However with the gse collapse and the tarp funds

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However, with the GSE collapse and the TARP funds unavailable for troubled mortgage purchases, the solution adopted was for the Fed’s balance sheet to house the GSE assets and some of its debt. In the meanwhile, bank holding companies (backed through government- insured deposits in their bank subsidiaries and FDIC’s loan guarantee programs) and the GSEs continued to expand their holdings of mortgage assets. 43 In effect, a massive transfer of mortgage-related assets took place towards those financial institutions that had the greatest access to government guarantees. There is no shortage of proximate causes for why the Fed was so involved in the GSE bailout. A polarized U.S. Congress made it difficult formally to set up a RTC-style vehicle, leaving the Fed as the politically easiest way out. The Fed represented the most sophisticated regulatory agency around to handle the task with expediency. The Fed had already been dealing with the rescue of other large financial institutions and their mortgage portfolios. The Federal Reserve Act explicitly allows the Fed to engage in purchases of GSE debt and securities. Finally, as we detailed in Chapter 1, the Federal Housing Enterprises Financial Safety and Soundness Act (FHEFSSA) of 1992, as well as some of the earlier pieces of legislation set in 1954, had laid out the special features of the GSEs. Most of these were re-affirmed by the Housing and Economic Recovery Act (HERA) of 2008, including the special status that the GSEs can use the Fed as their fiscal agent. But the real question is why the Fed balance sheet continues to remain the place for holding GSE securities two years after the conservatorship of Fannie and Freddie. It has
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81 certainly been beyond what would seem to be a period of expediency in which the Fed support might have been necessary. To us, the answer lies in the government’s unwillingness to recognize the GSE securities and debt on its own balance sheet. The Fed says that the mortgages are guaranteed by the Treasury; the Treasury refuses explicitly to recognize agency debt or mortgages on its balance; and in the meanwhile the financial sector and foreign governments treat these securities as virtually riskless. Given their too-big-to-fail and interconnected-to-the-max status, it is simply incredible that the advantage of keeping the GSEs off-balance sheet is for the government to have the flexibility to default on their debt if necessary. Any hint of such default would most likely trigger a run on a large number of domestic financial institutions, forcing the government to announce a complete bailout. The reserve status of the U.S. dollar could be substantially impaired. The government’s credit risk spreads would shoot up overnight, as they did for Ireland in the fall of 2008 when it announced universal deposit insurance for its entire banking sector.
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