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Lockhart: Fannie and Freddie Over Time Should Move Over Into The Private Sector

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In an effort to help with the expecting tsunami of foreclosures, the government is putting pressure on Fannie Mae and Freddie Mac to modify their "underwater" mortgages when people fall behind on payments. But won't this just encourage people to not make payments? I decided to get insight from James Lockhart, Former Federal Housing Finance Agency Director and Vice Chairman of WL Ross & Co.

LL: Should loan modification be opened to people who are behind on their mortgages?

JL: Everyone is in favor of modifications over foreclosures. The real issue is how do you do them? No one has figured out how to do them without causing some moral hazard. Meaning everyone that has an underwater mortgage wanting to get their principal reduced. We need structure where it would apply to people who are seriously underwater. You don't want people to strategically default so they can get a write down on their mortgage.

LL: Its kind of scary- I hear its en vogue for people to stop paying their mortgage. Where do you draw the line?

JL: Exactly. I came out in favor two years ago on this but people can't draw the line. One of the proposals- you do a principal reduction and if you were able to sell the house later at a higher price the lender would get part of that back. Its an equity appreciation type of mortgage and everyone thought was too complicated.

LL: Fannie and Freddie are being pressed to restructured mortgages in order to reduce the foreclosure wave do you agree with this?

JL: I agree Fannie and Freddie should be active in the mortgage modification space. The idea of principal reductions is something they have resisted just for the reasons we have been talking about- how do you do them that will not cause more harm than good?

LL: Fannie and Freddie rarely reduce loan balances, what's in the best interest of taxpayers?

JL: The best thing for the taxpayer is stabilizing the mortgage market. That will help the economy recovery over the long-term. We need to get confidence back into the market. Properly done- judicious write-downs make sense. One of the things Treasury is ignoring and I think is important is the private label securities. They are the ones who have more troubled mortgages than Fannie and Freddie. We've been pushing the Treasury the idea that they encourage say its ok basically for servicers of private label mortgage backed securities to sell mortgages at a discount and then those mortgages could be reworked by servicers that are better at it to do things like principal reductions.

LL: Should the 30 year mortgage be eliminated so the private sector can get back into the mortgage business?

JL: Intellectually that sounds good but I don't think it will ever happen. What a 30 year mortgage does is basically transfer the interest rate risk from the homeowner to the mortgage holder. It seems to be an idea that is extremely popular. What we need to do is over time move the mortgage market back into the private sector. Reforming Fannie and Freddie is a part of that. We need to lay out a blueprint in the next five years to encourage the private market to get back into the mortgage market.

LL: Should Fannie and Freddie be privatized?

JL: I think the function of Fannie and Freddie over time should move over into the private sector, yes. There may be a residual that stays within the government and to me that's really FHFA , over time we need to figure out a mechanism to wean the mortgage market off of Uncle Sam.

LL: How should the new Congress tackle Fannie and Freddie?

JL: The Republicans in the House have some very strong ideas on Fannie and Freddie so I think there will be a will there to do something. What I hope gets done is they can create a transition if you will to move it back into the private sector. You can't do it right away. The mortgage market is too fragile and they're too big a part of it. I think there are ways to do it.

LL: Is it five years, 10 years?

JL: Probably five years. Unfortunately it might take five years to get legislation but I hope not. Five years from when the legislation passes there should be a clear trajectory on how to get them or their successors into the private sector.

LL: Will QE2 help the mortgage industry? Do you think more quantitative easing is necessary?

JL: I don't think we need additional QE. We don't need QE3. My view is the Fed was doing that because they were seeing very little action in Congress. Maybe the change in the tax bill may relieve the need for much of QE2. Any of the real problem is it so far has not really moved down interest rates as they were expecting and I'm not sure they will. What we need is some animal spirits to rise again in the markets. We need confidence to come back in the economy and I think Ben (Bernanke) was trying to help that by saying they would pump money back into the economy. But on the other hand, I think the bond markets get afraid of the possibility of inflation.

LL: What's housing outlook as we go into 2011?

JL: As we predicted the housing market is still in a fragile state. Hopefully this is only on a temporary small letdown in home prices. The whole mortgage servicing area is in the flux with the attorney generals looking at it. There are a lot of uncertainty in the mortgage market and until we relieve some of that uncertainty, including the future of Fannie and Freddie- its going to be hard to see a very robust recovery.

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A Senior Talent Producer at CNBC, and author of "Thriving in the New Economy:Lessons from Today's Top Business Minds."