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These economic forces play out in tables 3 2 and 3 3

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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. (2) Investment banks started out with a leverage of around 23:1, slightly lower than that of Fannie and Freddie but rocketed steadily towards a leverage exceeding 30 (Bear
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41 Stearns and Lehman Brothers being the most levered investment banks). In contrast, commercial bank leverage stood steady in the range of 10:1 to 15:1 consistent with a capital requirement of 8-10% for being well-capitalized. Citigroup, however, was levered close to 20:1 by 2007. Again, the leverage of commercial banks was significantly understated by their reported balance-sheet figures, as they had engaged in a significant amount of off-balance sheet vehicle guarantees. 21 (3) What is telling, however, about this asset growth (and in the case of investment banks, leverage too) is that there was little improvement in the underlying economic profitability. The ROA for commercial banks during 2003-06 was steady around 1.3%, for investment banks was 0.7%-0.8%, and in fact was declining steadily for Fannie and Freddie from 0.7% to 0.4%. However, the ROE painted a different picture to the shareholders. Since commercial banks did not ramp up leverage that much, their ROE was steady in the range of 13%-17%, that of investment banks kept rising with their leverage from 15% to 22%, and that of Fannie and Freddie in fact fell from 20% to 9%. And, while Fannie’s and Freddie’s book leverage in fact came down over this period due to pressures from the regulator, these leverage numbers did not capture the credit risk on their outstanding MBS, as well as the risk that mortgages were increasingly of worse quality over time. And all of these numbers also don’t do justice to the fact that the risk in the financial sector was becoming all too concentrated on one asset class: housing. Table 3-2: Total Asset Growth and Equally-weighted Leverage of the Top Five U.S. Commercial Banks, Top Five U.S. Investment Banks, and GSEs Asset Growth relative to 2003 Leverage Year Commercial banks Investment banks Fannie- Freddie Commercial banks Investment banks Fannie- Freddie 2003 1.0 1.0 1.0 13.4 23.0 28.2 2004 1.3 1.3 1.0 11.8 24.0 25.8 2005 1.4 1.5 0.9 11.9 24.5 25.3 2006 1.7 1.8 0.9 11.8 27.3 24.2 2007 1.9 2.1 0.9 12.6 30.9 23.8
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42 Source: Fortune and authors’ calculations. 2003 assets are normalized to 1.0 in all sectors.
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