Congress has been working for more than a year now to tighten the regulation of Fannie Mae and Freddie Mac, the two troubled government-sponsored mortgage companies that have helped banks to finance home ownership for millions of Americans. Accounting problems at both have spurred this effort, because it has become clear that if the companies should fail or otherwise encounter a severe financial setback, it would pose a considerable risk to taxpayers (who may have to bail them out) and the economy in general (because of their dominance of the residential mortgage market and the potential vulnerability of their financial partners).

Yet, as much as tougher regulation of Fannie Mae and Freddie Mac is warranted, Congress has so far circled the central issue instead of engaging it. The purpose of tighter regulation is to reduce or control the companies' risks. But we already know why these risks arise: Fannie Mae and Freddie Mac have accumulated portfolios of mortgages amounting to $1.7 trillion that are financed largely by short-term borrowing. Much of their income depends on the spread between the interest rates on the long-term mortgages they purchase from commercial lenders and the short-term rates on the money they borrow--a strategy that makes them extremely vulnerable to changes in interest rates.

In recent Congressional testimony, the Federal Reserve chairman, Alan Greenspan, made a notably sensible suggestion: limit the size of Fannie Mae and Freddie Mac's portfolios of mortgages and mortgage-backed securities to $100 billion to $200 billion. He is likely to repeat this idea, and perhaps go beyond it, in Senate testimony scheduled for Wednesday. A restriction of this kind would substantially reduce the interest rate risks faced by Fannie Mae and Freddie Mac without interfering with their support for the residential housing market. Instead of holding mortgages for investment, they would expand their existing business of pooling these mortgages and selling interests in them as mortgage-backed securities that offload the interest rate risk onto investors. This idea, of course, is not new: Fannie Mae and Freddie Mac have been doing this for many years and now bear the credit risk--but not the interest rate risk--of $1.5 trillion in outstanding mortgage-backed securities.

Advocates for Fannie Mae and Freddie Mac will point out that limiting their ability to buy and hold mortgages and mortgage-backed securities will substantially reduce their profits, and they will be right. Both companies profit handsomely from using their government-granted financing advantages to buy and hold these assets, which pay considerably higher interest rates than they have to pay to their lenders. But Congress ought to understand that this strategy is a classic case of making society take the risks while private investors take the profits--just as the savings and loan associations that went belly up in the late 1980's did. If Fannie Mae and Freddie Mac profit from the interest rate risks they are taking, the management and the shareholders pocket the gains; but if they fail or suffer financial reverses because of this risk, the taxpayers will bear the burden.

If there were some evidence that this risk-taking was necessary to make the country's mortgage system function, then it might be argued that the taxpayers should take these risks because they receive benefits as homebuyers. Mr. Greenspan and other eminent economists have advised Congress that this is not the case. When the companies borrow to buy and hold mortgages, it does nothing to reduce mortgage rates.

Since Mr. Greenspan's testimony, the chairmen of both the Senate Banking Committee and the relevant House subcommittee have said that they will consider limiting the size of Fannie Mae's and Freddie Mac's portfolios as part of the legislation they are developing. If so, this proposal will properly be the key element of the Congressional debate. Both Fannie Mae and Freddie Mac will not like it. But tightening regulation of these two companies without reducing the real source of the risks they create would be like bailing furiously while ignoring the hole in the boat.

Peter J. Wallison is a resident fellow at AEI.