Heritage Foundation Leadership for America

The stock of mortgage giants Freddie Mac and Fannie Mae fell sharply this week. The drop not only shows how far they've fallen in investors' esteem - it calls into question both how the government regulates the companies and plans in Congress to milk the two to cover other housing outlays.

Fannie and Freddie were originally chartered by the federal government - and that's a big reason they've prospered for decades. Both buy mortgages from lenders and package them into securities that are sold around the globe, and also invest in mortgages and mortgage-related securities. But their borrowing costs are greatly lowered because it's assumed that the feds stand behind their debt.

But the subprime crisis has investors nervous about any mortgage-linked investment. Triggering Monday's sudden sell-off was a research report suggesting that an accounting-rule change would force both to raise tens of billions of dollars of new capital.

The drop was brutal: The two companies lost roughly 20 percent of their value. Then Jim Lockhart, the head of the Office of Federal Housing Enterprise Oversight, stepped in to calm the fears. He pointed out that his agency decides whether Fannie and Freddie are adequately capitalized - and the stocks regained about half their losses the next day.

But the real damage has been done. Investors are starting to see what some have warned about for years - namely, that both Fannie and Freddie are far riskier propositions than many, especially in Congress, have thought.

This "revelation" is long past due. Together, these entities underwrite about 80 percent of the mortgage-backed securities market. The failure or severe mismanagement of either one could have major consequences for the rest of the economy.

Why have years of warnings about Fannie and Freddie's financial condition largely fallen on deaf ears? Mainly because the two have built auras as invincible, all-knowing and essential parts of the economy. Their lobbying muscle is legendary in Washington. Even a series of major accounting scandals, which forced senior managers in both companies to resign, failed to really dent this image.

Increased investor scrutiny and regulatory oversight is long past due, and we can all be grateful if Monday's panic leads to this. The one good part of the Senate's housing bill would impose a stronger oversight of both Fannie Mae and Freddie Mac - which now is even more important if the two are to regain investor confidence.

Monday's price drop also shows how foolish it is for Congress to rely upon the two to pay for a deeply flawed housing bailout. Both the House and Senate are working on bills that impose a small fee on the mortgages that Fannie and Freddie hold in their investment portfolio. The Senate wants to use the money to refinance about 500,000 bad mortgages into ones with a federal guarantee; the House wants it for low-income housing programs.

Lawmakers were figuring the Freddie/Fannie investors wouldn't miss the money. But with investor confidence quite shaky after Monday, that looks like a terrible bet.

Instead of relying on those funds, Congress should modernize and strengthen both firms' regulator. That improved oversight would help to reassure the markets that future housing problems won't develop into crises that could threaten the viability of either firm or require a massive bailout with taxpayer dollars.

Both Fannie Mae and Freddie Mac are behemoths whose financial health is fairly precarious. As the market knows, both need tens of billions of dollars more in capital than they have. Monday's stock-price drop is a warning.

David C. John is a senior research fellow in economic-policy studies at The Heritage Foundation.