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Let Fannie Mae, Freddie Mac Live, Hedge Fund Investor Says

Stocks in this article: FNMA FMCC FMCKJ FNMAS

NEW YORK ( TheStreet) --Politicians are fixated on winding down Fannie Mae (FNMA) and Freddie Mac (FMCC) in the name of housing reform, but they are yet to come up with a better system to replace them, according to Michael Kao, founder of hedge fund Akanthos Capital.

Kao is one of a small number of professional investors who are making a seemingly long-shot bet that junior preferred shares of the housing giants that now trade for pennies on the dollar will recover in value once the government's $187 billion bailout is repaid.

Kao has long been a supporter of returning the GSEs to their old public/private model where they behaved as private companies with the public goal of providing access to credit.

In a presentation at the Value Investing Congress in 2011, Kao argued that the GSEs were not the sole cause of the crisis. While they deviated from their mandate, he says, this was a failure of regulation.

"The public-private model is a time-tested model," says Kao and argues that it is the only way the government can continue to subsidize housing, without assuming direct responsibility for $5 trillion worth of mortgages. What it needs is better regulation and an approach to business that encourages competition from private capital.

But there is no appetite in Washington to recapitalize the government sponsored enterprises or GSEs and return them to their private form. Politicians want to see the housing giants, which epitomize the problem of too-big-to-fail, permanently replaced.

Earlier this week, bipartisan legislation was introduced by Tennessee Republican Senator Bob Corker and Senator Mark Warner, a Virginia Democrat, to replace the GSEs with a new federal agency that backstops private capital.

Under the new legislation, Fannie Mae and Freddie Mac will be replaced by a new government agency called the Federal Mortgage Insurance Corporation. The agency will collect premiums from the industry. In the event of a crisis, the FMIC will act as a backstop, stepping in to insure investors of conventional mortgages from losses but only after private capital has absorbed the first 10% of the loss.

It is a proposal that accomplishes little, according to Kao.

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