No safety net for Fannie and Freddie

In the wake of scandals, Congress should follow the Bush administration to take bolder action.

It is received wisdom on Wall Street that the federal government would bail out Fannie Mae and Freddie Mac if they could not pay their debts – even though they are for-profit, privately owned mortgage finance companies. That's because they were specially created by the federal government to encourage homeownership.

This is received wisdom notwithstanding required language on Fannie and Freddie securities that they are "not guaranteed by the United States and do not constitute a debt or obligation of the United States," and it allows Fannie and Freddie to borrow money more cheaply than other private companies because they are perceived as low-risk borrowers.

Fannie and Freddie had been the darlings of Wall Street as they reported growth and profits year after year by borrowing money at low rates and using it to purchase residential mortgages that pay interest at higher rates. But the seemingly remote possibility of a bailout has become more likely as wave after wave of accounting scandals involving the misstatement of earnings sweep over the two companies.

The risk that these scandals pose has been compounded by the fact that Fannie and Freddie's hedging strategies expose them to serious risks: If the interest payments that the two companies owe to their lenders become mismatched with the interest payments they receive from homeowners whose mortgages they own, the companies can become insolvent. While only a handful of policy wonks focus on this arcane issue, the cost to taxpayers of a bailout could be hundreds of billions of dollars, easily dwarfing the cost of the Savings and Loan crisis of the 1980s. Hundreds of billions of dollars: That figure should make taxpayers sit up and take notice.

The Bush administration, while not generally known for its financial prudence, has been trying to back away from this implicit guarantee and potential liability. This makes it the first administration to do so since these two for-profit companies were formed nearly 40 years ago.

Indeed, former Treasury Secretary John Snow had repeatedly denied the existence of the implicit guarantee. And just recently, Treasury Undersecretary Emil Henry stated that the United States should avoid "unnecessary" bailouts of these two companies. Clearly the Bush administration is trying to adjust Wall Street's expectations about the implicit guarantee.

But convincing Wall Street that there is no guarantee is not as easy as "sayin' it ain't so." Wall Street believes that the implicit guarantee was part of the original charters of the two companies, which were formed to create a liquid national market for residential mortgages. This national market was intended to replace the fragmented local mortgage markets that failed to move capital from mature markets, such as the Northeast, to rapidly growing housing markets, such as the West. Fannie and Freddie succeeded in nurturing such a market, which provided diversified investment opportunities for those with capital and decreased borrowing costs for those who needed it – a genuine win-win scenario designed by the government and executed, mostly, by the private sector.

Moreover, the very structure of Fannie and Freddie's charters gives strong support to the notion that the federal government will bail them out if they cannot make good on their obligations, notwithstanding the required securities disclaimers quoted above.

The charters grant them special regulatory privileges, including lines of credit with the Treasury, exemption from a broad swath of securities regulations that affect other public companies, and presidential appointments to the board of each company. These terms create the appearance of a special relationship between each of these companies and the federal government, a relationship that Wall Street has taken to the bank.

For most of those who follow these issues carefully and dispassionately, there is agreement that the national mortgage market is now vibrant and that there is no need to grant these special regulatory privileges to Fannie and Freddie, which could expose taxpayers to inconceivably huge liability.

Moreover, principled commentators on the right and the left, including American Enterprise Institute scholars and Public Citizen's Ralph Nader, agree that the implicit guarantee is no longer justified in today's sophisticated mortgage market. For the former, the guarantee amounts to the privatization of profits and the socialization of losses. For the latter, it is just another example of corporate welfare. And indeed, in today's world, it is both of those things.

As the Fannie and Freddie scandals have lapped on the shores of Capitol Hill, Congress has considered a variety of regulatory reforms that are all decidedly incremental and none of which would eliminate the implicit guarantee.

Momentum is building, starting within the Bush administration, to take bolder action. Both sides of the aisle in Congress should follow the administration's lead on this financially prudent course.

• David Reiss is an assistant professor of law at Brooklyn Law School.