Photo: Geof Kern
By Shawn Tully
June 13, 2013

On the morning of Feb. 11, 2011, Treasury Secretary Timothy Geithner gave a speech at the Brookings Institution near DuPont Circle in Washington, D.C., addressing the future of Fannie Mae and Freddie Mac. “We need to wind down Fannie and Freddie and substantially reduce the government’s footprint in the housing market,” he declared.

Geithner’s position enjoyed remarkably wide support from lawmakers, regulators, and economists across the political spectrum. The prevailing — virtually universal — view was, and still is, that the twin colossi of housing finance that stuck taxpayers with a $189 billion bailout bill after their collapse in 2008, that inflated the real estate bubble with artificially cheap credit and hence helped sink the U.S. economy, should never, ever be allowed to regain their former dominance.

Today, 2 1/2 years after Geithner’s principled pronouncement, Fannie and Freddie are bigger and more powerful than ever. Real estate is roaring back, and so are the players that, as much as any other, caused its crash. In fact, almost all the policy decisions that have been made since the government took control of Fannie and Freddie have failed miserably in the mission to de-emphasize their role in the economy — instead giving the pair unintended but powerful advantages and squeezing out private competitors. The two institutions, now essentially owned by the government, are virtually the whole show in the mortgage market, guaranteeing 80% of all new home loans in America. That’s almost double their market share before the credit crisis. In one of the strangest turns of events in the annals of business, Fannie and Freddie have rapidly morphed from epic money losers into unprecedented money machines.

In the first quarter of 2013, Fannie Mae posted an incredible $58.7 billion in net income. That figure exceeds the highest earnings for an entire year ever reported by a Fortune 500 company, Exxon Mobil’s 2008 profit of $45.2 billion. The smaller Freddie Mac is booming too: Since the start of 2012, Freddie has reported $15.6 billion in profits. For this year Fannie and Freddie combined should earn more than $100 billion, matching the combined 2012 profits for Exxon, Wal-Mart, and Apple. Rather than fading away, Fannie and Freddie are now minting money from your mortgage.

All that money goes straight to the U.S. Treasury. And the unexpected bounty from Fannie and Freddie is so big that it has greatly improved the federal budget picture. The estimated $100 billion in contributions this year is a major reason the deficit for fiscal 2013 is expected to be far lower than the shortfall projected last year. Indeed, the U.S. is now expected to reach its statutory debt limit in October rather than in May.

The astounding resurgence of Fannie and Freddie has even brought new life to its formerly zombie securities. The Treasury essentially owns Fannie and Freddie through its right to buy 79.9% of its shares any time it wants for virtually nothing. In 2010 the shares of both companies were delisted from the NYSE. Though they still trade over the counter, investors found the stocks practically worthless; for a couple of years Fannie’s common languished under 30ยข. In May, Fannie’s shares jumped 20-fold, to more than $5, before retreating to around $2.

The frenzy in Fannie and Freddie shares is fueling another kind of speculation: That the pair, given their fabulous profitability, will reemerge as privatized companies resembling the old Fannie and Freddie. Prominent investors, such as hedge fund managers John Paulson of Paulson & Co. and Richard Perry of Perry Capital and mutual fund manager Bruce Berkowitz of Fairholme Capital, have been buying up junior preferred shares issued before the collapse. Those shares have tripled in 2013.

The investors speculating in Fannie and Freddie shares — including Millstein & Co.’s Jim Millstein, the former Treasury official who orchestrated the privatization of AIG — are lobbying hard for the government to sell its stakes in Fannie and Freddie, a solution that would deliver a huge gain on their investments. It’s highly unlikely to happen.

“Republicans will never agree to a Fannie and Freddie that are private and benefit from a government guarantee,” says Edward Mills, a former congressional staffer who worked on the bailout. “Democrats like the guarantee but don’t want shareholders to benefit from it. And no one wants to do anything that hurts the fragile housing market, which they’re perceived as greatly helping.”

