Column: Bailouts don't solve problem

A host on one of the leading late night television shows recently joked that "we're going to have a great show tonight, but if it isn't, the federal government will bail us out!"

There's nothing more unfortunate than truth behind a bad joke.

These days it seems the federal government would rather bail out slowing industries with billions of taxpayer dollars instead of allowing the free market system to work.

Over the summer, Congress approved a housing bill, which I voted against, that granted the Treasury Department the authority to take control of Fannie Mae and Freddie Mac - the nation's two largest government-sponsored enterprises. Freddie and Fannie do not provide - or "originate" - mortgages directly to borrowers; they purchase mortgages from the originating lenders, bundle them into securities, and sell them to investors.

Fannie and Freddie own approximately $1.5 trillion of these mortgages, many of which will never be repaid. As a result of holding so much bad debt, they are, in effect, bankrupt. But since the federal government has always implied that it would stand behind Fannie Mae and Freddie Mac, the Treasury Department recently announced it would assume control of the operations of the GSEs, ostensibly to ensure that Fannie and Freddie do not fail and that they make prudent financial decisions in the future. American taxpayers could now be on the hook for more than $200 billion to "rescue" Freddie and Fannie - meaning, to ensure that their creditors (investors) get paid.

As chairman of the Republican Policy Committee in 2003, I provided my Senate colleagues with detailed analysis of the GSEs' investment strategies that led them to take on more risk and more debt than they should. My committee also recommended reforms, including improved disclosure requirements and transparency; increased risk-based regulatory oversight; and ways to create a greater separation between the taxpayers and the business operations of these firms. Unfortunately, Congress did not heed the warning, and stronger regulation was resisted. Now we find that because of a lack of adequate oversight, they have taken on much more debt than they could handle, and a lot of investors could be left holding the bag.

Under the recently announced takeover, known as a conservatorship, the Treasury Department will provide $100 billion to each of the two GSEs to pay their debts and continue operations. The federal government could end up owning approximately 80 percent of the companies.

After the federal government takes over the operations of the GSEs, it would stop paying out future dividends to investors who held shares in either company (following one final dividend payout). The GSEs would also be permitted to grow their mortgage-backed securities portfolios by approximately $20 billion per month until 2010, after which they would reduce their portfolio size by 10 percent annually to a total of $250 billion.

This bailout encourages "moral hazard:" that is, it will encourage other financial institutions to take on excessive risk knowing that the federal government could bail them out. What Congress and the administration should do is send a strong signal to financial markets that irresponsible risk-taking will not be rewarded. One way is by introducing legislation to put Fannie and Freddie on a path towards complete segregation from the federal government and its guarantees. In other words, to allow them to operate as any other corporation. If they make a profit, their investors benefit - if they don't, the government (taxpayers) will no longer bail them out. Congress should gradually reduce the size of the GSEs portfolios, phase out their line of credit, have them pay state and local taxes, register their securities with the Securities and Exchange Commission, and abide by the same capital requirements as other private institutions.

To substitute for the subsidized mortgage interest rates offered by the GSEs, Congress should streamline regulation and support best practices for covered bonds, which are widely used in Europe to better align the incentives of lenders and originators to avoid excessive risk-taking while providing financial institutions with another avenue to raise capital.

I remain concerned about the economic ramifications of Fannie and Freddie's struggles, but I do not support writing a blank check with American taxpayer dollars. Though the action by the Treasury Department may be a stopgap measure to prevent the "meltdown" of the mortgage industry, the next administration and Congress will have to immediately take up sweeping reforms of these mortgage giants in order to avoid the situation we're in today from happening again.