paper about MBS

Until the crisis of 2007-2009 the gses appeared to be

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Unformatted text preview: Until the crisis of 2007-2009, the GSEs appeared to be highly profitable compared to almost any other financial institution including most hedge funds, as witnessed by their return on equity (even though they were losing the race to the bottom, which we outlined in Chapter 3). Freddie’s ROE averaged 23% per year from 1977-2006 and Fannie’s averaged 17%. In the last ten years of this period, Fannie’s ROE was 23%. Part of this stellar performance is attributable to their ability to borrow at below-market rates because of their implicit government backing (see Chapter 1), and part is due to the GSEs’ taking on tail risk, earning consistent spreads in normal times albeit at the risk of significant losses during an economic downturn. Our first long-term policy recommendation is to discontinue the trading function of the GSEs . We believe that there is no role for a gigantic government-sponsored hedge fund that trades in mortgage-related contracts. The trading function in many respects highlights the worst aspects of a “privatize the gains, socialize the losses” entity. By being able to borrow cheaply, the GSEs invested in a highly levered portfolio of increasingly risky mortgages to boost profits. When the credit risk that they took on materialized, the tax payer was stuck with a huge bill, a significant proportion of which represents the losses of the retained mortgage portfolios. 8.1.1 Transition What to do with the $1.7 trillion portfolio of assets? We envision that the government could slowly wind down the assets on the GSEs’ balance sheets -- for example, by corralling them into a “GSE Resolution Trust Corporation” (GSE RTC). A similar structure was established 106 during the savings and loan (S&L) crisis in the late 1980s and early 1990s in the United States and during banking crises in other countries (e.g., Sweden in the early 1990s). Specifically, the Resolution Trust Corporation (RTC) was set up after the S&L crisis in 1989 with the intention of being a “bad bank” (technically a United States government-owned asset management company). It took over the loss-ridden assets (which included commercial properties, commercial mortgages, and residential mortgages) of troubled S&Ls and was charged with the business of liquidating these assets. In six years, the RTC closed or otherwise resolved 747 thrifts with total assets of $394 billion. In 1995 its duties were transferred to the reformed and empowered Federal Deposit Insurance Corporation (FDIC). The RTC pioneered the use of so-called “equity partnerships” to help liquidate the real estate and financial assets that it inherited from insolvent thrift institutions. While a number of different structures were used, all of the equity partnerships involved a private sector partner’s acquiring a partial interest in a pool of assets, controlling the management and sale of the assets in the pool, and making distributions to the RTC reflective of the RTC’s retained interest. Although the prices that the...
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Until the crisis of 2007-2009 the GSEs appeared to be...

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