On Friday, FHA bowed to the inevitable and conceded that it’s broke, way broke. We’ve thought so for a while, but now that FHA’s woes are out in the open, the question of federal housing finance can no longer be swept under the rug. Conventional wisdom notwithstanding, I think we’ll see a rewrite soon not just of FHA, but also Fannie and Freddie. A good thing too, as all three of these mortgage-market bulwarks urgently need a makeover.

FHA has long prided itself on being different from Fannie and Freddie, fulfilling a public mission to promote low-income homeownership through its unique full-faith-and-credit stamp. Indeed, it’s this mission FHA now is wrapping around itself as a flag to defend itself from those arguing – as I do – that its finances point to a fundamental problem that requires urgent remedy.

Mission notwithstanding, FHA proved just as susceptible to the siren’s lure that tempted Fannie and Freddie to founder. Fearful that FHA was being bypassed during the housing boom, the Bush Administration’s FHA Commissioner loosened its standards in 2006 to gain what he aptly described as “marketshare.” I commented at the time about how inappropriate it is for public capital to be deployed to compete with private institutions, but FHA was determined to make itself important all over again despite Bush Administration rhetoric about the importance of the private sector.

Of course, FHA’s timing was more than mistaken – it was unbelievably awful. It got “marketshare” alright. Ramping up in a big way just as private investors realized how big a bet they had placed on subprime loans, FHA took all the business it could get in 2007 and 2008. This turned out to be lots of business, leading the aforesaid FHA official to pat himself on the back. Now, he should hit himself in the head – the 2007-2009 book is of course disastrous, driving FHA into a hole at least $13 billion deep. FHA on Friday promised tidy clean-ups, but it’s hard to see how any of them will amount to much. If FHA really means what it says about sticking lenders with the bill for bad loans, its volume will drop dramatically, depriving it of the new premiums it needs to bolster its balance sheet. Even if it does keep sufficient volume to make ends meet, its modeling remains more than suspect. As recently as this summer, FHA anticipated a year-end surplus of about $5 billion. Oops. And, it’s $13 billion deficit is premised on house-price scenarios that forecast about five percent annual house-price appreciation over the next three years, almost double the FRB’s three percent baseline scenario in its 2013 stress tests. If the Fed’s right and FHA’s wrong – and so far my money’s on the Fed – FHA’s losses would rise well north of $13 billion.

What all this means is not just that FHA is in a world of hurt, but also that its budget treatment has to change early next year. Because of FHA’s prior, rosy projections, OMB and CBO have scored FHA as a “negative net subsidy.” In human-speak, that means FHA is treated as a revenue-raiser – the more business it does, the lower the federal deficit because FHA is scored as making money. Now that its losses have been forced into the open, this fundamental budget assumption cannot continue. FHA costs money and, so, it will have to shrink and change as policy-makers lump it into the larger deficit-reduction package now preoccupying Washington.

Where do Fannie and Freddie fit into this messy picture? Some have suggested they can continue in conservatorship even as FHA takes its lumps. I don’t think so. If FHA shrinks – for example, if its loan limit drops below the stratospheric $729,750 that Congress seemed to think defines affordable housing – then the business must go somewhere. To private lenders and securitizers? Maybe, but their capacity to do much of anything is, at best, suspect given the host of capital and reform rules confronting the industry. So, over to you Fannie and Freddie.

The GSEs could take on business forced out of FHA, but to what fiscal end? Arguably, the new business just adds revenue that flows through the GSEs to Treasury that could be scored favorably in the complex budget calculus. But, I doubt Congress will just let one side of the taxpayer-risk equation grow after it’s learned yet again how much this can cost. Instead, a package of reforms is likely that redesigns FHA, Fannie and Freddie in concert and to good effect for fiscal policy. The White House has repeatedly talked about GSE wind-down and, now, I think we’ll see what it thinks this means. Let’s hope that, as it contemplates this, it recognizes just how dependent mortgage markets remain on all three federal housing backstops, moving with caution and in concert with finalizing the new mortgage rules. If not, we’ll get fiscal benefits, but at considerable cost to housing finance and the long-term recovery.