In an unusual and even courageous step, the Office of Federal Housing Enterprise Oversight last month took on the question of whether Fannie Mae and Freddie Mac pose a systemic risk to the U.S. economy. The comprehensive report, which considered a number of possible scenarios, described how financial troubles at Fannie and Freddie might cause serious harm to the general economy, and how that harm might be averted.

The verdict: There is no significant danger now, because Fannie and Freddie are currently healthy, but even today they are so large that an unresolved financial crisis affecting either of them could seriously damage the nation's economy as a whole. And since they are growing rapidly, the threat they pose grows along with them.

This is a serious and sobering thought, especially because OFHEO--as a government agency--was unable to include in its report the two most significant reasons why Fannie and Freddie create systemic risk.

First, it would have been impolitic for OFHEO to point out to Congress that the health of the entire home financing structure in this country rests on the decisions of only two small groups--the executives of Fannie Mae and Freddie Mac. It is, after all, Congress that established and perpetuates this structure, and it is not for regulatory agencies to question the wisdom of Congress. Yet the fact remains that if the management of either of these companies seriously miscalculates its company's risks, both the residential financing system and the real economy of the United States will be in serious trouble.

This situation has arisen because Congress, which gave Fannie and Freddie what is in effect a joint monopoly over the secondary mortgage market almost a generation ago, has thus far been unwilling to reconsider the decision, even though these two companies have grown to mammoth and market-moving dimensions.

Today, Fannie and Freddie--which are in the business of buying mortgages from banks and other lenders, and thus creating a secondary mortgage market and liquidity for mortgage lenders--completely dominate the home mortgage business. It is accurate to say that the market could not function today with its current efficiency without both of them operating at full capacity.

But this also means that if for any reason one or both of them is unable to perform their functions, lenders will be unable to liquidate their balance sheets by selling their mortgages; mortgage lending will slow and interest rates rise; homes will not be bought or sold so easily; home construction will slow; and all the businesses that depend on a vigorous housing market will be harmed. This is the very definition of a systemic effect.

To be sure, the private sector will eventually be able to take up the slack, but it will take time before private secondary-market players have the capacity to handle the existing market now served by Fannie Mae and Freddie Mac. Needless to say, this would not be a problem if the secondary market for conventional conforming mortgages--the middle-class mortgages Fannie and Freddie alone are able to buy and sell--consisted of more than two gigantic companies.

A good example of how a diversified market achieves stability was the unexpected fall of Enron Corp. In that case, one of the country's largest companies sank suddenly and without a trace, but the highly diversified and competitive energy market continued to function satisfactorily. In finance as in biology, diversity creates stability, and lack of diversity creates the conditions for catastrophic collapse.

The second major systemic risk factor that OFHEO could not mention in its report is related to the first. The report notes that one of the best defenses against a collapse by Fannie or Freddie is OFHEO's own ability to supervise and regulate these companies--in effect to stop bad decisions before they damage safety and soundness.

This idea is unrealistic. As we saw in the S&L crisis, efforts by a regulatory agency to limit an industry's growth are often met by congressional opposition if it will mean higher costs for consumers. If OFHEO, finding risky activities at Fannie and Freddie, tried to restrict their growth, it would be strongly opposed both by the two companies themselves and by those in Congress who fear the resulting rise in home mortgage rates.

This is opposition that OFHEO will not be able to resist. The likelihood, then, is that Fannie and Freddie will be allowed to stay on their risky course--as were the S&Ls--because Congress does not want to face the short-term result of a regulatory crackdown.

In the end, the only protection against the systemic risk associated with Fannie and Freddie is their full privatization, so that a fully competitive secondary mortgage market will develop in this country. In that way, if one or more of the players encounters financial difficulties there will be no collapse in residential lending and no systemic effect on the general economy.

Peter J. Wallison is a resident fellow at the American Enterprise Institute. He was formerly general counsel of the Treasury and White House counsel for President Reagan.