Reform's Chance

The Senate has an opportunity to strengthen Fannie Mae and Freddie Mac. It must seize it.

THE CAUSE of reforming government-sponsored enterprises (GSEs) may not be a lost one after all. Last week, a meeting involving Treasury Secretary Henry M. Paulson Jr., Senate Banking Committee leaders and the heads of the GSEs -- Fannie Mae and Freddie Mac -- ended with all sides pronouncing themselves ready to settle the issue at last. The House passed a bill to tighten regulation of the mammoth mortgage companies almost a year ago, but the effort stalled in the Senate. Sen. Richard C. Shelby (Ala.), the ranking Republican on the Banking Committee, had well-founded concerns that a new law might be too weak. Now he appears willing to deal.

Since another opportunity to craft a good law may not come around soon, it is essential that Congress get it right this time. If the lawmakers achieve nothing else, they must at least provide solid assurances that the GSEs maintain a sufficient capital base. Under current law, Fannie and Freddie are required to hold a reserve fund equal to 2.5 percent of their assets -- only half the ratio required of commercial banks. That thin layer of protection reflects the implicit guarantee of a federal bailout that the GSEs enjoy. (The GSEs have held somewhat more in reserve in recent months due to a temporary agreement with their regulator.) But given the immense size of the GSEs -- they currently hold or guarantee $5 trillion worth of mortgages, about 80 percent of the market -- everyone would be better off if they could rely more on their own resources. At the moment, the firms' losses are significant: $3.6 billion in the fourth quarter of 2007 for Fannie and $2.5 billion for Freddie. Losses could grow as Fannie and Freddie take on more risk to help prop up the housing market. And if you think the economy looks shaky now, just watch what happens if a GSE goes belly up.

Fannie and Freddie have recently promised to raise more capital in the financial markets, though it remains to be seen how well they'll do, given that selling more stock is not in the short-term interests of current shareholders. And they have long resisted tighter statutory capital requirements because shareholders wanted the companies' spare cash to be spent on dividends. The House bill originally permitted a proposed new GSE regulatory body to adjust capital requirements to reflect not only the safety and soundness of the firms but also the "systemic risk" posed by their activities -- i.e., the threat that their collapse might pose to the economy as a whole. In the end, however, that provision was removed. It should be restored by the Senate. With great wealth and power come great responsibility. The GSEs must be more closely supervised, because the national interest comes first.