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FOR PART 1 GO TO https://www.scribd.com/document/334826631/GSE-Reform-anda-Conspiracy-of-Silence-Draft-1-4
Though marketed as an academic book by an academic publisher, Princeton University Press,
Guaranteed To Fail is more like a political tract that makes its case with inflammatory rhetoric
as a substitute for evidence. They describe Fannie and a Freddie as a "ticking time bomb," a
"monster" created by "Dr. Frankenstein.” The GSEs are also called “the Devil's Cigarette
Lighter," as well as "King Kong," and "Godzilla." The companies sparked a "Gold Rush," which
precipitated "Falling Off A Cliff," and "The End of Days.” They claim the GSEs are "the largest
hedge fund on the planet,” and, apparently, the only hedge funds on the planet that took buy and
hold position on all credit risk.
On February 11, 2011, the same day that Treasury released its report to Congress, BlackRock
published a nice glossy document, "Getting Housing Finance Back On Track." which evaluated
Treasury's three proposals. Of those three, BlackRock preferred the one advocated by Hancock
and Passmore, which was a "continuous catastrophic reinsurance program guaranteed by the
Federal Government that would be used to back primary guarantees sourced solely with
significant private capital." Moreover, wrote BlackRock, "the tone of the Report leads us to
believe that [this option] is the one favored most by the Treasury and the US Department of
Housing and Urban Development (HUD)."
A few weeks later, on March 2011, the Koch Brothers Mercatus Center presented, "Five
Proposals for a New Housing Finance System in the United States." Three of those proposals
came from experts who spoke at Brookings–Peter Wallison, Lawrence White and Dwight
Jaffee–and all of the proposals advocated abolition of the GSEs.

BEGINNING PART 2

Edward DeMarco Knew The GSEs Were Destined To Fail
Brookings had invited representatives from Fannie and Freddie to speak at its GSE reform
conference, but both companies declined. They were subject to the oversight and control of
acting FHFA director Edward DeMarco, who rejected any argument that favored the GSEs. His
views aligned with those of other prominent mortgage experts. "Peter Wallison exposes how the
government's push to weaken traditional mortgage underwriting standards proved to be the root
cause of the financial crisis," wrote DeMarco on the back cover Wallison's 2015 book, Hidden in
Plain Sight.40
40

The book is a rehash of his earlier book, Bad History, Worse Policy , and his countless other articles the focus on
Ed Pinto’s risk categorizations set at June 30, 2008.

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DeMarco’s contempt for the GSE business model went back to 1989, when, as a young
economist at the General Accounting Office, he was struck by the “risk-filled characteristics” of
this “strange set of institutions.” He worked on additional GSE reports, produced by GAO and
by Treasury, which he joined in 1994. Like other experts, he dismisses the GSEs’ decades of
stellar loan performance and profitability, because he knew that the seeds of their destruction
were always there. He, like other experts, insist that the GSEs imploded. But when pressed on
specifics during an interview with FCIC staffers, he offered a potpourri of non-answers. From
the memorandum of the interview:
Mr. DeMarco remarked that the issues facing the GSEs in the late 2000s were not a new
phenomenon. The entities were unstable and perversely incented institutions that just
happened to collapse in 2007-2008. Mr. DeMarco found no pleasure in the fact that he
spent a career warning about the potential for GSE collapse, only to arrive at OFHEO
18 months before things imploded.
[FCIC staffer] Chris Seefer asked Mr. DeMarco if he was saying he predicted the GSE
collapse, to which Mr. DeMarco replied using a saying from his father: even if you have
the right of way, if that truck hits you are still dead. He meant that there is no satisfaction
from the collapse. Mr. DeMarco did not join OFHEO with the expectation that there
would be such a severe problem, or that he would be a conservator eighteen months
later. It is no secret that the battle and public policy tension over the GSEs has been
going on for years.
When asked about other warning signs from the 1990s about a subprime crisis, DeMarco’s
memory becomes hazy. And when pressed about what he did at Treasury, DeMarco's memory
became hazy:
Mr. DeMarco then jumped back in time in his narrative, to issues he warned he has not
looked at for ten years. He said that HUD and Treasury published a report on subprime
lending concerns in 1998. Mr. DeMarco was involved in it, but could not recall much
about the report’s details, other than that it reviewed the concerns of the day. However,
according to Mr. DeMarco, subprime lending in 1998 was different from 2005. An
OFHEO taskforce was put together to examine the issues of the non-traditional mortgage
report, which Mr. DeMarco was not involved in. In 2007, he started to see the first wave
of the financial crisis, and the need to deal with the subprime realm.
There's a reason why DeMarco chose to "not remember" the Clinton Administration's
HUD/Treasury report, which was published in April 2000. It serves as a damning indictment of
Alan Greenspan and the 2000 Republican Congress. It lays out in clear and precise detail all the