What has emerged is a political stalemate that will probably preserve Fannie and Freddie in their current state for years to come. If it continues, the powerful real estate rebound — the 12.1% year-over-year rise in home prices in April was the largest monthly gain in seven years — should provide a much-needed boost to our creeping recovery. But the housing market is now hooked, more than ever, on artificially cheap credit furnished by Fannie and Freddie.

The ultracheap mortgages Fannie and Freddie enable pose two towering problems. First, they’re almost totally squeezing out private lenders, which need to price their home loans for true credit risk. Despite its roaring comeback, real estate isn’t yet in a bubble again. But subsidized credit threatens to create a new one. Second, the new Fannie and Freddie still pose a huge risk to taxpayers. They are bizarre financial creations, designed to carry both practically zero capital and gigantic balance sheets supporting trillions in home loans — a recipe for another bailout in the future if there’s a new housing downturn.

To appreciate the extent of the threat, it helps to understand how government policy has empowered Fannie and Freddie at the expense of potential competitors. As we’ll see, everything from the Federal Reserve’s preferential purchases of Fannie’s and Freddie’s bonds to new regulations under the Dodd-Frank financial reform bill has penalized private lenders — and boosted the mortgage giants. A well-intentioned move to raise the rates they charge and thus even the playing field has instead helped create their profit windfall. Even as they boom, it’s unclear whether anyone in Washington has the will or the leverage to control the newly reborn Fannie and Freddie. Perhaps no quandary poses a graver threat to America’s economic future.

Fannie Mae and Freddie Mac have stood as pillars of housing finance for decades. It’s only recently that their central role has expanded into a near monopoly. Fannie was chartered in 1938, and Freddie created in 1970, to promote homeownership for middle- and lower-income Americans. They do not originate loans. Rather, they purchase mortgages from banks, brokers, and other private originators, package the loans into mortgage-backed securities (MBS), and sell those bonds back to banks, insurance companies, or pension funds. They also hold loans on their own books as investments, a business now being radically downsized. They’re really galactic-size mortgage insurers.

Before the housing bubble, Fannie and Freddie insured around 45% of all home loans. Traditionally they guaranteed only so-called conforming mortgages — those that met strict credit guidelines, typically 15- or 30-year loans at fixed interest rates. Private lenders competed actively for the same size mortgages that Fannie and Freddie guaranteed — in the $100,000 to $400,000 range (today the conforming limit in most cities is $417,000) — but specialized more in adjustable-rate loans and also in furnishing “jumbo” mortgages too large for Fannie and Freddie. The catch was that Fannie- and Freddie-backed mortgages were artificially underpriced because of their implicit government backing. To compete, the banks priced their loans too low as well, and got away with it because investors flocked to buy mortgage bonds as a way to profit from the booming housing market.

To make matters worse, in the early 1990s Congress enacted affordable-housing policies that prompted Fannie and Freddie to lower their credit standards. When the good times rolled in the mid-2000s, Fannie and Freddie looked like an ideal blend of enlightened housing policy and private-sector efficiency. Their stocks soared, their CEOs — notably Fannie Mae’s politically powerful Franklin Raines — collected eight-figure compensation, and politicians lauded their essential role in bringing affordable housing to millions who’d been deprived of the virtual right of ownership.

When the housing market crashed in 2008, however, Fannie and Freddie quickly exhausted their capital. The fees they were charging and the rates on the loans held on their books were far too low to compensate for the wave of defaults. The same problem pummeled lenders from Bank of America to Countrywide to Washington Mutual. In September 2008, the Treasury placed Fannie and Freddie in “conservatorship” under a newly created, independent regulator whose primary role is to oversee them: the Federal Housing Finance Agency.

The Treasury provided a massive bailout in exchange for senior preferred stock and warrants to buy 79.9% of their shares, an arrangement that kept the liabilities of Fannie and Freddie off the government’s books. The preferreds carried a heavy 10% dividend. By 2011 the government held — and still holds — $117 billion in preferred shares of Fannie, and Fannie was paying almost $12 billion a year in dividends. In a bizarre twist the government demanded that both of its wards pay out the dividends in cash even while they were taking big losses. To pay, Fannie and Freddie simply issued more preferred stock to the Treasury, then sent the same dollars the government was handing them right back in the form of dividends.

