THE PATH THAT FANNIE MAE and Freddie Mac follow out of conservatorship will be guided by the results of the mid-term elections.

As of press time, Republicans were poised to gain a majority in the House of Representatives, though the potential balance of power in the Senate was less clear.

A Republican majority in the House would have a big affect on not only the content but also the timing of future housing finance legislation.

Since the federal government took control of the government-sponsored enterprises (GSEs) in September 2008, the Republican refrain has been to “blow up"

Fannie Mae and Freddie Mac and let the private sector replace them—the sooner, the better.

Yet with Republicans poised to assume a leadership role in shaping future GSE legislation, their tone has shifted. Suddenly, key Republicans are privately conceding that it's a much more complex issue than their rhetoric has suggested—particularly when you take into account the volume of business the GSEs do. Freddie Mac, for one, processed about $600 million of multifamily deals per month in the first half of the year; that figure nearly doubled to $1.1 billion per month in the second half.

Republicans now say the transition will be a long-term process. “It's easy to throw rocks at a house when you're outside of it, but when you're running the house it's a different perspective,” said one Beltway insider who requested anonymity. “There's now a different tone about blowing up Fannie and Freddie. They realize the risk to the economy is too severe."

Stumbling Blocks

If Republicans win more seats or take control of either the House or Senate, it will certainly make it tougher for the Obama administration to get its housing finance wish list fulfilled. There will likely be a new face chairing the House Financial Services Committee—someone likely less sympathetic to the Obama administration than Rep. Barney Frank (D-Mass.).

Additionally, 13-term Rep. Paul Kanjorski (D-Pa.), who has worked closely on the GSE reform issue, may not win re-election.

Yet despite this potential control, the Republicans' free market vision is hampered by the fact that the free market might not be up to the task. Banks continue to struggle with balance sheets weighed down by bad real estate loans; the CMBS industry is in the early stages of recovery; and life insurance companies have a limited capital allocation with which to lend.

There's also been momentum around the creation of a covered bond marketplace, which would be another piece of the private sector liquidity jigsaw puzzle. But covered bond legislation is currently stalled in Congress, and there are doubts about just how much liquidity the industry could provide. As a result, many Republicans are realizing that the federal government's involvement in mortgage finance is necessary for the foreseeable future.

While a divided Congress may be able to forge a middle path in the legislation, history suggests it may also result in more gridlock. “You're going to need some bipartisanship to deal with this,” says Michael Berman, chairman-elect of the Washington, D.C.-based Mortgage Bankers Association and president and CEO of Needham, Mass.-based lender CWCapital. “And if you can't create that consensus, then this issue isn't going to move until after the next presidential election."

Points of Contention

The Obama administration will unveil its framework for the future system in January, a starting point for legislators. But even if some consensus can be reached in shaping legislation, there is no quick fix concerning the transition from here to there.

“It's so enormous and so complicated and the path to a vibrant private sector participation is so uncertain that everybody just has to take a deep breath and consider that we're in this for the long haul,” says Doug Bibby, president of the Washington, D.C.-based National Multi Housing Council. “This is a multi-year proposition— some people are saying seven to ten years, some are more optimistic and saying five to seven years."

While there are points of consensus between the parties, there are far more disagreements. Everyone agrees that the federal government's role has to shrink, that the next generation of housing finance entities needs to be privately capitalized so that taxpayers will be fully protected.

But some of the most critical decisions— such as the creation of an explicit federal government guarantee—lack clear consensus. In general, Democrats believe that an explicit federal guarantee, similar to that used by Ginnie Mae in securitizing FHA loans, is necessary to ensure liquidity through good times and bad. That guarantee would likely be paid for by the entities, with the proceeds going into a reserve to protect against losses and some diverted into an affordable housing fund.

But Republicans generally aren't as enamored with the idea of allocating too much, if any, federal credit in that direction.

And affordable housing would be less of a focus as Republicans believe that affordable housing mandates are partly to blame for the GSEs' collapse. You can also expect to see more support for the creation of a covered bonds market should Republicans wrest control.

Other fundamental issues, such as whether the next generation of housing finance entities will be existing companies or newly created companies—and how many should exist—still remain unclear.

Alternate Route

There's another path for Fannie and Freddie that few people are talking about right now but is entirely possible no matter which party controls the House. Rather than start from scratch and replicate the infrastructure already in place at the GSEs, Fannie and Freddie could follow GM or AIG on a path back to the private sector.

As the GSEs continue to shrink their portfolios, they are getting closer to being profitable and paying back the government. Private capital is beginning to compete more effectively and will continue to grow more competitive. So why re-invent the wheel?

“What I would do is re-charter, reregulate, and re-capitalize them, and then put the GSEs on a glide path out of the federal government,” Bibby says. “A smaller, re-capitalized, re-chartered Fannie and Freddie can be a vital and much smaller part of the market, and we would be better off."