TCS Daily


An Alarming Precedent

By Duane D. Freese - July 28, 2005 12:00 AM

With all due respect to Voltaire, it is not so much that the perfect is the enemy of the good as the "meaningful" that's the enemy of the appropriate.

At least that is the case with the newest proposed reforms of Fannie Mae and Freddie Mac, the two congressionally chartered private companies that have made America's mortgage markets the deepest and soundest in the world.

In the aftermath of financial scandals involving the two companies, everyone recognized that they needed better oversight -- a new regulator for the two government-sponsored enterprises, setting safety, soundness and risk-based capital standards, as well as ensuring appropriate auditing and disclosures to Congress.

All those steps make sense. They are appropriate and they have bipartisan support. But some in Congress have seen the window to reform open and want something more "meaningful."

"We're not interested in consensus just to get a bill," says Senate Banking Committee Chairman Richard Shelby, R-Ala. "We want a meaningful bill."

And what is meaningful? Well, the bill Sen. Shelby has authored is today before the Senate Banking Committee. And rather than focus on safety and soundness, it would severely curtail certain kinds of investments by the mortgage makers, in essence forcing them to shed themselves of most of their $1.5 trillion in mortgage portfolios that back their debentures sold to foreign investors.

The justification for such a forced divestiture was summed up by Federal Reserve Chairman Alan Greenspan in Senate testimony earlier this year.

"We at the Federal Reserve remain concerned about the growth and magnitude of the mortgage portfolios of the Government Sponsored Enterprises (GSEs), which concentrate interest rate risk and prepayment risk at these two institutions and makes our financial system dependent on their ability to manage these risks," he said.

In his testimony, Greenspan said that Fannie's and Freddie's portfolios at the current time and level pose no systemic risk. Yet, the only "meaningful" reform had to be divestiture. Why? Well, Greenspan provided the rationale for that as well: "World-class regulation, by itself, may not be sufficient and indeed might even worsen the potential for systemic risk if market participants inferred from such regulation that the government would be more likely to back GSE debt in the event of financial stress."

In short, the more involved the government is, the more investors might think they have nothing to lose if they invest, and the more reckless Fannie and Freddie might become with the money invested with them, putting in deeper danger the nation's financial system.

But there is a big problem with this kind of thinking. It is a slippery slope argument, and it amounts to sloppy thinking. As James C. Miller III, a consultant to Freddie Mac who chaired the Federal Trade Commission and later the Office of Management and Budget under Reagan, noted in a Washington Times column: "Forcing financially sound companies to divest the bulk of their assets would be unprecedented."

"Conservatives," he argued. "should be alarmed at the precedent this proposal would set. Once government grants itself this power, why couldn't it eventually be applied to other companies and industries?"

Miller wrote that his own CapAnalysis Group's stress tests for inflation, interest and default scenarios found Freddie, at least, survived far better than other financial institutions.

Shouldn't Congress, before ordering a business to divest itself of assets, prove that it really poses a danger? And couldn't it try to do something less drastic? Appropriate oversight would include risked-based capital standards and focus Fannie and Freddie on their mission -- promoting affordable housing for all Americans.

Being supported by consensus, such appropriate reform might even prove meaningful -- protecting the interests of taxpayers against any bailout and homeowners in seeing the mortgage market remain deep.

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