As the Administration weighs options for reorganizing Fannie Mae (FNM) and Freddie Mac (FRE) in the wake of their dismal financial performance, a strategy that spawned a lot of chatter but little action earlier in the financial crisis may be back on the table. Months ago, policymakers and outside experts weighed the benefits of creating a "bad bank" to hold commercial banks' toxic assets, but the idea never gained traction. Now, some suggest, the concept could help to restructure the mortgage giants—but the hurdles that caused commercial banks to adopt a different solution remain.
Fannie Mae said on Aug. 6 that it lost $14.8 billion in the second quarter and plans to draw down another $10.7 billion from the federal government to balance its books. That brings to $85 billion the amount of funds that it and Freddie Mac have received from Uncle Sam since the government took over the companies last September, driving home just how shaky the government-sponsored entities remain. Small wonder, then, that speculation has resumed over what the government will ultimately do with the companies, which long functioned as publicly traded firms with a government-defined mission to bolster the housing markets.
One option: The "bad bank," which The Washington Post suggested on Aug. 6 could be the tool the Obama Administration uses to resolve the problem. By establishing a separate entity to hold Fannie and Freddie's toxic assets, the surviving companies could go forward with clean balance sheets, unencumbered by past mistakes and capable of raising fresh capital from the private sector. The bad assets would be unwound over time.
Sheila Bair, chairman of the Federal Deposit Insurance Corp., pushed for much the same approach to tackling the bad assets of commercial banks this winter as did others outside government. The argument: It would restore investors' faith in the newly scrubbed companies, letting them raise new capital without fear that it would be rapidly wiped out as the toxic assets deteriorated. Instead, the Treasury Dept. funneled hundreds of billions of dollars directly into the nation's banks though its Troubled Asset Relief Program, shoring up the banks and temporarily reassuring investors. When government-supervised "stress tests" suggested most of the big banks only needed manageable amounts of additional capital to survive, despite their toxic assets, the capital markets rallied and the banks were able to raise funds quickly.
Direct investment won out in part because it was simpler. Banks' toxic assets consisted of a stew of highly complex mortgage-backed securities that had been bundled, repackaged, and leveraged, and banks proved unwilling to sell them at prices investors were willing to pay. Infusing banks with cash was less complicated then separating bad assets and building a new institution, and dealt more directly with one of the banks' biggest problems—lack of capital—than a bad bank could.
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