The redacted Version of Treasury Secretary Henry M. Paulson, Jr. presentation on “The Role of the GSEs in Supporting the Housing Recovery” to the Economic Club of Washington

In 2009 and during a meeting with the Washington Economic Club Treasury Secretary Henry M. Paulson, Jr described how during the housing market downturn, investors fled mortgages that carried any credit risk. But, because the GSEs assume the credit risk on the mortgages that they guarantee, and since investors believed that there was then an implied government backing, the conforming loan market continued to function relatively well. Consequentially the GSEs (Fannie Mae and Freddie Mac) share of new mortgage business rose from 46 percent in the second quarter of 2007 to 84 percent in the second quarter of 2008.

As the extraordinary housing correction deepened, weaknesses in these the GSEs Fannie Mae and Freddie Mac became apparent. In July 2008, investors lost confidence as they became increasingly uncertain about Fannie and Freddie's capital position. The GSEs' already depressed stock prices plummeted even further.

While shareholder losses did not pose a public policy concern, the share price dropping further weakened confidence among the holders of the $5.4 trillion of GSE debt and mortgage-backed securities-MBS. Investors at home and abroad were reducing purchases and even selling from their holdings of GSE debt. The consequences of either GSE failing would be catastrophic. We couldn't wait for a failure; we had to act preemptively to shore up confidence in these enterprises.

In July 2008, I requested that Congress quickly complete work on long-sought GSE regulatory reform and also provide Treasury with expanded authority to support Fannie, Freddie and the Federal Home Loan Banks. Congress did so – giving us enormous temporary authorities to inject capital if the GSEs asked for it, and to create a back up liquidity facility for GSE debt.

Negative earnings announcements by Fannie Mae and Freddie Mac in August 2008 reflected those worsening conditions, and further added to the markets turmoil. Our examination found capital to be inadequate – in terms of both the quality of capital and the embedded losses stemming from worsening mortgage market conditions. Confidence in the GSE model was largely shattered. Simply injecting even a great deal of equity into their business model would not create the market confidence necessary to fund these enterprises going forward and to bolster confidence in the $5.4 trillion of extant GSE obligations, which posed the greatest systemic risk. Market fragility and the GSEs' deteriorating balance sheets required that we take immediate responsibility for the GSE structural ambiguities that U.S. policymakers had neglected for decades.

We had to stabilize the situation immediately. The markets were exceptionally fragile and would be further threatened in September when we expected that a number of large financial institutions, including Lehman Brothers, would post disappointing earnings. Chairman Bernanke, FHFA Director Lockhart and I met almost daily, over a 10 day period, to work toward a comprehensive action plan. As I made clear at the time, we sought a temporary solution that would achieve three goals: (1) stabilize markets, (2) promote mortgage availability, and (3) protect the taxpayer.

In comprehensive action taken on September 7^th 2008, FHFA placed Fannie and Freddie into conservatorship, enabling the Federal Treasury to take creative steps to support their obligations. Our actions would have been impossible to implement were it not for the GSE reform legislation that gave FHFA the expanded power to make qualitative and quantitative judgments about capital and also gave Treasury the financial authorities necessary to make conservatorship a stabilizing, as opposed to a destabilizing, event. We devised Preferred Stock Purchase Agreements to effectively guarantee the GSEs' obligations by ensuring Fannie and Freddie would maintain a positive net worth.

The Treasury also established a new secured lending credit facility intended to serve as an ultimate liquidity backstop. To further support the availability of mortgage financing, Treasury initiated a program to purchase GSE MBS and has purchased over $50 billion thus far averting the financial market meltdown had these institutions collapsed and allowed the GSEs to continue, in the midst of overall market stress, so that they may perform their essential role of providing mortgage finance. This conservatorship, with the explicit backing of the federal government, is temporary and must be resolved for the long-term. In the meantime, the GSEs must serve the taxpayers' interest by assisting in turning the corner on the housing correction, which is critical to return normalcy to the capital markets and resume U.S. economic growth. The GSEs can facilitate progress through the housing correction by keeping mortgage rates low and by mitigating foreclosures.

