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Speaking in Phoenix on Tuesday, President Obama associated himself with a bipartisan proposal to slowly get Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) out of the business of backing mortgages. According to the plan, formulated in the Senate, a new federal agency called the Federal Mortgage Insurance Corporation would backstop banks and other private investors against catastrophic mortgage losses, but only after they had run though their own substantial capital first.

Obama said, “For too long these companies were allowed to make huge profits buying mortgages, knowing that if their bets went bad, taxpayers would be left holding the bag. It was 'heads we win, tails you lose,' and it was wrong. The good news is right now there's a bipartisan group of senators working to end Fannie and Freddie as we know them. And I support these kinds of reform efforts."

It sounds good, but there is reason to worry that this plan would protect the government against losses but at the price of raising interest costs to homebuyers. And it would do nothing to address the deeper abuses in the whole system of securitizing mortgages.

Today, the mortgage market is heavily reliant on Fannie and Freddie, which together own or guarantee about half of all U.S. residential mortgages, and 90 percent of newly issued ones. For ordinary borrowers, it’s effectively impossible to get a loan at prevailing interest rates unless you meet Fannie’s standards. And since Fannie and Freddie got so badly burned in the subprime meltdown (requiring a government bailout of $187 billion), they demand nothing less than sterling credit on the part of loan applicants. So a lot of homeowners who desperately need to refinance at today’s low interest rates can’t qualify.

It’s clear that the current versions of Fannie and Freddie are badly dysfunctional. The mortgage market is too reliant on them, but homeowners who most need their help often don’t get it.

Would the Obama/Senate version of “winding down” Fannie and Freddie be an improvement? I don’t think so. And the Republican alternative of getting government out of the business of backstopping mortgages altogether would be even worse.

To appreciate why this proposed reform is a lemon, consider the history of Fannie Mae. Obama’s account of Fannie’s history went back less than a decade. But when President Roosevelt launched the original Federal National Mortgage Association, (FNMA, soon nicknamed Fannie Mae) it was a public entity with a clear public purpose — to increase the supply of mortgage funds by replenishing the working capital of local lenders. Fannie did this by selling bonds and purchasing mortgages. There was no corruption, no complex securitization of mortgage bonds, no bond traders took wild risks, and losses were rare. Fannie helped increase the home ownership rate.

Then in 1969, Fannie was privatized, though money markets assumed that it still enjoyed a tacit government guarantee. By the 1990s, Fannie was behaving less like a public entity with a public purpose and more like a private, profit-maximizing corporation enriching its executives with a government guarantee.

At first, Fannie resisted getting mixed up with sub-prime, but by 2004 and 2005, it was buying toxic securities in order to protect its market share. When the collapse came, Fannie lost big.

The lesson is not that government should get out of the business of backing mortgages. It’s that public entities should be public, and should operate in the public interest. Corrupted Fannie was the worst sort of hybrid, using tacit government guarantees for private enrichment.

If something like the “bipartisan” Senate bill passes — it’s the work of conservative Republicans like Bob Corker of Tennessee and conservative Democrats like Mark Warner of Virginia — private lenders will cover their own fannies thanks to the new federal guarantee, but will demand higher interest rates from borrowers.

A real reform would kill the current version of Fannie Mae — and restore something like Franklin Roosevelt’s. Don’t hold your breath.

Source: Mortgage Reform: Watch Your Fannie