Arthur F. Burns Fellow Peter J. Wallison

With portfolios of almost $3 trillion, capital of $65 billion, and no obvious end to the fall in home values, the continued solvency of Fannie Mae and Freddie Mac has to be in question. Last week, Freddie shocked Wall Street with a quarterly loss of over $2 billion, and in their subsequent discussion with analysts, Freddie's management indicated more and larger losses could be expected.

Fannie reported a somewhat smaller loss a few weeks earlier, and most likely it will continue along the same path on which Freddie is now embarked. Since no one can predict where the bottom of the housing market may be, it is important to recognize that a loss of, say, 3% on portfolios of $3 trillion would easily wipe out what is left of their capital.

If this comes to pass, the failure of the Senate Banking Committee to take up and pass regulatory reform legislation that the Democratic-controlled House passed months ago will be a blunder of the first order. H.R. 1427, the Federal Housing Finance Reform Act, gives the regulator of these government-sponsored enterprises important new powers, including authority to wind down the GSEs in an orderly way in the event of insolvency. Without that power, Congress will have no choice but to bail out the institutions--possibly with as much or more taxpayer money than it used to bail out the S&L industry only 15 years ago.

Fannie and Freddie are chartered by Congress through special legislation, and they are not covered by the bankruptcy laws, by state laws governing corporate insolvencies, or by the laws relating to the liquidation of insolvent banks. In fact, there is very little that their regulator, the Office of Federal Housing Enterprise Oversight (OFHEO), can do in the event that their losses mount to the point that they become insolvent.

If that happens, there are only two courses available. First, OFHEO could step in as a conservator, a power it has under the current GSE chartering legislation. But a conservator--in contrast to a receiver--has very little authority. Conservators can take control of failing companies and operate them in a way that preserves their assets and whatever value remains for their shareholders. Unlike receivers, however, conservators have no authority to reorganize or wind down an insolvent company by selling its assets and paying off its creditors.

The legal authority of OFHEO as a conservator is further muddied because there has never been a conservatorship or a liquidation of a government-sponsored enterprise. The legal disputes that are bound to ensue as OFHEO struggles to refloat these institutions will be daunting and well-nigh endless. In the best case, OFHEO will be able to put new management in place that will stanch the losses. The more likely outcome is that the condition of both GSEs in conservatorship will continue to deteriorate, resulting eventually in a government recapitalization.

The alternative to conservatorship is, if anything, worse. Even if Fannie and Freddie are insolvent, they will not become illiquid; the capital markets will continue to fund institutions they believe are backed by the federal government. Thus, it will be tempting for all concerned simply to wait for things to improve, leaving the GSEs' current managements in place.

This has been done before. In the early 1980s, a much smaller and less-important Fannie became insolvent when inflation caused interest rates to rise substantially, reducing the value of Fannie's assets. Despite its insolvency, Fannie survived because its government backing enabled it to roll over its debt. The same would be true today, as shown by the fact that the financial markets have been willing to accept GSE debt, even though neither company has been able to publish audited current financial statements for several years. But this time, the decline in asset values will come from credit losses, not interest-rate fluctuations, and thus cannot be waited out.

Allowing either of these GSEs to continue operating would be a disaster for the taxpayers, and the S&L industry experience shows why. As long as a company is insolvent, it has nothing to lose--and everything to gain--from risk-taking. The fact that insolvent S&Ls were allowed to continue to operate through much of the 1980s was the major source of the $150 billion in losses they ultimately imposed on the federal government and the taxpayers.

The GSEs are nothing more than huge S&Ls, but in one respect they are more dangerous. The S&Ls were fueled in their risk-taking by federally insured deposits of up to $100,000, but Fannie and Freddie have what the capital markets consider to be government backing for all their debt.

Thus, as long as they are permitted to operate, they will do so without the tempering effect of market discipline and under the supervision of a regulator that has fewer powers than the Federal Home Loan Bank Board, the late and unlamented regulator of the S&Ls. Under these circumstances their managements will, as the S&Ls did in their day, "gamble for resurrection," with the U.S. taxpayer ultimately on the hook if the risks don't pan out.

There is a responsible solution. A Congress that is now consumed with the usual desire to "do something, anything" about the subprime mortgage mess could, for a change, try to do something that actually addresses a foreseeable problem.

Beginning with the Senate Banking Committee--headed, incidentally, by presidential candidate Christopher Dodd--it could adopt, unchanged, the legislation passed by the House last May. With the powers of a receiver, the GSEs' regulator could if necessary reorganize the companies, reduce their assets and liabilities, and possibly keep them afloat. If Congress fails to act, and the worst occurs, taxpayers are unlikely to forget who let it happen.

Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies at AEI.