Nov. 29 (Bloomberg) -- Fannie Mae, the biggest player in the $7.6 trillion U.S. home mortgage market, should fire Chief Executive Officer Franklin Raines -- no matter the outcome of investigations into whether the company fiddled with its earnings.

The U.S. government, which created Fannie Mae in 1938 to make more mortgages available to home buyers, should then cut its ties with both that company and mortgage-buying rival Freddie Mac, prodding them to break up into less-risky parts.

Washington-based Fannie Mae has anointed itself guardian of the American dream. Equating its role in fostering mortgages to motherhood required the company to be squeaky clean. Though Raines, 55 and CEO since 1999, insists that Fannie Mae's accounting was acceptable, he shouldn't have allowed the least suspicion to arise.

That was especially imperative after Freddie Mac was caught managing earnings last year and had to dump its CEO and pay a $125 million fine. Raines's personal reputation required more, too: This year, he helped set up an institute for corporate ethics at the University of Virginia.

Mortgage Money

Freddie Mac, which the government formed in 1970, and Fannie Mae buy mortgages from lenders, providing cash that can be used for additional mortgages. The companies profit from interest on their mortgage holdings and from fees for guaranteeing mortgages they package for investors.

These so-called government-sponsored companies have fulfilled their public purpose. Sixty-eight percent of Americans now own their homes, according to the National Association of Home Builders.

In recent years, the companies catered more to their shareholders than to home buyers, hurting both in the process. By taking on riskier loans to keep profits growing, Fannie and Freddie exposed stockholders to losses and provided more liquidity than home buyers needed, helping overheat the housing market.

Tougher regulation -- particularly a permanent increase in the capital Fannie and Freddie must keep in reserve for losses on bad loans -- would reduce their risk. Breaking up the companies would help even more.

Five From Two

Fannie Mae could spin off at least two companies, giving each a third of its mortgages and a third of its $940 billion in debt. Freddie Mac could split in half and divide its mortgages and $666 billion in debt in two.

Fannie and Freddie now own or guarantee about half of all U.S. home mortgages. Five companies would increase competition for mortgages as well as spread the risk. Competition would be enhanced further if the government ended its relationship with the mortgage companies. Eliminating the notion that the U.S. all but guarantees the companies' debts would let banks compete for mortgage funds on equal terms.

While Raines insists he and his company are innocent, smoke has been emanating from Fannie Mae. Armando Falcon, head of the Office of Federal Housing Enterprise Oversight, which regulates the government-chartered companies, said Fannie Mae's accounting misdeeds were ``a continuous effort,'' including an instance where earnings were inflated to ensure executives got bonuses.

A former accounting employee said the company harassed him after he complained about policies. And Fannie Mae agreed to increase its required capital by 30 percent more than the required amount and to change the way it accounts for hedges against its mortgage holdings.

Raines, who was director of the U.S. Office of Management and Budget from 1996 to 1998, will be a hard man to push. But he must go, and Fannie Mae should search for his successor outside the company. Freddie Mac had to do that last year after replacing CEO Leland Brendsel with insider Gregory Parseghian -- who then was found to have been implicated in the accounting subterfuge.

To contact the writer of this column: David Pauly in Normandy Beach, New Jersey dpauly@bloomberg.net

Last Updated: November 29, 2004 00:16 EST