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abuses in subprime lending and Wall Street securitizations that eventually led to the crisis in
2008. Sixteen years later, the report remains timely and timeless. It conclusively debunks the
"gee, we didn't know what was happening," meme repeated endlessly by apologists for Wall
Street fraud
As director of FHFA, DeMarco had two jobs. As regulator of the GSEs, his job was to promote
and maintain the safety and soundness of both companies. (The term "safety and soundness,"
refers to a very specific risk rating methodology used by federal regulators.) As conservator,
FHFA's job is to restore the soundness and solvency of both companies. He never had any power
or authority to impair the financial health of the two companies that he held in disdain.
One of DeMarco’s duties was to set minimum capital ratios for the GSEs, so as to assure their
ongoing safety and soundness. The basic process for setting those ratios is like that of any credit
analysis or business decision. You grapple with two eternal questions: How do the past and
present inform us about the future? And, what is the breakeven? Mortgage experts at the Urban
Institute, Laurie Goodman and Jun Zhu, did just that. In “The GSE Reform Debate: How Much
Capital Is Enough?”they write:
This paper demonstrates that collateral composition, house price experience, and
diversification significantly affect credit risk, and thus the capital requirement. Our
empirical results demonstrate that 4–5 percent capital would have covered Fannie Mae
and Freddie Mac (the GSEs) using the 2007 experience. With the GSEs’ current book of
business, that is too high, as collateral composition has changed in favor of much more
pristine loans.
But DeMarco seemed to reject this approach when questioned by the FCIC:
[FCIC staffer] Chris Seefer next asked Mr. DeMarco about a December 2008 a hearing
on the GSEs and the roles in the financial crisis. In the testimony of Mr. Raines and Mr.
Mudd, as well as what the FCIC is hearing from people currently being interviewed, the
models assumed 10% declines in housing prices in 2008 and 2009 and spit out results
that said it was not going to be good, but not make Fannie insolvent. However, these
models did not feed in scenarios of 30-40% housing declines in certain parts of the
country that significantly hurt the GSEs. What the FCIC is hearing is that the housing
market’s drop caused the collapse of the GSEs, not the undue credit risk and lousy
models.
Mr. DeMarco replied that he had just said that the GSEs were taking on riskier loans,
their models were lousy, there was not enough capital, and the underwriting was
worsening. From late 2007 until the conservatorship, Director Lockhart was making
speeches and pleas to improve the supervisory tools available to OFHEO, including
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raising capital levels. Mr. Lockhart became quite well known for his PowerPoint deck
detailing the elaborate risk taken by the GSEs. In fact, Mr. DeMarco stated that OFHEO
had been saying this before Mr. Lockhart started. Perhaps OFHEO should have started
warning earlier than it did, but it does have a record of it.
No, no, no, it's not a 30% drop in home prices! It's must be GSEs fault for taking on riskier loans
and having lousy models and underwriting! To someone in the financial world, that kind of talk,
which minimizes the impact of a 30% drop in home prices on loan recovery, seems silly. All
business outcomes are a result of a combination of factors. And in the business of mortgage
lending, home price appreciation, or depreciation, is the biggest factor in loan recovery. One
metric explains a lot. In 2005, loss severity on subprime loans in California was 1%. In 2009 it
was 70%, a 7,000 percent increase.41
The GSEs' mission is to liquefy the mortgage markets when other private lenders withdraw. But
DeMarco seemed oblivious to the importance of that function when he spoke to the FCIC:

