RUTHFULLY YOURS

“I do think I do not want the same kind of focus on safety and soundness that we have in OCC (Office of the Comptroller of the Currency) and OTS (Office of Thrift Supervision). I want to roll the dice a little bit more in this situation towards subsidized housing … .”

Rep. Barney Frank, Sept. 25, 2003

“I just briefly will say, Mr. Chairman, obviously, like most of us here, this is one of the great success stories of all time .. . .”

Sen. Chris Dodd, Feb. 24, 2004

This “great success story” turned out to be an epic failure. The account of Fannie Mae and Freddie Mac has been splashed all over this paper since that fateful day in the fall of 2008. The GSEs were at the heart of the housing bubble and are major contributors to our current economic malaise.

Today, it is widely understood that in order to grow and expand their profits, they dramatically grew their portfolios. It is also understood that the GSE investment portfolios grew because they were funded by implicitly government-subsidized debt.

This seal of approval absolved these mortgage giants of any type of market discipline, which would have kept in check wholly private firms.

What is often overlooked is the relationship between these two mortgage giants and the federal government. Without their allies in Congress, Fannie and Freddie would not have been able to continue their reckless ways and engage in arbitrage with leverage ratios of 100-to-1.

As Frank’s quote suggests, these members’ willingness to gamble on safety and soundness sprang from a desire to have the GSEs comply with their aspirations for homeownership. Getting many more Americans into homes was their goal, and the GSEs were their primary vehicle.

Beyond the duopoly over the prime mortgage market, Fannie and Freddie were heavily invested in the subprime and Alt-A market. Through the affordable housing goals put in place by Congress in 1992, the GSEs became the largest purchasers of junk mortgages (well over $1 trillion worth). This meant that despite the low quality of the loans, millions of Americans now had a mortgage they otherwise could not afford.

Believing the GSEs should be doing even more to promote affordable housing, their allies in Congress created a housing slush fund that would have taken a portion of the companies’ profits and sent it to like-minded organizations, thus ensuring that this army of affordable housing activists would continue to grow.

Congress is now on the brink of passing legislation which will fundamentally change our financial sector. A product of the reform effort led by Dodd and Frank is the creation of a too-big-to-fail industry.

Within the House bill, regulators would be able to make loans to, or purchase the debt obligations of, any institution it deems systemically risky, purchase its assets, assume or guarantee its obligations, take liens on assets, or sell or transfer the company’s assets.

Beyond the clear competitive advantage these firms will gain compared with their smaller counterparts in terms of lower cost of capital, the Dodd-Frank approach will ensure that an inextricable link is created between big business and big government.

Given human nature, favors will be offered in exchange for leniency toward this new class of too-big-to-fail institutions. Instead of focusing on providing the best possible service to their customers, these banks will focus their efforts on appeasing the federal government and their allies in Congress.

Whether it is striving toward another altruistic goal while defying the principles of sound banking, or funneling cash into friendly organizations, the closer big government gets to big business, the more likely these favors will become the rule instead of the exception. Political pull replaces market forces and vanquishes market discipline.

The great failure of Fannie and Freddie should have taught us that big business paired with big government produces big problems. Allowing Washington to arbitrarily deem institutions systemically risky will bifurcate our financial system between those with the implied government backstop and everyone else.

Instead of institutionalizing this Too Big to Fail model, the federal government should abolish it. Instead of authorizing regulators to bail out creditors and counterparties, it should be known that no shareholder, creditor or counterparty will ever again be shielded from losses of a failed firm. Market discipline, a cornerstone of any well-functioning market, must be strengthened, not weakened.

Over the last couple of weeks, Frank has issued a series of press releases attempting to place the blame for the failure of Fannie and Freddie on Republicans. In one, he even alleges that it was the “Republican Congress that promoted homeownership at all costs.” The irony of this statement is irresistible.

When the House GSE reform bill was on the floor in 2005, I offered an amendment authorizing their regulator to rein in the GSEs based on the systemic threat they posed — obviously a necessary step given recent events.

Through the work of an army of lobbyists employed by the GSEs and activist organizations like Acorn, my amendment was portrayed as an attack on affordable housing. Unfortunately, this argument won out, and Frank joined with the majority of the House in opposing my amendment and several others that would have reined in the GSEs’ excessive risk-taking.

Dodd and his fellow Senate Democrats stonewalled the companion GSE reform legislation from getting to the floor, which ultimately killed our reform efforts.

It is abundantly clear that Frank and Dodd were central in protecting the two original Too Big to Fail institutions. Instead of following their lead and creating an industry of these firms, Congress should take a step back and reconsider this approach. Once that link between big business and big government is established, it will never be broken.

• Royce, a Republican, represents California’s 40th Congressional District (northern Orange County) and is a senior member of the House Financial Services Committee.