since the government took over the companies last September, driving home just how shaky the government-sponsored entities remain. Small wonder, then, that speculation has resumed over what the government will ultimately do with the companies, which long functioned as publicly traded firms with a government-defined mission to bolster the housing markets.

One option: The "bad bank," which The Washington Post suggested on Aug. 6 could be the tool the Obama Administration uses to resolve the problem. By establishing a separate entity to hold Fannie and Freddie's toxic assets, the surviving companies could go forward with clean balance sheets, unencumbered by past mistakes and capable of raising fresh capital from the private sector. The bad assets would be unwound over time.

The Best Way to Recapitalize

Sheila Bair, chairman of the Federal Deposit Insurance Corp., pushed for much the same approach to tackling the bad assets of commercial banks this winter as did others outside government. The argument: It would restore investors' faith in the newly scrubbed companies, letting them raise new capital without fear that it would be rapidly wiped out as the toxic assets deteriorated. Instead, the Treasury Dept. funneled hundreds of billions of dollars directly into the nation's banks though its Troubled Asset Relief Program, shoring up the banks and temporarily reassuring investors. When government-supervised "stress tests" suggested most of the big banks only needed manageable amounts of additional capital to survive, despite their toxic assets, the capital markets rallied and the banks were able to raise funds quickly.

Direct investment won out in part because it was simpler. Banks' toxic assets consisted of a stew of highly complex mortgage-backed securities that had been bundled, repackaged, and leveraged, and banks proved unwilling to sell them at prices investors were willing to pay. Infusing banks with cash was less complicated then separating bad assets and building a new institution, and dealt more directly with one of the banks' biggest problems—lack of capital—than a bad bank could.

"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."

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