Arthur F. Burns Fellow Peter J. Wallison

If Fannie Mae and Freddie Mac were ordinary corporations, the sudden collapse of investor confidence last week would have set them to work on their bankruptcy applications. But they are not ordinary corporations--and they are likely to survive because their debt securities have been viewed for decades as ultimately backed by the U.S. government. Barring the unlikely event of a credit market loss of confidence in the U.S. government itself, they should be able to attract the necessary financing for continued operations.

The key judgment about their financial condition will not be made by the equity markets, but by their regulator, the Office of Federal Housing Enterprise Oversight (OFHEO). As long as OFHEO believes they are adequately capitalized--as James Lockhart, the director of the agency, affirmed in a public statement last week--they will continue to operate: buying, holding and securitizing mortgages as they have for decades. And last night the Treasury and the Federal Reserve announced they would take steps to prop up the two corporations if and as needed.

So there is no reason for stock market panic, nor for handwringing in the credit markets about an imminent default. Indeed, with the Senate finally--after months of dithering--passing legislation on Friday for a strong new Fannie and Freddie regulator, there is hope that the government will finally be able to rein in the excesses of these enterprises.

Yet there is little evidence the real lessons have sunk in. Just as the grave risks Fannie and Freddie create for taxpayers are finally being recognized, Fed Chairman Ben Bernanke and Treasury Secretary Henry Paulson were asking a seemingly compliant Congress to involve the Fed in supervising the largest investment banks--which will only create similar risks elsewhere in the economy. (More on this later.)

Although they are owned by shareholders, Fannie and Freddie are government sponsored enterprises, or GSEs, chartered by Congress to perform a government mission: providing a national market for mortgages and enhancing the availability of affordable housing. This, together with a brace of special statutory exemptions and the fact that the U.S. government has always bailed out its GSEs, has led the capital markets to believe, correctly, that the U.S. government will never allow Fannie and Freddie to fail.

The result has been a complete loss of market discipline, uncontrolled growth, and the development of two giant companies whose deteriorated financial condition now threatens the stability of both the U.S. and the world economy. The story of Fannie and Freddie is a cautionary tale about the moral hazard created by government support for private institutions--a tale we saw played out in the S&L debacle less than 20 years ago, and one we may be about to inflict on ourselves again.

There might have been a time when it was possible to believe that the feds would not stand behind Fannie and Freddie's obligations, but today, the possibility that any holder of their senior debt (or their mortgage-backed securities) would be allowed to suffer a loss is simply unimaginable.

First, because of unprecedented conditions in the capital markets, they are now virtually the only consistent buyers and securitizers of U.S. mortgages. If they could no longer raise the necessary funds to continue this activity, housing finance--already very weak--would come to a halt. The consequences for the housing market in the United States would be dire.

The result of a GSE default for the financial markets and the world economy would, if anything, be even worse. Fannie and Freddie's debt securities are held by thousands of U.S. banks--often in amounts in excess of their capital--and in large amounts by financial institutions around the world. Many of the world's most important central banks also hold huge inventories of these securities.

If there were ever the slightest doubt that the U.S. would stand behind these obligations, there would be a rush for the exits that would make what occurred in the equity markets last week look like a stately minuet. The value of GSE debt securities would plummet, and with it the capital of virtually all the world's major banks and other financial intermediaries. With weakened capital, lending would decline and further damage already weak economies, perhaps with truly disastrous results.

Thus, because the U.S. government will not allow Fannie and Freddie to default, they should be able to survive. If housing prices turn up again and their losses are stanched (or if they can raise more capital to cover the losses they will suffer in the future), these two companies will get through this period. This is by far the most likely outcome of the current period of stress.

But their survival will not be unalloyed good news. It will chase the wolf from the door only temporarily. Their embedded losses--made worse by the risky commitments they are probably now making in order to recover their profitability or hide their losses--will, as in the case of the S&Ls, eventually have to be paid. And of course, if Fannie and Freddie actually become insolvent, the U.S. government is now ready to step up. Considering that these two companies now have something like $5.3 trillion in liabilities, this is no small step.

This is a bad state of affairs; the U.S. government has lost any room to maneuver. Worse still are indications that no lessons have been learned. In the same week when it became apparent that implicit government backing has made the U.S. hostage to the health of two companies that grew out of control, Messrs. Bernanke and Paulson told Congress that they wanted a new regulatory structure for investment banks like Bear Stearns.

In this plan, the Fed would have supervisory authority over these companies and oversee a formal system for their "orderly liquidation." The only reason the Fed might want to regulate the investment banks is that it believes itself to be somehow at risk. The markets, ever clear-eyed, will read this for what it is--potential Fed backing if the big investment banks get into trouble. In other words, we are now proposing to introduce a government-created moral hazard into investment banking. The resulting loss of market discipline will replicate the experience with the S&Ls and Fannie and Freddie.

According to reports, not an eye blinked in the House Financial Services Committee when the Fed's bid for more power was laid on the table last Thursday. This is fully consistent with the past willingness of Congress to condone--and even encourage--unimpeded growth at Fannie and Freddie.

If Congress actually believes that the Fed can assume responsibility for supervising and liquidating the large investment banks--and yet not become responsible for bailing them out when their enhanced access to capital results in massive losses--they deserve to wrestle with the future crisis they are now setting in train. But the American people do not.

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