paper about MBS

19 as is well documented now by the crisis credit

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Unformatted text preview: 19 As is well documented now by the crisis, credit rating agencies provided inflated ratings to MBS and other asset-backed securities. These inflated ratings allowed increasingly risky credits to receive beneficial capital treatment. Specifically, since AAA-rated securities were given special status with respect to capital requirements, financial institutions such as FDIC-insured depository institutions, too-big-to-fail institutions, and LCFIs, all with artificially low costs of 40 funding due to explicit or implicit government guarantees – much like Fannie Mae and Freddie Mac -- had a particular incentive to lever up on these AAA-rated securities. 20 Tables 3-2 and 3-3 highlight this race to the bottom. Table 3-2 shows the total asset growth (relative to 2003) and equally-weighted leverage (assets divided by shareholder’s equity) for the five largest commercial banks (Citigroup, JPMorgan, Wells Fargo, Bank of America, and Wachovia), five largest investment banks (Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear Stearns), and the two largest GSEs (Fannie Mae and Freddie Mac) in the U.S. during the period 2003 to 2007. Table 3-3 shows the return on assets (ROA) – an accounting measure of overall profitability of the firm, and return on equity (ROE) – an accounting measure of the performance of just the equity of the firm, again for these three sets of financial firms. In a competitive race to the bottom involving financial risk-taking, we would expect that firms expand their balance-sheets (and off-balance sheet positions if faced with on-balance sheet constraints), do so increasingly with leverage, and finance assets with an increasingly risky profile. Their economic performance as a whole – debt and equity combined – does not rise, and due to the undertaking of excessive risks, may even decline. However, the performance of their equity rises – both due to higher risk that pays off in good times and to greater leverage. As the bets go bad, equity loses value first, resulting in sharp falls in its ROE. These economic forces play out in Tables 3-2 and 3-3, when viewed in combination with Figure 3-1: (1) Investment banks and commercial banks grew their balance sheets by a factor of two between 2003 and 2007. When off-balance sheet activities of some commercial banks (especially Citigroup) are taken into account, this growth is even higher. Interestingly, Fannie and Freddie did not grow much in terms of their on-balance sheet assets over this period and in fact shrunk somewhat. They were constrained in their asset growth (and leverage) by HUD and the prudential regulator (OFHEO) following the accounting scandals of 2003-04. This, however, is misleading because their off-balance growth was not reined in. As Figure 1-1 (and Figure 3-1) showed, their extension of MBS guarantees grew by a factor of two as well. All in all, the largest financial firms were willing to hold and guarantee mortgages and MBS at a pace hitherto unseen. pace hitherto unseen....
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19 As is well documented now by the crisis credit rating...

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