Are Fannie and Freddie safe and sound?

• Author: Wallison, Peter J.
• Position: Letter From Washington

The recent management shakeup at Freddie Mac has significant implications for that company as well as its larger sibling, Fannie Mae. Until the company finally publishes its revised financial statements, we will not know for sure whether there is a serious problem underlying all the speculation, but the very shock caused by the abrupt departure of its top three officers has already changed the political landscape on which these government-sponsored enterprises (known as GSEs) have previously operated. Despite efforts by Freddie Mac to minimize the importance of what occurred, the event has significant implications for those--investors, policymakers, and analysts--who are concerned about the future of Fannie and Freddie.

The first and most obvious implication is that the GSEs will now likely have to accede to the adoption of legislation that requires them to register both their equity and debt securities with the Securities and Exchange Commission. Although legislation to accomplish this was introduced shortly after the Enron debacle, the GSEs had successfully staved it off by agreeing to register their equity securities voluntarily under the Securities Exchange Act of 1934. This enabled them to avoid the registration of the securities they issue regularly--mortgage-backed securities--and the stringent prospectus disclosure this would entail. The surprise associated with the Freddie Mac shakeup appears to have given the original legislation--known as the Shays-Markey bill--new life, and it now seems likely to pass.

It is also possible that Congress will retain enough interest in this subject--for a sufficient length of time--to enact what might be considered "tougher" regulation. Thus far, the focus of the reform effort--principally by Representative Richard Baker (R-LA)--has been to find a more muscular regulator for the GSEs. Both the Federal Reserve and the U.S. Treasury have been suggested as candidates. But the most significant risk for Fannie and Freddie in any such legislation would not be a larger and perhaps more forceful investigator of their safety and soundness; it would be that any new legislation might forbid outright--or give their new regulator authority to limit--their purchases of whole mortgages and mortgage-backed securities. It has become clear that their financial risks derive principally from their accumulation of portfolios of whole mortgages and mortgage-backed securities, which requires them to take interest rate...