In mid-2012 a reversal of fortune prompted the Treasury to radically alter the rules for Fannie and Freddie. The bailouts of Fannie and Freddie had been designed to prevent them from reemerging as private companies. Geithner frequently inveighed against the “privatization of profits and socialization of losses.” To that end, under the conservatorship Fannie and Freddie were denied the ability to pay down any of the preferred. But after losing $253 billion from 2008 to 2011, Fannie and Freddie suddenly turned wildly profitable. (Most of Fannie’s $58.7 billion profit for the first quarter is actually a paper gain from transforming past tax losses into current income — credits that will shield Fannie from taxes for years to come. Fannie, though, must pay those billions in paper earnings fully to the Treasury in 2012, and it has the liquidity to do so.) The Obama administration feared that as Fannie and Freddie became flush with new capital, political pressure would increase to reprivatize them. There was also concern that their hefty dividends might require the pair to tap into more government funds in the future.

So in August, the Treasury decided to abolish the 10% dividend from Fannie and Freddie. As of Jan. 1, they’re required to essentially pay whatever they earn as the dividend on their preferred shares. And they will hold minuscule amounts of capital — declining to zero, in fact, by 2018. Holding no capital will lower their costs and further enhance their profitability, since capital requirements are a drag on bank earnings. The change in regulations effectively ensures that Fannie and Freddie can go on for the foreseeable future under their current structure. They’ve been insuring mortgages of excellent quality since 2009, with extremely low rates of default. Years of strong earnings are likely to follow.

The bailout of Fannie and Freddie was designed to usher in a new home-financing system dominated by private capital. So how did the pair grow bigger than ever, doubling their market share to 80%? Consider how they make money. Fannie and Freddie rely on two sources of revenue. The first is “spread income,” generated from mortgages they hold as investments, which is the difference between the extremely low rates they pay on corporate borrowings and the yields on the mortgage bonds they own — chiefly the ones they guarantee themselves. This traditionally provided two-thirds of earnings. At the direction of regulators hoping to curb their power, Fannie and Freddie are required to shrink their investment portfolios 15% a year.

The second source of revenue is the “guarantee fee,” or “g-fee,” that Fannie and Freddie collect from homeowners whose loans they insure. The g-fee is built into the monthly rate that folks pay on their mortgages. The U.S. Treasury has always effectively guaranteed that the holders of securities insured by Fannie and Freddie will receive full payment on their interest and principal. That guarantee eliminates all credit risk for holders of the mortgage-backed securities, and hence makes them very attractive. If that g-fee premium is too low — and it almost always is, including today — bank competitors need to pay a far higher rate than Fannie and Freddie on their MBS to raise money.

After the real estate implosion of 2008, the biggest source of private financing — securitizations — virtually vanished as the banks that packaged loans either disappeared or retreated and wary investors shunned even the safest securities. But Fannie and Freddie mortgage-backed securities, the only totally safe kind, were more popular than ever, even at extremely low yields. So the banks and brokers that originate home loans brought virtually all their business to Fannie and Freddie. Instead of holding the loans they originated or securitizing them on their own, the banks sold almost everything. The biggest source of profits at Fannie and Freddie shifted from their portfolios to g-fees. In 2012 Fannie guaranteed $828 billion in new single-family loans that generate g-fees, benefiting especially from a refinancing boom. That’s 47% more than in 2011 and surpasses the total guarantees it provided at the peak of the market in 2006.

But why, five years after the crash, does private capital remain largely absent from housing finance? The reason is twofold. First, Fannie and Freddie systematically underprice any reasonable private issuer — the same state of affairs that helped create the credit crisis in the first place. The problem is the gap between the rate for which Fannie and Freddie can sell, say, 10-year mortgage-backed securities and what a private lender has to pay in interest to borrow to fund its mortgages. Here’s where Fed policy is dangerously discriminating against private banks. The Fed is buying large volumes of Fannie and Freddie paper, and not purchasing or planning to buy private mortgage-backed securities. As a result, the spreads between the benchmark Treasuries and Fannie and Freddie bonds, always small, have been especially tiny.

