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With each new month, more bad news piles up about Freddie Mac and Fannie Mae, the two government-chartered, but publicly traded, mortgage finance companies. This month, Freddie Mac reported that it expects a more than $1 billion loss in the second half of 2006. In a December filing with the Securities and Exchange Commission, Fannie Mae released its final report of after-tax loss in earnings in the amount of $7.9 billion for fiscal year 2002 through fiscal year 2004. And, notwithstanding the progress that Fannie has made in filing its financial statements, Standard & Poor’s has recently found pervasive deficiencies in Fannie’s internal controls. If Fannie or Freddie were to become insolvent, the American taxpayer would be on the hook for the cost of making good on the implied guarantee that the federal government gives to investors who have purchased the many hundreds of billions of dollars of Fannie and Freddie securities that are currently outstanding. But the chances are slim that Congress will meaningfully reform the regulation of these two scandal-ridden companies. This is notwithstanding the fact that House Financial Services Chairman Barney Frank, D-Mass., now believes that the House will pass a reform bill in April. The bill now being considered by Frank’s committee, in consultation with the Treasury Department, would slightly increase the funding and supervisory power of Fannie and Freddie’s federal regulator, the Office of Federal Housing Enterprise Oversight (OFHEO). But the bill would leave OFHEO far weaker than necessary to supervise these two financial behemoths. And of greatest importance, the bill would not address the really bad news about Fannie and Freddie: the federal government’s implied guarantee of their tremendous financial obligations. The Federal Reserve should therefore act independently to limit that exposure as much as possible until Congress is able to come up with a proportionate response to this latent crisis. Alan Greenspan and Benjamin Bernanke, the past and current chairmen of the Federal Reserve Board, have both recognized this precise risk. So the good news is that the Federal Reserve can start taking actions independently that would reduce the magnitude of the threat that these companies pose to the international financial system and the American taxpayer. (Yes, these companies are so large that the failure of either one would present a serious risk to the entire international financial system.) The Federal Reserve Board grants Fannie and Freddie significant privileges that treat them as instrumentalities of the federal government. First, the Federal Reserve regards Fannie and Freddie’s obligations as the equivalent of explicitly guaranteed government securities. Second, Federal Reserve banks act as fiscal agents for Fannie and Freddie, a role that they primarily play for the federal government. Finally and most importantly, Fannie and Freddie’s securities are eligible for unlimited investment by state banks that are Federal Reserve members, a policy which signifies that those securities are no-risk investments on par with Treasury securities. These special privileges reinforce the implied guarantee that has allowed Fannie and Freddie to issue such extraordinarily large amounts of securities and thus become such risky ventures for the entire financial system. Federal Reserve must act The Federal Reserve should stop granting privileges to Fannie and Freddie that exceed those required by statute. This will work to reduce the amount of Fannie and Freddie securities that are outstanding by making them less attractive investments. It will also signal to investors that the federal government will not necessarily guarantee those securities. Such a course will have the short-term benefit of reducing the risk that such debt poses as well as the long-term benefit of putting pressure on Congress and Fannie and Freddie themselves to hammer out a solution that meaningfully protects the American taxpayer. Many financial crises have their Cassandras, vainly attempting to warn a heedless public of impending ruin. The Savings & Loan fiasco of the 1980s as well as the more recent Internet bust come to mind. The magnitude of the crisis posed by the more than $1.5 trillion of outstanding Fannie and Freddie debt could easily dwarf those earlier ones. Unlike Cassandra herself, the chairman of the Federal Reserve has the power to prevent the crisis that he himself has predicted. It remains to be seen whether he in fact will do so. The stakes may be hundreds of billions of dollars from the public’s purse. So let’s hope he does. David J. Reiss is an associate professor of law at Brooklyn Law School.

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