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Treasury Secretary Paulson appeared before the Senate Banking Committee this afternoon to explain the proposal he issued Sunday night to provide support “if needed” to Fannie Mae (FNM) and Freddie Mac (FRE), the government-sponsored enterprises [GSEs] that “now touch 70% of new mortgages and represent the only functioning secondary mortgage market.”

If approved by Congress, Paulson’s proposal would:

First, as a liquidity backstop, the plan includes an 18 month temporary increase in Treasury’s existing authority to make credit available for the GSEs.

I think Wall St. is concerned that 18 months of unlimited authority for the Treasury could take us into a Democratic administration who could decide to nationalize the GSEs.

Given the difficulty in determining the appropriate size of the credit line we are not proposing a particular dollar amount. Flexibility is the best means of increasing market confidence in the GSEs, and also the best means of minimizing taxpayer risk.

Several of the Senators on the Committee displayed concern to outright disdain in giving the Treasury a blank check. The Treasury can create an unlimited amount of paper that would balloon the deficit. Foreigners would start bailing out of U.S. debt instruments en masse. This would push up inflation and jump up interest rates, regardless of the Fed’s monetary policy. And any “market confidence” by Wall St. has so far not been reflected in Fannie and Freddie’s stock price.

Second, to ensure the GSEs have access to sufficient capital to continue to fulfill their mission, the plan gives Treasury an 18-month temporary authority to purchase – only if necessary – equity in either of the two GSEs.

This proposal is totally ridiculous, yet none of the Senators asked Paulson why he wants the authority to buy Fannie & Freddie stock. Treasury buying equity in the GSEs will further dilute current shareholder value. And for all the Treasury Secretary’s talk about “minimizing taxpayer risk,” the truth is the GSEs need to shrink in order to strengthen their balance sheets. Tighter credit conditions mean that current and future loans purchased and securitizations the GSEs make are of higher quality, thus strengthening their financial position over time.

If either of these authorities is used, it would be done so only at Treasury’s discretion, under terms and conditions that protect the U.S. taxpayer and are agreed to by both Treasury and the GSE.

Again, neither Wall St. nor many politicians would be enthusiastic about giving Treasury this authority without Congressional approval each time it is used.

Third, to help protect the financial system from future systemic risk, the plan strengthens the GSE regulatory reform legislation currently moving through Congress by providing the Federal Reserve authority to access information and perform a consultative role in the new GSE regulator’s process for setting capital requirements and other prudent standards.

The Federal Reserve issued a statement Sunday night “that it has granted the Federal Reserve Bank of New York the authority to lend to Fannie Mae and Freddie Mac should such lending prove necessary. Any lending would be at the primary credit rate and collateralized by U.S. government and federal agency securities.” Paulson said at today’s hearing that a $2.25 billion backstop was set up in 1971 for each GSE. The Fed has $1 trillion in their bank, so there’s no reason why the window cannot be opened up to the GSEs “if necessary.” However, it would not be prudent for the Fed to loan too much money to one customer.

Interesting dynamics played out Wednesday between the Fed and the Treasury. Both Bernanke and Paulson want the backstop shifted from the Fed to the Treasury as soon as possible, so that the Treasury can enact fiscal responsibility on the GSEs. Theoretically, the Fed does not engage in politics!

The fallout from the housing and credit bubbles is an issue that transcends political party lines. The Treasury, Federal Reserve, elected officials, and investors need to realize that only by shrinking can the financial and mortgage markets remain solvent before they can begin to grow into stronger entities better able to withstand the storm of a future down cycle.

Disclosure: Author is long FNM & FRE.

Source: Why Paulson's Proposal Doesn't Sit Well in Congress