Second there was a growing possibility that the loans

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Second, there was a growing possibility that the loans that were underlying these securities were going to default. In other words, the promised payments on these securities were less likely to be paid out. What was a security worth? The initial cost, or what one could sell it for? It would be great to pretend that a house was worth what someone paid for it in June of 2006. But house prices in the fall of 2008 didn’t reflect a temporary drop, but a permanent correction. Of course, the problem was that Fannie Mae and Freddie Mac were the largest holders of relatively illiquid mortgages and mortgage-backed securities (MBSs) -- in fact, $1.52 trillion worth as of September 2008. Within this portfolio, Fannie and Freddie (along with the FHLB System) held $308 billion of the ratings-inflated non-prime AAA MBS, which became notoriously difficult to value once the crisis started. It is clear that the failure of the GSEs would have led to a fire sale of these assets that would infect the rest of the financial system, especially the banking sector and broker-dealers that were holding similar assets. To the extent that the MBS market is one of the largest debt markets, the fire sale could have brought other financial institutions down – similar to our analogy to Madison Avenue boutiques when Saks Fifth Avenue conducted their own version of a fire sale. What is worse, as we will explain in Chapter 6, the rescue of Fannie and Freddie required the Treasury to be “in bed with the Fed”, and any future resolution of these giants would also have to take into account the implications for the over-expanded Federal Reserve balance sheet.
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61 Chapter 5: End of Days " In come the waves: The worldwide rise in house prices is the biggest bubble in history. Prepare for the economic pain when it pops " - The Economist, June 16, 2005 As of December 2007, five months after the financial crisis started but nine months before the financial system collapsed, the two largest government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, looked quite different than they did a decade earlier in 1997. For example, in 1997, with $21 billion of shareholder equity, and a $481 billion portfolio of mortgages and $1.06 trillion of mortgage-backed security (MBS) guarantees, supported by $256 billion of notional financial derivatives, the combined two GSEs had a leverage ratio (i.e., (dollar mortgage exposure/shareholder equity) of 72. As high as this leverage was, their mortgage exposure was fairly safe. Of the $481 billion portfolio, less than $10 billion was in private-label securities backed by the riskier non-prime mortgages. While data are sparser from this period, the analysis in Chapter 2 showed that, in terms of guaranteeing riskier MBS in 1997, the GSEs had started to support risky loans with high loan-to-value ratios and low credit scores.
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