Mr. DeMarco shared a memory from a visit to Fannie during the first week of the crash
in early 2007. He recalled that Mr. Lockhart was out of town. The meeting was held in a
big room with Fannie's senior management, who were “apoplectic” that the market was
becoming illiquid. They blamed OFHEO’s caps and other regulations for putting the
brakes on their efforts to provide liquidity. Fannie wanted to provide liquidity, because it
was their purpose in life. Mr. DeMarco remembered these being heated discussions,
which ended with OFHEO telling Fannie no. In late July or early August 2007, Fannie
asked for caps modifications to allow them to purchase more loans for their own
portfolio. OFHEO also rejected this request. According to Mr. DeMarco, in the following
weeks and months there were a large number of Congressional inquiries and a great deal
of pressure to allow Fannie to increase their involvement in and support of the mortgage
market. OFHEO held off on granting the increase, because Fannie needed to complete
mediation work to allow investors the ability to rely on timely audit statements. This was
the story until March 2008.42

41

Sources: Subprime Mortgage Derivatives, by Laurie Goodman, et al. Trust Company of the West Mortgage
Monitor.
42
DeMarco makes various claims about the GSEs’ financial reporting that are false, and suggest that he lied to
obscure the true circumstances under which the GSEs were placed in conservatorship. Witnesses gave conflicting
accounts about the decision to place the GSEs in conservatorship, which may be one reason why FCIC never
disclosed verbatim transcripts or recordings of the relevant interviews. One needs to get into the weeds to untangle
his misleading statements, which will be examined in a separate paper.

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After FHFA placed the companies in conservatorship, it set their minimum capital ratios at zero,
according to the agency’s lawyer. The GSEs no longer needed capital, because, according to
FHFA, Treasury extended a commitment to provide financial support.
This issue came up in litigation brought by private shareholders who challenged the legality of
some of DeMarco’s actions. Judge Douglas Ginsberg wanted to be sure he heard right, since the
idea of zero capital seemed, on its face, absurd. “There seems to be in the statute [referencing 12
U.S.C. Sec. 4614] a whole typology of classifications, adequately recapitalized, and then undercapitalized, and within that significantly under-capitalized, critically under-capitalized, okay?”
“Your Honor, that entire system by virtue of the Director's action was set aside,” said FHFA’s
lawyer. “There is an issuance by the Director that says this system doesn't apply.”
After leaving office in January 2014, DeMarco would repeatedly speak out in opposition to the,
idea that FHFA should do its job. "Restoring Fannie Mae and Freddie Mac is not the solution,”
he said in a speech given three months after the GSEs have fully repaid all bailout funds. “They
failed and their business model failed. Going backwards to an obviously failed model cannot be
dressed up with some promise of higher capital or explicit rather than implicit guarantees."
Have any doubts? Don't. "There should be no doubt that this set of events [leading to
conservatorship of the government-sponsored enterprises] and the billions of dollars in
subsequent losses meant that Fannie Mae and Freddie Mac had failed," DeMarco continued. In
fact, "there was broad consensus at that time that not only had Fannie Mae and Freddie Mac
failed, but the GSE model had failed."
DeMarco had no legal authority to dismantle or hollow out the GSEs, though his words and his
actions show that he actively pursued his agenda to do just that.

Losses After The Government Takeover
Speakers at the Brookings event could cite the GSEs’ massive losses, and their ensuing
government bailout, as proof that GSE model was a failure. Though none of them demonstrated
that they had ever studied the companies’ SEC filings. Which is unfortunate, the financial
statements of a large bank are not self explanatory. One cannot fully appreciate a large
institution’s financial strength without paying close attention to the timing differences under
Generally Accepted Accounting Principles, which are subject to dramatic change because they
may reflect guesstimates about uncertain outcomes.
In 2008 the Wall Street banks received government funds because they faced liquidity crises,
whereas the GSEs received government funds to offset timing differences under GAAP.
Taxpayers were never called upon to fund any cash shortfall or operating expense at the GSEs.

