Fannie's new watchdog: All bark?

NEW YORK (Fortune) -- Backers of the housing rescue bill have been trying to reassure skeptics in Congress by pointing to the bill's creation of a new world-class regulator for Fannie Mae and Freddie Mac. But opponents doubt any watchdog will have enough teeth to keep the well-connected mortgage guarantors in line.

Indeed, debate in the House ahead of Wednesday's passage of the Housing and Economic Recovery Act of 2008 suggests that even with a stronger regulator in place, the companies' quasi-governmental status - which critics say allow managers and shareholders to reap the fruits of housing booms, while consigning taxpayers to pay for the inevitable missteps - will remain a source of conflict.

The bailout bill, which is expected to be approved by the Senate and signed by President Bush in coming days, gives the government the authority to buy shares in the companies and to lend freely to them in times of market stress. The bill also creates a new, independent agency - the Federal Housing Finance Agency - to replace the mortgage giants' current regulator, the Office of Federal Housing Enterprise Oversight.

Treasury Secretary Henry Paulson has said a tougher regulator would help ensure that Fannie and Freddie avoid making mistakes that would lead to return trips to the taxpayer trough.

Fannie (FNM, Fortune 500) and Freddie (FRE, Fortune 500) were created by Congress to provide funds for the mortgage market. They have historically been able to borrow at below-market rates, as investors assume their obligations will be made good by the government if the companies run into financial trouble. But with house prices plunging after a long run-up, investors now fear mortgage-related losses will wipe out the companies' thin equity cushions.

The legislation gives the new regulator more authority than did its predecessor. The FHFA will be on par with other federal financial regulators in its capacity to set underwriting and capital standards, assess penalties and remove officers and directors, for instance. The companies were widely perceived in the past to be able to make end runs around OHFEO and lobby Congress directly.

It's clear that the promise of more oversight was crucial to getting conservatives' support for the rescue package, which will provide funding to enable 400,000 or more homeowners in trouble with their lenders to avoid foreclosure.

But if the new agency is stronger than OFHEO, it's an open question whether any regulator can control Fannie and Freddie.

For one thing, it's easy to see that overseers from the Fed on down did little in recent years to rein in the financial sector excesses that led in large part to the housing bust. That's among the reasons some skeptics say the companies should be nationalized and made part of the government, while others advocate that Fannie and Freddie be set free altogether.

"Ending the amorphous status of Fannie and Freddie seems highly desirable," Jared Bernstein, a senior economist at the Economic Policy Institute, told Congress in testimony this week. "The fact that they are private on paper but public in the minds of investors is highly distortionary."

Beyond that, there's the issue of how much actual latitude a regulator might have in policing huge companies in a sensitive industry at a time of crisis. With the private mortgage lending industry in near collapse, Paulson and other officials are counting on Fannie and Freddie to keep providing money for the mortgage markets.

Yet skeptics of Fannie and Freddie - which together hold $1.4 trillion of mortgages and guarantee some $3.5 trillion in mortgage-backed securities - say the companies must, at the very least, drastically shrink their mortgage holdings to reduce the risk of future taxpayer bailouts. Judging by the massive selloff in the companies' shares earlier this month before Paulson responded with his bailout plan, investors seem to agree.

Rep. Kevin Brady of Texas, for one, believes any congressional action should specify stricter capital standards, along with plans to wind down the companies' mortgage portfolios and replace the top executives at Fannie and Freddie.

"The millionaire captains who grounded this ship have proven they are not the ones to steer us to calmer seas," he said Wednesday in voting against the bill, which passed the House by a 272-152 vote Wednesday.

Others, such as Bernstein, say any taxpayer support of privately owned companies must be accompanied by congressional action that penalizes execs who led their companies into the abyss.

"The taxpayer foots the bill, often taking on the same bad debt that got these bad actors into trouble in the first place," he testified earlier this week. "Yet, too often, the bailout also saves these managers' compensation packages."

The size of those compensation packages came into view last week, when Freddie disclosed that CEO Richard Syron made at least $10 million last year - for his supposedly stellar performance in a year in which the company started recognizing the massive losses that have hammered its shares in 2008.

While no taxpayer dollars have yet been lavished on Fannie and Freddie, merely putting in place rules that could enable the government to buy the companies' shares "changes forever the links between Freddie and Fannie and the government," Cumberland Advisors economist Bob Eisenbeis wrote last week.

Unfortunately for whoever ends up with the job of running the companies' new regulator, much else remains unchanged.