By Neil Irwin
Washington Post Staff Writer
Saturday, November 1, 2008

The government may need to back home mortgages indefinitely to keep the broader housing market from going into a tailspin every time there is a financial crisis, Federal Reserve Chairman Ben S. Bernanke said yesterday.

In a speech to a forum on housing finance, Bernanke argued that government-sponsored companies Fannie Mae and Freddie Mac have played a crucial role propping up mortgage lending throughout the current financial crisis, even while purely private lending has shut down. But the Fed chairman said that, at some point, Fannie Mae and Freddie Mac need to be overhauled.

Bernanke was offering an opening salvo in what is likely to be a long debate over what to do with the mortgage finance giants, which the government effectively took over in September. Bernanke made clear that a scenario in which Fannie and Freddie went back to their old structure -- independent companies with implicit government backing -- would be fraught with problems. He laid out several alternatives, without endorsing any of them.

"Everybody's coming to the table laying out their ideas," said Howard Glaser, a consultant in the housing finance industry. "Bernanke was giving a menu of options more than anything else. But he is clearly saying that there's going to be a big government role in providing mortgage liquidity."

Bernanke's remarks came as a new report showed that almost one of every five homeowners owes more on their mortgage than their properties are worth. About 7.5 million mortgages, or 18 percent of all properties with a mortgage, were under water, according to the report, by First American CoreLogic.

As Americans grapple with the fallout of the most severe financial crisis in generations, bank regulators and the Treasury Department are considering ways to try to help people at risk of foreclosure. Congress and the next administration will probably have to grapple with myriad issues, including the fate of Fannie Mae and Freddie Mac.

Bernanke emphasized that during the financial crisis, very few mortgages have been issued that did not have implicit federal backing. This, Bernanke said, demonstrates the need for some government role in lending.

"At least under the most stressed conditions, some form of government backstop may be necessary to ensure continued securitization of mortgages," Bernanke said in his speech, which was delivered by videoconference to a forum at the University of California at Berkeley.

He expressed his discomfort with the old structure, in which Fannie Mae and Freddie Mac were publicly chartered companies that nonetheless tried to maximize returns for shareholders. That, Bernanke noted, created major risks for the financial system as a whole, exposed the government to huge potential losses and simultaneously enriched shareholders.

"We must strive to design a housing financing system that ensures the successful funding and securitization of mortgages during times of financial stress but does not create institutions that pose systemic risks to our financial markets and the economy," Bernanke said.

One approach would be to make Fannie Mae and Freddie Mac fully private, with no government guarantee, implied or otherwise. That would eliminate the conflict between their public and private missions, Bernanke said, but could create new problems -- namely, whether they would continue to fund mortgages under "highly stressed financial conditions," such as those that exist today.

"So, if [the companies] were privatized, it would seem advisable to retain some means of providing government support to the mortgage securitization process during times of turmoil," Bernanke said, perhaps by offering government insurance for bonds that fund mortgages.

Another approach would be to encourage private banks to move toward a form of mortgage funding called "covered bonds." These securities, used widely in Europe, enable banks to sell off packages of mortgages or other securities, but to guarantee them against losses. Thus, banks have ample incentive to make sure the loans contained in the bonds are of high quality.

Bernanke outlined a final alternative, in which Fannie Mae and Freddie Mac would be pulled closer to the government, perhaps in an approach similar to public utilities. Under this approach, a regulator would set fees and other strict limitations on the entities, capping their profitability.

This would not eliminate the inherent conflict between the companies' public and private missions, Bernanke said, but "might allow the enterprise to retain some of the flexibility and innovation associated with private-sector enterprises" and "may be able to resist political influences."