The interim report on Fannie Mae by its regulator, the Office of Federal Housing Enterprise Oversight, raises an important question. Will strengthening the U.S. mortgage company's regulation--the current focus of congressional reformers--protect taxpayers and the economy against the losses that could occur if either Fannie or its smaller cousin, Freddie Mac, should encounter financial difficulties?
Although much of the media focus has been on the governance issues cited in the OFHEO report, far more important was the regulator's charge that Fannie's management deliberately cooked the books. It is obvious that when a management fails to abide by the rules, regulation is useless and stricter regulation--by a larger and more competent regulator--is likely to provide no better solution.
Although we sometimes assume that regulators are all-seeing, that is not the case. If a management wants to evade the rules, its most significant and risky decisions are taken by a small group at the top of the company and withheld from the regulators. Indeed, the sequence of events that led to the OFHEO report on Fannie is the best example of this phenomenon, since the report would probably never have been written, or even attempted, if the board of Freddie Mac had not discovered almost two years ago that its own management was fudging the company's financial reports. The resulting dismissals were a surprise, not only to the market but to OFHEO as well. Thus, despite the fact that OFHEO was regularly receiving reports from Freddie and had supervisory staff regularly present in Freddie's offices, it did not discover that Freddie was manipulating its numbers until it was told the day before Freddie's board fired the company's top management.
Having been alerted in this embarrassing way, OFHEO drew the logical inference that if Freddie was not reporting its results accurately, Fannie might be doing the same. As a result, it sought and received a special congressional appropriation to carry out a forensic audit, hired an auditing firm, and began to look for activities similar to those reported by Freddie. The outcome was the current interim report on Fannie, with more certainly to come. It seems clear that if Freddie's board had not discovered the truth and acted forcefully, we and OFHEO would still be unaware of what was happening at Fannie.
The lesson we should draw from this is as sobering as it is timely: that regulation alone--even strict regulation--is a very weak reed if we are hoping to prevent the financial dislocation and loss that would follow the failure of Fannie or Freddie. The success of regulation is wholly dependent on the willingness of managements to abide by the rules and, while most managements willingly do so, there are instances--such as our recent experience with Fannie and Freddie--where they do not. While we can absorb the occasional bank failure that results from these random acts of evasion, there are cases where this risk is unacceptable--where the entity involved is so large and so vital to the general health of the economy that we cannot take the risk that its managements will evade the rules.
Fannie and Freddie both fall into this category. A financial failure of either would throw residential mortgage markets into chaos and the necessary and almost inevitable government bailout would ultimately cost taxpayers a bundle. For this reason, the only real protection for taxpayers and the economy is to remove the government backing from Fannie and Freddie and to turn them into private entities--just two more competitors in a competitive secondary mortgage market. This is the point that Alan Greenspan, Federal Reserve chairman, has been making: that there is danger in the concentration of mortgage risk in just two entities and that the only realistic and viable solution is privatisation.
There are of course objections to privatisation. Some contend that it would leave Fannie and Freddie as the dominant players in the mortgage markets, unregulated and so large as to be too big to fail. Others argue that mortgage rates would increase. All these concerns can be addressed. Fannie and Freddie could easily be reduced in size in the course of privatisation and minor changes in regulation could lead to a mortgage financing system that produces lower rates without government backing.
But the most important step is to recognise now that merely tightening the regulation of Fannie and Freddie will not be sufficient and that it will leave U.S. taxpayers and the economy vulnerable to serious losses if the managements of either company decide to ignore or evade the strictures of regulation.
Peter J. Wallison is a resident fellow at the American Enterprise Institute and coauthor, with Thomas Stanton and Bert Ely, of Privatizing Fannie Mae, Freddie Mac and the Federal Home Loan Banks: Why and How.