Some highlights from a recent speech by Emil W. Henry Jr., Assistant Secretary for Financial Institutions, U.S. Department of the Treasury. "Imagine for just a moment if some of our most prominent complex financial institutions announced major accounting improprieties, significant restatements and serial failings and shortcomings in risk management and internal controls, and then further announced the cessation of annual reports and other standard disclosure materials."

"Does anyone doubt the ferocity of market discipline that would sweep down upon these institutions in the form of higher borrowing costs for market-based funding and heightened counterparty scrutiny? Simply put, traditional market discipline has not applied for the GSEs."

"That lack of market discipline is reflected in preferential funding rates that result directly from the market's long-standing false belief that the US government guarantees or stands behind GSE debt. Of course, it is this funding advantage which drove the expansion of the portfolios in the first place."

"Systemic events can unfold by direct and/or indirect spillovers. How could such a systemic event begin? They are many possible sparks but an unexpected sharp or volatile..interest rate 'shock' would certainly be a distinct possibility. If such an interest rate shock occurred in a way that was not captured by the models, the results could be without precedent."

"The GSEs make use of a considerable amount of short-term funding. Short-term instruments account for more than 20 percent of all outstanding debt for both Fannie Mae and Freddie Mac. In a financial crisis, the GSEs might face difficulty in accessing debt markets. This difficultly might force the GSEs liquidate some MBS holdings, putting excessive downward pressure on prices in a market that the GSEs are supposed to be stabilizing."

"There are virtually limitless scenarios. But you get the point. We already know the lessons here. There is no need to endure the test. I feel compelled to remind you that the federal government has taken steps to assist a troubled GSE in the past. Do we really want to be faced with unwarranted and irresponsible calls for bailing out another failed GSE?"

"What I hope you ask yourself after hearing this is 'Why?' and 'What can we do about it?' The answer to the first question is unsatisfying. Ignoring all the rhetoric and spin, the simple truth is that there is no need for our financial markets to be exposed to this risk. Passionate statements made by the GSEs to the contrary, the GSE investment portfolios are not necessary for them to stay true to their mission."

"The answer to the second question is much more satisfying, we can address this risk rather easily. As long as the portfolios of the GSEs are reduced gradually and responsibly, the overall impact to the housing market should be trivial."