What Will It Take to Privatize Fannie Mae and Freddie Mac?

Treasury Secretary-designate Steven Mnuchin's call to return Fannie Mae and Freddie Mac to the private sector may sound simple in concept, but he will have to overcome a host of issues and answer several key questions to make it happen.

As previous unsuccessful attempts at housing finance reform have shown, unwinding the conservatorship of the government-sponsored enterprises — and doing so in a way that ensures they are "absolutely safe," as Mnuchin has said — is extremely challenging.

Here's a look at the issues Mnuchin must confront:

Government Backing

One of the toughest issues is whether and what kind of government support Fannie and Freddie should have.

Pre-conservatorship, Fannie and Freddie operated with an implicit government guarantee of their mortgage securities. Since then, the GSEs have had an all-but-explicit guarantee by virtue of their Treasury bailout.

The question is: what should it be going forward? Congressional Republicans want little to no government role in the mortgage market, but eliminating support outright might freeze liquidity, wreak havoc on the secondary market and prompt a spike in mortgage interest rates for consumers.

On the other hand, the mortgage market cannot go back to the days of a nebulous, open-ended government guarantee of Fannie and Freddie. The financial crisis clearly showed that the government will rescue the GSEs. The terms of that guarantee should be explicit to ensure a more orderly and defined government response in the event of a catastrophic market failure.

What Do the GSEs Still Owe?

While the two GSEs have paid $253 billion in preferred stock dividends to the Treasury Department, those funds don't count as bailout repayment and the conservatorship agreement contains no mechanism for Fannie and Freddie to repay the bailout.

It will also take time for the Treasury to extricate itself from its ownership stake in Fannie and Freddie. The Treasury, which at one point owned 92% of American International Group, sold off its stake in the insurer over the course of about 19 months. It netted a $5 billion return on its nearly $70 billion investment, in addition to the $17.7 billion the Federal Reserve gained on its nearly $113 billion in loans and other bailout funds. Combined, the $182.3 billion AIG bailout made the federal government a 12.5% return over four years.

The GSE conservatorship has lasted twice as long as the government held its stake in AIG. During that time, the Treasury has made a 40% return on its investment in Freddie and a 29% return on its investment in Fannie.

Combined, the $63.4 billion the GSEs have paid in dividends reflect a 33.5% return for the Treasury. Those results could help bolster calls to retroactively credit the dividends as full or partial repayment of Fannie and Freddie's Treasury draws.

But even if that happens, Fannie and Freddie's dwindling capital reserves remain a challenge. The GSEs are required to reduce their capital reserves to zero by 2018. That mandate would have to be reversed as part of any privatization effort.

But rebuilding a cash cushion may be difficult at a time when mortgage originations — a key source of GSE revenue — are expected to drop over the coming years. Total volume is expected to drop 16%, to $1.58 trillion, in 2017 and remain near that level in 2018.

More Competition, Less Collaboration

The competitive spirit between Fannie and Freddie that thrived before the housing crisis has already started to re-emerge and privatizing the GSEs would no doubt intensify the competition between the two mortgage giants.

That should benefit small and midsize lenders looking to sell their loans directly to Fannie and Freddie, as well as large volume lenders that can leverage their scale for better pricing. But it could also negatively affect the collaborative efforts Fannie and Freddie have made to overhaul industry data standards and technology.

For example, the joint Uniform Mortgage Data Program has resulted in unprecedented insights into collateral valuations data and paved the way for new automated risk management tools. While its success has relied on consistent data standards and common applications, the GSEs have already started to deviate from that strategy by developing their own proprietary data collection requirements and collection portals for certain aspects of the UMDP.

Likewise, the Common Securitization Platform promises to make it easier for secondary market investors to do business with the GSEs. The CSP is being developed by Common Securitization Solutions, a company co-owned by Fannie and Freddie, but some small lenders have already expressed concern that attempts in Congress to sell the CSP to a private entity could squeeze them out of the mortgage market entirely. Work on the CSP has moved slowly and some are pushing to scrap the initiative before it even gets off the ground.

Fannie and Freddie have also had a virtual blank check to invest in technology and initiatives like the UMDP and Common Securitization Platform. After all, whatever they don't spend gets collected in the Treasury's quarterly profit sweep. But as private companies accountable to their shareholders, those costs will have to be rationalized.

Under conservatorship, Fannie and Freddie didn't have to consider the revenue implications of forgoing a combined estimated $200 million to $250 million per year in fees by making their automated underwriting systems free for lenders to use. Would they have made the same decision as publicly-traded companies?

The Federal Housing Finance Agency must continue to prioritize collaboration between Fannie and Freddie to improve noncompetitive business functions and other initiatives that make it safer and easier for mortgage companies and the secondary market to do business with the GSEs.

These are just a few of the issues that Mnuchin will have to resolve going forward. Considering that lawmakers disagree about many of them already, it's clear he has his work cut out for him if he wants to succeed where so many have failed.