Problems at giant mortgage investors Freddie Mac and Fannie Mae in 2003 are producing a response in 2004 that might sound radical: It's the once-forbidden "P-word" -- privatization.

Last week a full-blown conference held in Washington DC focused solely on how to sever the multi-billion dollar ties between the two Congressionally-chartered mortgage finance firms and the federal Treasury.

The privatization meeting, which considered alternative approaches to de-federalizing Fannie and Freddie, follows on the heels of a bombshell report released just before Christmas by the Federal Reserve Board. That report severely questioned the efficiencies of the two big companies in comparison with the potential bailout risks they present to U.S. taxpayers.

The staff study by economist Wayne Passmore challenged Fannie's and Freddie's claims regarding the interest rate savings they provide to millions of home mortgage borrowers. Rather than the 1/4 to 1/2 of a percentage point estimated by the two companies, the Fed study put the rate savings at just 7 basic points -- .07 of a percentage point.

The study also found that while Fannie and Freddie receive about $143 billion a year in subsidies, direct and indirect, from their federal government ties via lower borrowing costs and tax breaks, they do not share their wealth generously with the home buying public.

Of the $143 billion in subsidies, according to Passmore, $27 billion goes to tax payments, $44 billion to consumers, but $72 billion -- more than half -- is pocketed by the corporations' shareholders, officers, employees and others.

The Fed study -- disputed vigorously by both companies -- capped a very rocky year for them. In June, Freddie Mac shocked the mortgage and real estate markets by announcing the forced resignation and firing of several top officials, including long-time CEO Leland Brendsel, because of $5 billion in accounting violations turned up by an internal investigation.

Later in the year, Fannie Mae admitted to $2 billion in accounting errors of its own, and the regulator for both companies fined Freddie Mac $125 million for its accounting problems and began an investigation at Fannie.

Wall Street analysts also piled on, questioning both companies' capital standards and use of risky derivatives to hedge their portfolios against interest rate movements. One report indicated that "at the end of (2002), Fannie's own (internal risk) models showed that its portfolio could have lost half of its market value if interest rates in the marketplace rose just 1 1/2 points. As one banking lobbyist on Capitol Hill put it, "Fannie has bet the farm (using derivatives to hedge its bets), and could have lost the farm."

Congressional critics and the Bush White House also piled on the bandwagon in 2003 by proposing reform legislation that would create a tough new oversight regulator located inside or alongside the Treasury department. The new regulator would be designed to ensure that both companies had adequate risk-based capital, refrained from entering new business endeavors beyond the scope of their charters, and do not endanger taxpayers' funds with risky, unsupervised hedging activities.

That legislation faltered when the Bush administration, taking a hardball approach, said the new regulatory agency needed to be even tougher and stronger.

Bipartisan negotiations are now underway in the Senate that would create a new regulator tough enough to pass White House muster, but that would allow Fannie and Freddie to continue to pursue their housing missions. Since Congress is still in recess, the legislation has not yet been introduced. But it is expected to be considered in high-profile hearings in the coming weeks.

Meanwhile, though, proponents of privatization are beating the drums. A paper delivered last week by Thomas H. Standton to a Capitol Hill conference sponsored by the American Enterprise Institute sketched out a step-by-step blueprint for "decoupling" the government and Fannie and Freddie. Stanton is a Washington DC lawyer and a faculty member at Johns Hopkins University.

Currently both companies have $2.25 billion lines of credit into the federal Treasury. That would be gradually phased out and the government ties removed during a multi-year period, leaving non-federally related holding companies at the end of the process.

Though Fannie and Freddie oppose privatization publicly, some current and former high officials confirm that the idea has been looked at by both companies, and might -- if regulatory pressures got too tough to continue doing business -- be considered an option.

Don't look for that anytime in the immediate future, however. Best bet: Fannie and Freddie get a new regulator in 2004 or 2005, increase their capital, rein in their growth, but continue to support housing and homeownership as they have for decades.

Published: January 19, 2004

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Kenneth R. Harney writes an award-winning, nationally-syndicated column on housing and real estate from Washington, D.C. He is also managing director of the National Real Estate Development Center, a professional education company. He is a past member of the Federal Reserve Board's Consumer Advisory Council, a committee that by federal statute reviews all Fed actions on home mortgage, consumer credit and banking industry regulation. He served as a member of the U.S. Department of Housing and Urban Development's Working Group on Computerized Loan Origination (CLO) systems, and is a member of the Editorial Board of the Fannie Mae Foundation's journal, Housing Policy Debate. He is the author of two books on mortgage finance and real estate.