July 16 (Bloomberg) -- It's time to put an end to the charade that no one ever believed.

Fannie Mae and Freddie Mac would be dead without the announced backing of the federal government for the securities they issue to guarantee home mortgages. That's a strong argument for dropping these public-private partnerships, in which management and shareholders have taken the public for a ride.

Treasury Secretary Henry Paulson's plan to shore up the companies includes no direct protection for stockholders, and their share prices plunged more yesterday. Fannie Mae closed at $7.07, down 82 percent this year, while Freddie Mac fell to $5.26, off 85 percent for the year.

Fannie Mae and Freddie Mac ``represent the only functioning secondary mortgage market,'' Paulson said yesterday in testimony to the Senate Banking Committee. ``Our plan is aimed at supporting the stability of financial markets, not just these two companies.''

The two companies own or guarantee more than half the $12 trillion of home mortgages in the U.S., so there was never any reason to think the government wouldn't step in to keep them operating. In fact, given the collapse of the housing market and current tight mortgage credit conditions, Fannie and Freddie may need to expand their balance sheets even further.

However, instead of just finding ways to keep them going, Paulson should have proposed a government takeover -- with a payment to shareholders based on, say, July 11 share prices of $10.25 for Fannie and $7.75 for Freddie.

Subsidized Profits

Over the years, both Fannie and Freddie have made very large profits precisely because they were able to raise money by selling securities regarded by most investors as carrying a government guarantee. As we have seen this week, the investors were right.

Effectively, the guarantee subsidized risk-taking by both companies. And the implicit subsidy has been enormous.

The Congressional Budget Office estimated that in 2003 the annual value of the subsidy to the housing government-sponsored enterprises -- these GSEs include Fannie, Freddie and the Federal Home Loan Banks -- at $23 billion. Only about half that got passed on to homeowners in the form of lower interest rates on mortgages, the CBO said.

``What happens to the rest of the subsidy?'' N. Gregory Mankiw, then chairman of the Council of Economic Advisers, asked in a speech that year. ``The outcome is exactly what one would expect with a private company -- it goes to executive compensation and to shareholder profits.''

Congressional Acquiescence

With adroit lobbying and large political contributions, Fannie and Freddie persuaded members of Congress to let them issue ever-more debt with the proceeds used not just to securitize and guarantee mortgages. The pair expanded far beyond their basic business by also purchasing large portfolios of mortgage-backed securities.

Federal Reserve Chairman Alan Greenspan expressed concern about Fannie and Freddie in congressional testimony in February 2004 because of their huge size and because, unlike well- capitalized financial institutions, they had not chosen to manage risk by holding more capital.

``Instead, they have chosen heightened leverage, which raises interest risk but enables them to multiply the profitability of subsidized debt in direct proportion to their degree of leverage,'' Greenspan said.

``Without the expectation of government support in a crisis, such leverage would not be possible without a significantly higher cost of debt,'' he added.

Buried Losses

And that is the source of today's crisis for Fannie and Freddie: Investors believe the companies have large unrecognized losses in their portfolios that will undermine their profitability well into the future. Whether this is true, that has devastated their share prices.

Both companies have raised significant amounts of capital during the past year -- more than enough to cover the portfolio losses they have reported. Both have capital well in excess of the standards set by their regulator, the Office of Federal Housing Enterprise Oversight, said on June 9.

None of that has reassured investors spooked by the big increase in mortgage defaults and foreclosures. Call it mark-to- market with a vengeance.

The crisis shows that officials such as Greenspan, Mankiw and a number of Treasury secretaries were correct in saying that Fannie and Freddie were on a potentially dangerous path and that they had become so large that their failure posed a risk for the U.S. financial system.

As much as anything, the crisis represents a political failure. Congress wasn't willing to see the two companies reined in.

End the Partnership

So it's time to end the public-private partnership with its built-in conflict of interest and the fiction -- maintained religiously by both companies -- that there really wasn't an important subsidy behind their success.

Let's make them fully public entities whose role is to support the securitization of home mortgages, not to buy the resulting securities. And over time, they must be forced to shed their dominant role in the U.S. mortgage market.

Homeownership is important in American society. Still, it has been far too heavily subsidized in the past, and not just via Fannie and Freddie. As I have argued before, home-mortgage interest ought not to be a deduction for personal income-tax purposes, partly because so much of the benefit flows to wealthier households who buy more expensive houses.

The Bush administration and Congress should see this crisis as an opportunity to begin a more sensible long-term housing policy by taking over Fannie and Freddie.

(John M. Berry is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: John M. Berry in Washington at jberry5@bloomberg.net

Last Updated: July 16, 2008 03:37 EDT