NEW YORK ( TheStreet) -- Fairholme Capital's proposal to replace Fannie Mae ( FNMA) and Freddie Mac ( FMCC) with two privately capitalized companies would give legislators in Washington quite a bit of what they have been proposing, but there are plenty of complications making it unlikely for the plan to succeed. Berkowitz -- the founder of Fairholme Capital Management -- sent a letter on Wednesday to acting Federal Housing Finance Agency (FHFA) director Edward DeMarco, proposing to establish two privately funded companies "to purchase, recapitalize and operate the mortgage-backed securities insurance business of Fannie and Freddie." Fannie Mae and Freddie Mac -- together known as the government sponsored enterprises, or GSEs -- were taken under government conservatorship at the height of the credit crisis in September 2008. The U.S. Treasury holds $117.1 billion senior preferred Fannie Mae shares and $72.3 billion in senior preferred Freddie Mac shares. Under their modified bailout agreements, the GSEs must pay all earnings to the government in excess of minimal capital cushions of $3 billion apiece. Following their next dividend payments in December, the government will have received $185.3 billion in dividends from Fannie and Freddie, for a five-year investment of $189.4 billion. But there's no mechanism in place for either GSE to repurchase any government-held preferred shares. Meanwhile, investors holding common and junior preferred shares of Fannie and Freddie have been out in the cold since September 2008. With the GSEs restored to profitability, some institutional investors -- including Fairholme Capital -- have made big bets on heavily discounted common and junior preferred GSE shares, hoping to recapture some value. Neither President Obama nor members of Congress of either party have shown any inclination to help rehabilitate Fannie and Freddie so they can resume operating as privately-held companies as they did before the credit crisis. The huge flow of GSE dividends to the government is also helping to reduce the federal budget deficit. With the GSEs continuing to purchase the lion's share of mortgage loans originated in the United States and holding $4.7 trillion in mortgage loans on their balance sheets as of Sept. 30, institutional investors holding common and junior preferred shares of Fannie and Freddie see plenty of value. Several of the investors, including Fairholme, Washington Federal ( WAFD) and Perry Capital have sued the government for destroying private shareholders' property.
"There will be significant congressional and administration interest in any solution involving a full or quasi-privatization of the GSEs," according to Kevin Petrasic, a partner with Paul Hastings in Washington. "The idea that you would have two behemoths out there without some government guarantee raises the question of whether there would be distortion in the housing market, and whether certain groups of potential borrowers would be left behind," Petrasic says. "There has historically been an inextricable link between the GSEs and housing policy." "The devil is in the details," Petrasic says. "What happens if we get into another housing finance problem with significant liability created for the privatized companies? "Financial institutions large and small and the economy would suddenly be at risk because of the reliance on the secondary mortgage market." In other words, under Berkowitz's proposal, there would be two new mortgage giants that would be "too big to fail."