How to fix Fannie Mae and Freddie Mac: Nationalize ‘em

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William Poole has long warned that mortgage titans Fannie Mae and Freddie Mac had grown so large that they posed a serious threat to the U.S. financial system.

It looks like the former Federal Reserve policymaker had it right. Stocks of both companies are in meltdown mode this week, sending ripples through U.S. markets, on fears that they don’t have the capital they’ll need to survive rising mortgage defaults.

So let’s admit the obvious, Poole suggests: Fannie and Freddie should be nationalized.

In America, nationalization is among the dirtiest of words. It conjures the image of the government grabbing control of private-sector assets.

But Fannie and Freddie, which buy or guarantee mortgages to support the housing market, are strange animals. They are owned by shareholders, but they were chartered by the government, and they’ve grown to their gargantuan sizes ($843 billion in assets at Fannie, $803 billion at Freddie) because investors worldwide believe their debts have the implicit backing of the U.S. Treasury.

If Fannie and Freddie face a wipeout of their capital because of loan losses, then, Uncle Sam couldn’t possibly allow the companies to collapse. So why not just nationalize them now, turning them into full-fledged government agencies and thereby taking away the uncertainty on Wall Street about their ability to continue buying home loans?

Poole, who was president of the Fed’s St. Louis branch until he retired in March, said in an interview with Bloomberg News this week that nationalization was ‘the only practical course’ for Fannie and Freddie.

Though he’s often labeled a curmudgeon, the 71-year-old Poole isn’t alone in his view of what to do with Fannie and Freddie, which combined either own or guarantee a total of $5 trillion of U.S. home loans, nearly half the entire market.

‘We have to stop pretending these are private companies,’ said Christopher Whalen, a managing director at research firm Institutional Risk Analytics.

There has always been an inherent conflict in the structure of Fannie and Freddie, Whalen notes: Their shareholders would reap the benefits if the companies took big risks and won, while it was presumed Uncle Sam would have to pick up the pieces if the companies blundered.

In Washington, Treasury Secretary Henry M. Paulson Jr. and others want Fannie and Freddie to get back on their feet on their own. But if the companies try to raise massive sums of new capital by issuing stock, they will severely dilute the ownership of their current shareholders (that’s a big reason the stocks have nosedived).

And what if, six months from now, the loan losses turn out to be so massive that any additional capital the companies raised in the interim is burned up?

Politically difficult as it may be, Whalen says, if you make Fannie and Freddie government agencies now, ‘you take a major source of instability out of the market. You don’t have to worry about it anymore.’ That would be one less issue for the housing market, which obviously has plenty.

Given the dilution risks they already face, shareholders of Fannie and Freddie ought to welcome a buyout even at these depressed prices, Whalen says.

In terms of stock market value, all that’s left of Fannie and Freddie now is about $18.2 billion, combined. Wall Street wouldn’t even notice that amount disappearing from the public market.