Nightmare on every street: how to carve Fannie and Freddie into pieces.

• Author: Pollock, Alex J.

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FANNIE MAE AND FREDDIE MAC are broke. The two government-sponsored enterprises (GSEs) that together finance more than $5 trillion in mortgages are insolvent, if you don't count the $150 billion already injected into them by the federal government. The common shares of these state-corporate hybrids have lost more than 99 percent of their value, both have been desisted from the New York Stock Exchange, and since September 2008 they have been official wards of the state. The largest owner of their obligations is now the United States Federal Reserve.

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Housing finance inflation was at the center of the financial crisis, and the GSES were at the center of housing finance inflation. Any meaningful reform of the mortgage system, and therefore the financial problems underlying the recession, must deal directly with Fannie and Freddie. But last summer our elected representatives instead passed a 2,300-pagc financial "reform" act that purposefully avoided addressing this central issue.

Discussions of how to reform Fannie and Freddie have now belatedly begun on Capitol Hill and in the Obama administration. The process will be complicated and controversial. But if we are to avoid future distortions and government-inflated bubbles in the housing market, Fannie and Freddie can and should be dismantled.

Divided and Conquered

The core problem with GSES isn't hard to understand. You can be a private company disciplined by the market, or you can be a government entity disciplined by the government. If you try to be both, you can avoid both disciplines.

To fix that, the first step is to put the GSES into receivership (as opposed to the current conservatorship), so that the small remaining value of the common shares and all their governance rights are wiped out. Then the restructuring can proceed, Julius Caesar style" divide them into three parts.

The first of those parts, unfortunately, must be a "bad bank," a liquidating trust that will bear Fannie and Freddie's deadweight losses--the $150 billion spent by the Treasury so far, plus the additional losses that are embedded in the GSEs' portfolios and will be realized over time. According to various estimates by the CBO and private analysts, it will cost in the range of $200 billion to $400 billion to make whole the foreign and domestic creditors of Fannie and Freddie. That cost will unjustly, but at this point unavoidably, be borne by taxpayers.

All the current debt...