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The distinction between liquidity and solvency, or between a liquidity crisis and insolvency, may
not be known to the man on the street. But to a financial regulator, or to an expert who presumes
to be qualified to design a new system of housing finance, the distinction is as basic as the
alphabet.
In his 2014 memoir, Stress Test, Timothy Geithner tries to blur that distinction, and give the
impression that the GSEs were hemorrhaging cash after their takeover. He recalls his first
morning as Treasury Secretary, when he sat down with President Obama in the Oval Office. “We
still had five 'financial bombs' to defuse," said Geithner. They were “Fannie Mae, Freddie Mac,
AIG, Citigroup, and Bank of America...All five had received major infusions of government cash
to save them from failure... And yet they were all in trouble again, and we needed to make sure
they didn’t explode—not to protect them from the consequences of their mistakes, but to prevent
another messy failure from ravaging the rest of the economy."
Fannie and Freddie "needed the most help," he continues. “They were quickly burning through
nearly $200 billion in taxpayer aid, and without another $200 billion or so—the equivalent of
more than three years’ worth of federal education department spending—they risked catastrophic
defaults."
Not true. When Geithner sat down with Obama on January 27, 2009, neither Fannie nor Freddie
had “burned through” a nickel of taxpayer largesse. The companies’ fourth quarter 2008
earnings, which determined their solvency and need for taxpayer support, had not yet been
announced. 43As of the end the fiscal third quarter, when numbers were set by the GSEs’
conservator, FHFA, both companies remained solvent, and had received no bailout whatsoever.
Then gradually, over a succession of 12 successive quarters, the GSEs received about $150
billion in taxpayer funds to cover losses covering non-cash accounting provisions. In addition,
FHFA dictated that the GSEs shall pay out $36 billion in cash dividends to Treasury up through
2011. Those cash dividends paid to Treasury, funded with taxpayer bailout dollars, illustrate how
the companies’ flow of funds was disconnected from the dire picture painted by Geithner.
So Fannie and Freddie were not, “quickly burning through nearly $200 billion in taxpayer aid,”
and, by the reckoning of almost anyone who works in financial services, they never “burned
through” anything. To most people who deal with distressed companies, "burning through,"
means burning through cash—not in the sense of throwing twenties into the fireplace—but in
terms of generating negative cash from operations, or perhaps as in generating insufficient cash
flow to repay debt as it matures. Almost nobody refers to a company that’s burning through
deferred tax assets or conservative loan loss provisions. The GSEs always generated robust

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A bank’s solvency is not something that’s marked to market, or calculated with precision on the first business day after
December 31. Instead, the way it works for the GSEs and other large financial institution, is that, subsequent to quarter’s end, a
series of formal management committees and determine the size of various non-cash provisions, which are based on internal
methodologies and involve a degree of professional judgement. Subsequently the provisions are approved by the Board, and then
reviewed for reasonableness by the outside auditor. Only then, following the auditor’s sign-off, are the final numbers available to
in SEC disclosures presented to the public.

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positive cash flow and always maintained sufficient cash and/or liquidity to repay all debt
obligations as they came due.
But in his book Geithner sought to create the false impression that in early 2009, the GSEs were
sinking like the Titanic and taking $400 billion in taxpayer funds with them. By the time he
wrote his book, most of those distressed loans on the GSEs’ books had been removed.
Those non-cash accounting provisions had converted into cash transactions, or loan liquidations
that generated cash proceeds. And those huge losses triggering huge taxpayer bailouts had
disappeared. Those non-cash accounting provisions were reversed in fiscal years 2012 and 2013.
If the loan loss provisions had been calculated accurately at the onset, the cost of the taxpayer
bailout would have approximated zero.