On November 25, 2008 the Federal Reserve announced a new program to purchase up to $100 billion in GSE debt securities and $500 billion in GSE MBS. This Federal Reserve program had a significant impact. The 30-year fixed rate fell to a record low 5.10 percent critical in addressing the housing correction – lower mortgage rates that may bring additional credit-worthy buyers into the housing market. Fannie and Freddie announced that they would suspend foreclosure sales and cease evictions of owner-occupied homes until January 9, 2009 so to allow time for implementation of the modification program.

In November 2008, FHFA, the GSEs, Treasury and the HOPE NOW Alliance announced a major streamlined loan modification program (SMP) to move struggling homeowners into affordable mortgages. The new protocol relies heavily on the "IndyMac model" developed by the FDIC and creates sustainable monthly mortgage payments by targeting a benchmark ratio of housing payments to monthly gross income. Together with the IndyMac/FDIC protocol, the SMP creates a powerful new model that should help ensure that no borrower who wants to stay in their home and can make a reasonable monthly payment will fall into foreclosure.

The SMP (streamlined loan modification program) will directly and immediately apply to the 50 percent of homeowners with loans serviced under the GSEs' auspices. Fannie and Freddie announced that they would suspend foreclosure sales and cease evictions of owner-occupied homes until January 9^th 2009 thus allowing time for implementation of the modification program.

In November, FHFA, the GSEs, the Treasury, and the HOPE NOW Alliance announced a major streamlined loan modification program (SMP) to move struggling homeowners into affordable mortgages. The new protocol relies heavily on the "IndyMac model" developed by the FDIC and creates sustainable monthly mortgage payments by targeting a benchmark ratio of housing payments to monthly gross income. Together with the IndyMac/FDIC protocol, the SMP creates a powerful new model that should help ensure that no borrower who wants to stay in their home and can make a reasonable monthly payment will fall into foreclosure.

The SMP (streamlined loan modification program) will directly and immediately apply to the 50 percent of homeowners with loans serviced under the GSEs' auspices. Fannie and Freddie announced that they would suspend foreclosure sales and cease evictions of owner-occupied homes until January 9th to allow time for implementation of the modification program.

Given the authority granted by Congress last summer, we have gone about as far as we can to avert systemic risk and to use the GSEs to speed progress through the housing correction that lies at the heart of our economic downturn. Although the effective guarantee of GSE debt and MBS has brought some degree of stabilization, it is not the most efficient way to remove the ambiguity inherent in the GSE structure, even temporarily.

The debate about the future of Fannie and Freddie requires answering the much larger and more important question of the federal government's role in the mortgage market and in housing policy, generally. Given the bubble we have experienced, policymakers must ask what amount of homeownership subsidies are appropriate.

In today's stressed mortgage market, between FHA-Ginnie Mae, Fannie Mae, and Freddie Mac, almost all new mortgage market originations have federal government credit support. This is not sustainable over the long-run. It will lead to inefficiency, less innovation and higher costs. It also contradicts basic U.S. market principles. By allowing the GSE structural ambiguities to persist for too long, U.S. policymakers have created an untenable situation. Today, Fannie Mae and Freddie Mac are in a temporary form that, while stable, cannot efficiently serve their Congressionally-chartered mission and protect the taxpayers' investment over the long-term.

The first step must be for policymakers to decide – in light of the recent housing bubble and the severe financial and economic penalty it has imposed on our nation – the role government should play in supporting home ownership. We cannot allow a repeat of the devastation this housing correction has wreaked on families and communities across the United States. Once that decision is made, the GSEs should be restructured to meet that public policy choice and satisfy three objectives: First, there must be no ambiguity as to government backing. It must be explicit or non-existent. Second, there must be a clear means of managing the conflict between public support and private profit. Third, there must be strong regulatory oversight of the resulting institutions.

For the complete version go to: http://www.ustreas.gov/press/releases/hp1345.htm