How the GSE Bailout Should Work

So what might the bailout of the GSEs look like? No one really knows, maybe not even Henry Paulson. But there are ways that a bailout could be structured to both protect shareholders and help prevent the need for another bailout in the future. Now is a good time for people with good ideas to come forward.

First, we have to consider what the goal of a bailout should be. In this case, it's very simple: ensure liquidity to the mortgage market. This protects banks that have committed to home loans assuming one of the GSEs would buy them. This also keeps mortgage borrowing rates stable.

Beyond that, though, there needs to also be some long-term solution to the GSE situation. Fannie Mae (FNM - commentary - Cramer's Take) and Freddie Mac (FRE - commentary - Cramer's Take) cannot return to business as usual. Another structure needs to be devised that reduces the systemic risk surrounding the mortgage GSEs.

On the other hand, a simple "demonstrable privatization" is not a near-term solution either. Currently Fannie Mae, Freddie Mac, and Ginnie Mae are the only thing standing between here and absolutely zero market for home loans.

Many solutions being bandied about presume the long-term model for mortgage securitization remains intact. But why? A big part of the inherent problem in the GSEs' current business model is that it requires substantial leverage to generate a reasonable return on equity.

Think about it. They collect a relatively small fee in exchange for guaranteeing MBS. The de facto leverage created is huge, evidenced by the fact that foreclosure rates in Fannie and Freddie's guarantee portfolio remain fairly low, and yet both GSEs are facing capital problems. There is just no way around the leverage issue if the current business model remains in place.

Covered bonds have been advanced as a long-term solution for the mortgage market. But covered bonds, as currently conceived, would not be a good replacement for agency MBS. This is because covered bonds would not trade generically, meaning that a covered bond from smaller banks would trade as well as those from larger banks. We'd wind up with large banks dominating the mortgage market, which has its own systemic risk problems. So what if in the future, the GSEs provided some limited guarantee on covered bonds? Remember that a covered bond is backed both by the credit of the issuing bank, as well as a pledged pool of mortgages. So in order for anyone to take a loss on a covered bond, the bank would have to be bankrupt and mortgages would have to be defaulting. Let's say the newly recapitalized GSEs are restructured more like an insurance company, where the GSEs would guarantee to investors some percentage of par, say 95%. Banks would remain on the hook for losses within the pledged pool as long as the bank itself remained solvent. But in the event that the bank goes under, covered bond investors would have a known limit on their losses. The GSE would also have contained costs, since in most cases the pool of mortgages which had originally secured the covered bond would have some residual value.

This plan combines the best parts of both the covered-bond idea (alignment of incentives) and the original mission of the GSEs (lowering mortgage rates). It would also kick-start the emergence of a covered-bond market because it would give investors a known set of outcomes when buying the new bond sector.

That leaves what to do with the old GSE guarantee portfolio. Assuming the Treasury has infused Fannie Mae and Freddie Mac with new capital, those portfolios could simply be allowed to run off.

Alternatively, the Treasury could require the new GSE to buy preferred shares of the old Fannie and Freddie, helping to offset tax payers costs. Eventually, this new GSE could be "demonstrably privatized" as market confidence is regained.

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At the time of publication, Graff had no positions in the stocks mentioned, although positions may change at any time.

Tom Graff is a Managing Director of Cavanaugh Capital Management, a registered investment advisor in Baltimore Maryland. The opinions expressed here are Graff's own and in no way are the statements of Cavanaugh Capital Management, and may or may not reflect the strategies being pursued for clients of Cavanaugh Capital Management. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Graff appreciates your feedback; click here to send him an email.