First Ignore The Law, Second Invent A Legal Mandate
When it was first published in February 11, 2011, “Path Forward for Reforming America’s
Housing Finance Market,” ignored the law on the books, which, in the absence of Congressional
action, mandated that the GSEs shall rebuild capital. The report simply made recommendations
to Congress
Geithner’s omission proved to be convenient. Eighteen months later, August 17, 2012, Treasury
cited the same report, or White Paper, as if it were something different. The document was no
longer a set of recommendations offered to the legislative branch. The same report had morphed
into a legal commitment by the executive branch.
Treasury acted, “upon the commitment made in the Administration’s 2011 White Paper that the
GSEs will be wound down and will not be allowed to retain profits, rebuild capital, and return to
the market in their prior form.”
Treasury executed the Third Amendment to the Senior Preferred Stock Purchase Agreement,
which, up until that point, provided a 10% coupon on Treasury’s equity investment. That 10%
coupon changed into something that was unprecedented in the history of regulated financial
institutions. Indeed, it was probably unprecedented in the history of modern corporate law.
Henceforth into perpetuity, every dollar of GSE earnings was to be distributed to Treasury by
way of cash dividends.
Peter Wallison opined on the thought process behind this decision:
Why did they do this? Now I’m not privy to all the internal discussions, but the reason
that many people like me thought they did it is that the then-Secretary of the Treasury
Tim Geithner was always a strong opponent of Fannie and Freddie, and he was afraid that
if they became profitable as they have now, if they became profitable and began to have
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earnings, they would recapitalize themselves. And the more capital they had, the more
they looked like a profitable, a successful, corporation, the more likely it would be that
Congress would be pressured into letting them out of the receivership44 and to return to
the market probably as government-sponsored enterprises again.
Wallison wasn’t privy to all the internal discussions, but his friend at the White House was.
James Parrott was a senior advisor at the National Economic Council who advised President
Obama on housing issues. He sent Wallison, Pinto and Pollock email to explain the Third
Amendment sweep a few hours before the public announcement.
“Hey guys,” said Parrott.” If you're interested, be glad to talk you through the changes we're
announcing on [the 100% dividend sweep] today. Feel like fellow travelers at this point so I owe
it to you.” Timothy Bowler, the Treasury official who had overseen the bailouts of Citigroup
and General Motors, was cc’d.
Parrott’s bonding with Wallison might have struck some as ironic. As 2011 wore on, Wallison
became an increasingly controversial and polarizing figure in Washington. In May 2011, Mike
Konczal of the Roosevelt Institute and Salon pointed reminded everyone that his FCIC dissent
was predicated on a pack of lies. Later, in July 2011, an investigation by Democrats on the
House Committee on Oversight and Government Reform exposed Wallison’s efforts to sabotage
the FCIC in order to thwart passage of Dodd-Frank. Then in November 2011, The Washington
Post printed Barry Ritholtz’s column, “The Big Lie Goes Viral,” which, as Ritholtz reminded
readers of his blog, was about at Wallison’s talking points. Later, in December 2011, The New
York Times published Joe Nocera’s column about Wallison and Pinto, titled, “The Big Lie.”
None of this ever gave Wallison’s allies any pause.
Parrott explained more later that day. “No principal is written down no matter what the quarterly
payment is,” explained Parrott. “Dividend is variable, set at whatever profit for quarter is,
eliminating ability to pay down principal (so they can’t repay their debt and escape as it were).”
Parrott’s terminology is sloppy because the entire idea behind the Third Amendment is
oxymoronic. A company does not pay down the principal of equity shares.

Why The Third Amendment Sweep Is Nonsensical
Indeed, the debate about the the Third Amendment sweep seems to go around in circles. So it is
worthwhile to recap certain basic principles of accounting and corporate law:
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Wallison misused the term “receivership” here. In the federal statutes, receivership refers to a period following a
formal announcement that FHFA will be winding down both companies.
The GSEs were in conservatorship, where they remain as of the date of this writing.

