The Treasury Should Revive the Snow Plan for Limiting GSE Debt Issuance

Despite both the recent release of a set of “GSE reform principles” by the Mortgage Bankers Association and Treasury Secretary Designee Steven Mnuchin’s promise to prioritize reform of Fannie Mae and Freddie Mac, as matters stand such reform seems likely to remain stalled for some time: while there may be a consensus to “do something,” there is far less agreement concerning what that something should be.

To jump start the debate, protect taxpayers, and encourage a more private mortgage market, Mr. Mnuchin, if confirmed, should strongly consider reviving a plan developed by his predecessor, John Snow. That plan would take advantage of the Treasury’s authority to place limits on Fannie and Freddie’s debt issuance to reduce those agencies’ indebtedness. The reduction can and should be done in a controlled manner that could be easily reversed if necessary; a 5 percent monthly reduction, for instance, should work smoothly.

The Treasury’s Authority

Some may be surprised to learn that the Treasury Secretary has such broad, unilateral authority. For those in doubt, the authority is found in the largely identical charters of Fannie Mae and Freddie Mac. According to Section 306(j)(1) of Freddie Mac’s charter, for example,

Any notes, debentures, or substantially identical types of unsecured obligations of the Corporation evidencing money borrowed, whether general or subordinated, shall be issued upon the approval of the Secretary of the Treasury and shall have such maturities and bear such rate or rates of interest as may be determined by the Corporation with the approval of the Secretary of the Treasury (emphasis added).

Section 306(k)(1) of the same document allows for similar Treasury authority over the GSE’s issuance of mortgage-backed securities. In short, neither Fannie Mae nor Freddie Mac can issue debt without the approval of the Treasury. (Those who still doubt this broad interpretation of the Treasury’s powers under Section 306 may wish to consult the Congressional Research Service” (CRS) independent legal analysis supporting the interpretation offered here.)

Under then Treasury Secretary John Snow, the Bush Administration announced its intention to more fully implement this authority. It’s position, as expressed by the Office of Management and Budget in the fiscal 2008 budget (page 75), was that

Fannie Mae and Freddie Mac fund their portfolios by issuing debt, and the U.S. Department of the Treasury has the responsibility to review and approve these GSEs’ debt-issuances. The Treasury Department’s debt approval authority is contained in Fannie Mae’s and Freddie Mac’s Charter Acts, and the Department has approved Fannie Mae and Freddie Mac’s debt on a regular basis. Treasury is developing a more formalized approach to their debt approval authority. As part of that approach, Treasury is developing new debt approval procedures to enhance the clarity, transparency, standardization, and documentation of Fannie Mae’s and Freddie Mac’s debt issuances.

The powers granted to it in Section 306 also allow the Treasury to increase the percentage of GSE debt that is in the form of mortgage backed securities, rather than unsecured debt. By taking this further step, the Treasury would help to reduce the interest rate risk carried on the GSE’s balance sheets.

No Serious Disruptions Likely

Some might be concerned that such a move would cause disruptions in the GSE debt markets.

The primary objection to these suggested reforms relates to a concern about mortgage rates. But one should keep in mind that by reducing the flow of GSE debt, all else equal, the Treasury would be pushing up the price of GSE debt, which, of course, will result in lower interest rates. Given that jumbo mortgage rates are currently very similar to conforming rates, other market players should be able to take any reduction in GSE market share with little impact on overall mortgage rates. The excess reserves in the commercial banking system alone could fund the entire mortgage market for at least a year or more. It is also helpful to note that when the original Snow plan was contemplated no disruptions to the GSE debt markets occurred.

Despite this and the CRS’s favorable review that the Snow plan was an acceptable interpretation of the law, John Snow resigned before it was implemented. Alas, his replacement, Hank Paulson, shelved Snow’s effort. We, of course, know the rest of that story. But if the next Treasury Secretary wants to 1) protect the taxpayer, 2) protect the financial system, and 3) motivate Washington (especially Congress) to do the hard and much needed work of reforming our mortgage finance system, he should take the Snow plan back off the shelf.

[Cross-posted from Alt-M.org]