2003 assets are normalized to 10 in all sectors

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and authors’ calculations. 2003 assets are normalized to 1.0 in all sectors. Leverage is defined as book assets to shareholder equity. Table 3-3: Equally-weighted Return on Assets and Return on Equity of the Top Five U.S. Commercial Banks, Top Five U.S. Investment Banks, and GSEs Return on Assets (ROA) Return on Equity (ROE) Year Commercial banks Investment banks Fannie- Freddie Commercial banks Investment banks Fannie- Freddie 2003 1.3% 0.7% 0.7% 17.5% 14.7% 20.3% 2004 1.1% 0.7% 0.5% 12.7% 15.8% 11.1% 2005 1.3% 0.7% 0.6% 15.7% 16.8% 12.2% 2006 1.3% 0.8% 0.4% 15.1% 22.1% 9.2% 2007 0.8% 0.2% -0.3% 10.2% 6.6% -8.2% Source: Fortune and authors’ calculations To summarize, banks (especially, investment banks) were growing aggressively during 2003-07 at a time when their underlying economic profitability was not improving. In parallel, Fannie and Freddie were growing aggressively (off balance-sheet) -- also in the face of declining profitability -- yet could not compete with the private players in terms of generating comparable returns to shareholders. The substantial inflow of capital into the United States over this period – primarily in the form of holdings of Treasuries and Agency debt, but which displaced domestic savings toward money-market funds and in turn as short-term borrowing for financial firms – facilitated the balance-sheet expansion without much market scrutiny. 22 When the housing prices declined in 2007 and the tail risk that these institutions had betted against materialized, they all experienced substantial stress. Commercial banks by virtue of their steady profitability (ROA) and less aggressive leverage suffered the least, but even amongst them the most leveraged and risky – Citigroup – eventually had to be bailed out. Investment banks and Fannie-Freddie fell off the cliff, both because of lower profitability (ROA) Thus, what had emerged in the financial sector was not a nimble, innovative set of mortgage finance firms, but instead a highly distorted market with two types of institutions – LCFI King Kongs and GSE Godzillas - both implicitly backed by the government, growing at feverish pace, with substantial leverage, fighting each other in risk-taking all the way to the bottom while absorbing the massive inflows of capital into the United States.
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43 and higher leverage. Leverage and risks – essential features that had helped them accelerate and pump up greater shareholder returns (ROE) in good times -- accelerated their decline when the housing markets hit the wall. 3.4 All-In Section 3.3 above described a “race to the bottom” between large financial institutions with implicit government guarantees and the GSEs. Given their low cost of funding, the lack of any market discipline imposed by creditors, and the systemic risk being borne by society and not themselves, they took on increasingly risky mortgage loans with ever-greater leverage. And as a result, an ever-larger share of the mortgage market was low-quality mortgage loans, and an ever-larger share of those was being securitized instead of being held by the originators. Because the mortgage originator often did not hold onto the loan, her incentives properly to evaluate the borrower and to monitor the loan after it was issued were reduced substantially.
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