FNMA FHLMC - Why not Private?

For a LONG time, FHLMC and FNMA were quite profitable. They buy mortgages from banks, put their guarantee on them, and sell them for more than they paid in nice pretty Mortgage Backed Security packages with a big bow. They made money doing this.

So why can't the banks get together and create a genuinely private entity that does exactly the same thing? It'd make a profit (if they're honest about underwriting criteria) adn FNMA and FHLMC can be quietly retired. (FNMA & FHLMC are technically private, but effectively subsidized).

It might work.

But there are a couple issues. Getting started, of course, requires a certain critical mass (and capital to back potential losses - like any other insurance). The big white potato in the room is the implicit government backing. Even though FNMA & FHLMC are in the toilet, everyone still expects their insurance on existing MBS to be honored.
Because the US Govt will honor it.

So how can a private mortgage bundling entity achieve the same thing? It would basically have to be honest! The purchase price for mortgages that conform to their underwriting criteria would have to be enough to cover the risk!

Right now, huge banks like B of A could do this internally. They can swallow their own risk. Why pay a 3rd party? The only reason they don't is because they get such an awesome deal from FNMA & FHLMC. They sell the mortgage (off their books) so they can generate more mortgages, collect more fees and servicing, and they pay only a small amount for doing so. It's a market distortion.

That's the bottom line. Remove the market distortion of the Govt providing free insurance to FNMA and FHLMC and they will have to build a lot more capital for their imprimatur to carry the same weight (and achieve the same price for their MBS's ).
Then they would be on a level playing field with a truly private entity.