The Rudman Report on Fannie Mae recites facts eerily similar to what we now know about Enron. According to the report, the CFO of Fannie misled the board (and possibly the CEO) about the financial position of the company. The CEO, head of the corporate governance committee of the powerful Business Roundtable, regularly misled Wall Street and the board, but may not have understood the accounting. The auditors (this time not Arthur Andersen) failed to stand up to the management or didn't understand what was happening. The board, primarily made up of independent directors, and the audit committee, made up entirely of independent directors, were unable to penetrate the scam and remained clueless as earnings were manipulated. In Fannie's case there was also a regulator, but the regulator did not begin to look into any problems until it had been surprised by similar wrongdoing at Fannie's smaller sibling, Freddie Mac.

What we should learn from this--much of which occurred after the adoption of Sarbanes-Oxley--is that a board made up primarily of independent directors, an audit committee made up entirely of independent directors, a Big Four accounting firm alerted to the dangers of accounting fraud, and a regulator that claimed to be fully on top of what was happening, could not prevent senior management from fudging the accounting and misleading the board and investors. No surprise there. Many observers were saying, both before and after the enactment of SOX, that a management determined to defraud or mislead could evade the scrutiny of all the gatekeepers.

This has important implications for the legislation now before Congress to reform the regulation of Fannie and Freddie and limit the size of their portfolios. Since dishonesty and incompetence are an unavoidable fact of life, and gatekeepers are unreliable, investors must protect themselves by diversifying their investments. But there is good reason to believe that diversification would not be available if dishonesty or incompetence at Fannie or Freddie in the future resulted in the collapse or financial incapacity of either.

Fannie and Freddie are not ordinary companies. They have almost $1.5 trillion of debt outstanding, which they borrowed to buy and carry portfolios of mortgages and mortgage-backed securities; these portfolios expose both companies to enormous interest-rate and prepayment risk. To hedge this risk, Fannie and Freddie are parties to derivatives transactions with notional values in the trillions, in which the counterparties are some of the largest financial institutions; any failure of Fannie or Freddie to meet its obligations would expose these institutions to substantial losses. Fannie and Freddie debt is also held widely by banks and other financial institutions, in some cases accounting for more than 100% of their capital; a decline in the value of that debt would seriously weaken these organizations and reduce their capacity to lend.

Finally, both companies are central to the real-estate financing market. If either of them could not function normally, that market--amounting to almost a third of the economy--would freeze up. As Alan Greenspan has pointed out for years, the risks inherent in the portfolios carried by Fannie and Freddie add up to huge systemic risk--the danger that a failure at either company will spread to the economy as a whole.

So here is the key difference between Enron and either Fannie or Freddie. Dishonesty or incompetence in Enron's management hurt shareholders and employees, both of whom could have protected themselves through diversification of investments. Dishonesty or incompetence in Fannie's or Freddie's managements could throw the economy into chaos, and from that catastrophe diversification provides no shelter. Faith in boards, audit committees, auditors and even regulators has been shown to be misplaced. Sure, Congress would likely come in and bail them out--but immediately, without extended debate, and with trillions of taxpayer dollars potentially at risk? Not a chance. And the damage in the meantime would be devastating.

As reform legislation languishes in the Senate, Congress should consider the lessons of Enron, Fannie and Freddie: Despite our best efforts, error and fraud will occur. That's why it's important to make sure--by reducing the size of Fannie and Freddie's portfolios--that no future management failure at either company will threaten the stability of the economy.

Peter J. Wallison is a resident fellow at AEI.