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•   A corporation has no legal obligation to pay cash dividends within any specified
timeframe, ever. If there were such an obligation, the investment would not be equity; it
would be debt. Debt is extinguished upon repayment of principal. If an equity investor
wants to recover his initial principal outlay, his only option is to sell the stock.
•   Dividends paid in cash reduce corporate equity. Whereas dividends paid in kind do not
change corporate equity45.
•   A company may pay cash dividends only to the extent that it can afford to. Otherwise,
under a variety of laws, it is prohibited from doing so.
•   By definition, a company in conservatorship cannot afford to pay cash dividends. When
preferred stock dividends come due, the company must pay those preferred dividends in
kind, because conservatorship is a legal obligation to conserve cash and preserve equity.
The foundation of all insolvency law is that equity gets paid last. Shareholders must wait
until the company returns to self-sufficiency before they receive a cash payout.
Treasury and the GSEs’ conservator, FHFA, reject the last two concepts.
In the absence of cash dividends, the GSEs would have accumulated almost $250 billion in
equity, an amount that, in 2008, would have enabled them to survive the worst housing crash
since the Great Depression. Today, the GSEs lack the requisite capital to operate outside of
conservatorship for one reason only, which is the cash dividend policy imposed by FHFA.
Assisting to the government, Congress gave the conservator the power of life and death over the
GSEs, with the authority to operate or liquidate the companies as it sees fit. No one, no
shareholder, no court, may challenge the conservator's decision-making.
FHFA does indeed have the power to kill off the GSEs, but only after it formally places the
companies in receivership, which is very different from conservatorship. If you're familiar with
the corporate bankruptcy code, conservatorship is like Chapter 11, in which the company is
given the opportunity to rearrange its affairs and eventually emerge out of bankruptcy.
Receivership is like Chapter 7, where the company is wound down and liquidated into nothing.
Though FHFA never went through the formality of placing the GSEs in receivership, the
conservator says it can start making arrangements to facilitate the liquidation process, by, for
instance, draining the GSEs of all equity.
D.C. District Court Judge Royce Lamberth wholeheartedly agrees. He ruled on the government's
motion to dismiss a lawsuit brought by GSE shareholders, who sought to reverse the total income
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Dividends in arrears may reduce one category of equity and increase another, but the net impact is zero.

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cash sweep, a change that FHFA authorized in August 2012. FHFA cited legislation enacted six
weeks before it placed the GSEs in conservatorship, and said this new law gave FHFA almost
unlimited discretion to do what it wanted. Consequently, the normal rules about protecting a
company's health--for the benefit of the company, the creditors and all shareholders--need not
really apply.
"It was Congress, after all, that parted the legal seas," wrote the Judge Lamberth, "so that FHFA
and Treasury could effectively do whatever they thought was needed to stabilize and, if
necessary, liquidate, the GSEs."
The way it normally works, a conservator uses his best efforts to restore a company to sustained
profitability. The decision to commence receivership is made as a last resort measure, once it
becomes obvious that full recovery will never be attained. Only then would a conservator
formally place a company in receivership and proceed to liquidate the assets and operations. But
according to Judge Lamberth, the distinction between conservatorship and receivership isn't
meaningful:
There surely can be a fluid progression from conservatorship to receivership without
violating HERA, and that progression could very well involve a conservator that
acknowledges an ultimate goal of liquidation. FHFA can lawfully take steps to maintain
operational soundness and solvency, conserving the assets of the GSEs, until it decides
that the time is right for liquidation.
Judge Lamberth's interpretation of the law, which affords FHFA absolute control over the GSEs,
does not fit the traditional definition of conservatorship. Though it does fit the definition of
nationalization. But it’s a weird kind of nationalization, since private investors still own shares of
common and preferred stock that are actively traded. FHFA has repeatedly argued that nobody
holding any of the preferred and common equity shares has any right to assert any property claim
whatsoever. So far as FHFA is concerned, the distinction between conservatorship and
nationalization is meaningless. Yet the government refuses to use the word, “nationalization,”
which has all kinds of legal and political connotations.
Judge Lamberth's dismissal of the case remains under appeal. Meanwhile, other similar cases
brought by shareholders are proceeding in other federal courts.
So far, FHFA has had declined to place the GSEs in receivership, for obvious reasons. Doing so
would destabilize the mortgage markets and the housing markets. The GSEs finance $5 trillion in
mortgages, close to half the U.S. total. So, before the two companies are finally liquidated, the
government must invent and implement an untested replacement, a brand new system of housing

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finance. In the absence of a replacement for the GSEs, no one would purchase a home for fear he
he could not resell it to buyer with financing.
In the absence of Congressional action, Ed DeMarco took other steps to hollow out, and
eventually dismantle, the two companies. In October 2012, he announced his plan for a Common
Securitization Platform, which would eventually turn Hancock and Passmore’s vision of GSE
reform into a fait accompli.

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