After years of neglect Congress and the administration have finally begun to consider legislation on Fannie Mae and Freddie Mac, but what they have put on the table does not address the real issue.

These two companies were created to increase the availability of residential mortgage credit by purchasing mortgages from banks and other lenders, thus making more funds available for mortgage lending. Although originally established as government agencies, they were permitted to become private companies--both are now listed on the New York Stock Exchange--while retaining government charters and so many other government links and benefits that they are known as government-sponsored enterprises.

This status, which has persuaded the capital markets that the government will not allow them to fail, enables them to borrow at Treasury-like rates and thus to keep all competition out of their one authorized business: buying high-quality middle-class mortgage loans from banks and other lenders.

Without significant competition in this growing market, the GSEs have doubled in size every five years for the last 20 and are now two of the four largest financial institutions in the United States. Together they hold or guarantee about half of all residential mortgages and have incurred debt and guarantee obligations now totaling about $3.5 trillion.

It is in the shadow of this enormous obligation, implicitly backed by the government and hence the taxpayers, that Congress and the administration have pledged themselves to create a better regulatory system for Fannie and Freddie.

Unfortunately, we are all well beyond the point where regulation alone will be effective. There are three principal reasons for this.

• First, as shown by the S&L debacle of the late 1980s, when dealing with politically powerful companies like the GSEs, regulatory agencies will not act--indeed Congress will prevent them from acting--until a crisis has arrived. So it is highly unlikely that any regulator will be able to rein in the growth of these companies or control their risk taking until a crisis occurs.

Then, of course, it is too late. Indeed, the only reason we have congressional interest now is that Freddie Mac attracted attention to itself by firing its top three officers a few months ago, a dramatic event that provoked media coverage. Otherwise, Congress would have let that sleeping dog lie--and grow--a good while longer.

• Second, the idea that Fannie and Freddie can be regulated like banks and thus kept safe and sound is misplaced. Although banks are regulated, they are still subject to some market discipline. Bank deposits are insured only up to $100,000, and other forms of debt are not protected at all. Nondeposit creditors of banks are therefore at risk, and have a strong interest in following the banks' financial condition.

But because all the obligations of the GSEs are deemed to be backed by the government, without any explicit limit, no creditor is truly at risk, and market discipline is far weaker than is the case with banks. So before disaster strikes, regulators will get few or no signals from the private sector that something is amiss.

• Finally, unlike bank regulation, there is no room here for even the smallest regulatory error. Banks, although heavily regulated, fail all the time. Over a thousand failed in the late 1980s and early 1990s, some of them quite large. But when a bank fails it usually has only local effect.

The failure of either GSE would be quite a different matter. There are only two of them and they are both central to the operation of the residential mortgage finance system in the United States. Any failure or weakening of either would have a devastating effect on the housing market, and through housing on the rest of the economy.

In other words, our economy and the welfare of the taxpayers is currently hostage to the decisions of only two managements. If either makes a serious mistake--one involving the financial health of the company--the economy will be in serious trouble.

As shown by our experience with banks, regulation cannot prevent such mistakes. Indeed, Freddie Mac's regulator did not know of the accounting manipulations that caused the dismissal of its principal officers.

Therefore, the only way to effectively protect the economy and the taxpayers is to separate the GSEs from the government--to privatize them fully by cutting their government links and their special privileges. This would subject them to market discipline as well as to much needed competition.

But the proposals now before Congress, including those from the administration, do not recognize this. They rest on the false premise that regulation can be effective with these politically powerful companies.

In this, they are more than misdirected; they are creating a false sense that the government is addressing a problem that it is really sweeping under the rug one more time.

Peter J. Wallison is a resident fellow at AEI.