In part because of the Fed’s purchases, Fannie and Freddie can sell all the bonds they want at yields of about 2.8%. That 2.8% is the first building block for a rate on a mortgage backed by Fannie and Freddie securities. An originator — the broker or bank that does all the paperwork and credit checks — adds 0.25% to pay for “servicing,” the cost of sending out statements and handling escrows for taxes and insurance. The second component added to that base rate is the g-fee. For many years it was also about 25 basis points. But in 2011, Congress and the FHFA decided to substantially raise the g-fee. The reason was simple and logical: If Fannie and Freddie raised the fee enough to really price for the long-term riskiness of their loans, the rates on their mortgages would rise, and private capital would come flooding back. In late 2011, Congress imposed a 10-basis-point increase to help fund extension of the payroll tax holiday. Another increase brought the fee to the current average of 54 basis points. And the consensus is that the FHFA will raise it to well over 0.70% this year.

So let’s calculate the approximate rate on a Fannie- or Freddie-backed mortgage with a g-fee of 70 basis points. Start with the 2.8% for their mortgage-backed securities, add the 0.25% servicing fee and the 0.70% g-fee, and the rate comes to 3.75%. Private lenders can’t come close to that figure. If, say, Bank of America or Wells Fargo wanted to securitize their own mortgage loans, they’d have to charge a dramatically higher rate. Bill Dallas, CEO of Skyline Financial, a California outfit that writes $3 billion to $4 billion a year in home loans, figures that banks and other originators would need to pay at least 200 basis points over Treasuries, or a rate well over 4%, to compete with Fannie-insured loans. “No one can get close to the credit guarantee they provide, so we have to charge a lot more, making private mortgages uncompetitive,” says Dallas. It’s easier just to pass every loan to Fannie or Freddie.

The second force restraining private capital is misguided regulation. Under the Dodd-Frank reform bill, which takes effect in 2014, lenders must adhere to strict underwriting standards. If they aren’t met, borrowers can legally refuse to pay and even sue the originator for supposedly designing a loan bound to fail. But the law creates an exception that greatly favors Fannie and Freddie: If the originator sells the loan to Fannie and Freddie instead of holding or securitizing it, it is effectively protected from the “ability to pay” provision. Dodd-Frank also may require banks to hold a fixed percentage of loans or MBS they securitize on their own books, raising their need to hold capital. “With all that regulatory uncertainty, the banks aren’t willing to rebuild big securitization platforms in preparation for getting back into the market,” says Jeb Mason, a former Treasury official who helped design the rescue of Fannie and Freddie.

The signs aren’t all discouraging. The market for securitizing extremely high-quality jumbos is creeping back, as evidenced by recent securitizations by J.P. Morgan Chase, Credit Suisse, and Redwood Trust. To bring private financing back in full force, Congress needs to take decisive action in two ways. First, it needs to raise the g-fee greatly. Second, and more controversially, Congress must set a firm schedule for closing Fannie Mae and Freddie Mac. That doesn’t mean the government needs to exit the business of guaranteeing mortgages. The FHFA’s acting chief, Edward DeMarco, has proposed replacing Fannie and Freddie with an agency that provides limited guarantees while transferring most of the risk to private lenders. Sen. Bob Corker (R-Tenn.) has proposed a bill with similar provisions.

It’s clear that financial fine-tuning isn’t enough. Private lenders need to know that the gigantic edge enjoyed by Fannie and Freddie will soon be a thing of the past and that politicians cannot restore it. If that’s the case, private capital will need to fill a giant hole, so the phaseout should happen over at least five years. But the fate of Fannie and Freddie should be made legally irreversible. That’s the only way to ensure that Geithner’s vision of a post-Fannie and Freddie world becomes a reality.

This story is from the July 1, 2013 issue of Fortune.

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