Monday, November 15, 2010

The Easy Way To Defund GSEs

Emil Henry, Jr., a former assistant secretary of the Treasury in the Bush administration, wrote an insightful editorial in last Thursday's Wall Street Journal regarding Fannie and Freddie.

According to Henry, Treasury has always had the power to rein in the GSEs. Here's what he wrote,

"But the Treasury doesn't need Congress or an academic assessment in order to tackle the most important reform goal: eliminating the GSEs and moving their activities to the private sector. Mr. Geithner himself can immediately reshape the mortgage markets—by withholding his approval of new debt issuances by the GSEs. That's the best way to begin curtailing the GSEs, and it can be done unilaterally.

Congress chartered the GSEs and in their charters required that the Treasury secretary approve all of their new debt. For decades, the Treasury exercised this duty, and the GSEs submitted each new debt issuance to the department for prior approval.

But the Clinton administration found this process cumbersome and a strain on Treasury staff. It established a new process that weakened the administrative approval process for GSE securities offerings. This hands-off approach represented an abdication of Treasury's essential oversight powers.

By the mid-2000s, the GSEs' process of debt approval had devolved to a simple notification of the Treasury, without any formal process of approval. The pace of debt issuance was so rapid that such notifications came to the Treasury weekly, typically on one piece of paper that simply listed proposed issuances without supporting data (such as income statements or balance sheets) upon which to make informed judgments.
I found these to be fairly stunning revelations. First, that Treasury has a legal ability to approve GSE debt issues- or not. Second, that this power had been abdicated to the point of the GSEs simply sending non-descriptive advisories of debt issuances.

Henry thus reasons,

If the Obama administration is serious about addressing the GSEs, it should re-establish a rigorous process to review all GSE debt issuance. That process should require the GSEs to provide Treasury with full financial data and justification for issuances, including statistics that show the creditworthiness of the agencies after each offering. In addition, the Treasury secretary should have to approve all new debt issuances personally.

The administration should also announce that in 2012 the Treasury will begin to deny a portion of GSE debt issuances with the goal of reducing their debt 50% by 2015 and 100% by 2018. This eight-year period of adjustment would allow the private markets ample time to provide secondary market liquidity.

There will be a private market ready to absorb the securities currently held by the GSEs. Private companies won't be able to borrow as cheaply as the GSEs could (thanks to their implicit government guarantee), but there will still be plenty of profit left to capture in the market for mortgage securities."

This might not be expected action for the next two years. But a change in administration could bring this about, regardless of who controls Congress from 2012 onward. I think Henry is correct to believe that private conduits would re-emerge if Fannie and Freddie were limited by debt ceilings. And there certainly would be sufficient profit in private label securitization, once the GSEs are hobbled and have begun to shrink.

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