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27 at its peak over 28 trillion worth of securities

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27 At its peak, over $2.8 trillion worth of securities were funded on an overnight basis through tri-party repo transactions. But as the financial crisis took hold, because the clearing banks had a huge amount of exposure on an intra-day basis, regulators worried that a failure of a major dealer could cause the clearing bank to falter, which in turn would cause the financial system to stop functioning. Like the New York City Department of Environmental Protection, the Federal Reserve cannot simply shut down the tri-party repo market because the financial system relies on this market; instead, the Fed has been frantically trying to develop a new repo infrastructure before the next financial crisis causes it to fail. 28
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56 A similar argument can be made for the GSEs. The mortgage finance market – the largest debt market in the U.S. serving a key economic function (i.e., housing) -- had become almost completely dependent on the GSEs for financing mortgages. For example, in 2007, of the $2.43 trillion in new residential single-family mortgage loans, the GSEs purchased $1.13 trillion worth of mortgages, the majority of which were then guaranteed by the GSEs and issued as MBS to the capital market. And like our New York City water tunnel analogy, when the GSEs effectively failed in 2008, pulling the plug on the GSEs would have created a 50% sucking sound from the mortgage finance market. In fact, ironically, the GSEs have headed in the opposite direction. According to Inside Mortgage Finance, in the first half of 2010, Fannie Mae and Freddie Mac accounted for a whopping 64% of all single-family mortgage securities. It is fairly clear that allowing the GSEs to fail would have disrupted the firms’ ongoing MBS issue/guarantee business, with major consequences for the U.S. mortgage markets. In the context of the evolving subprime mortgage crisis, with virtually no ongoing private mortgage investment activity, the result would likely have been a systemic failure of the U.S. mortgage system with obvious dire consequences for the real economy. But by no means is this evidence in favor of the GSE model. To the extent that mortgage originators can sell their loans to the GSEs, the originators have less incentive to monitor the loans. Inside Mortgage Finance reports that the three largest sellers to the GSEs during the 2002-2006 period were Countrywide, Wells Fargo, and Washington Mutual -- two of which received some notoriety during the crisis for poor loan quality. Why did this problem exist? Originators make their fees either way; so as long as the GSEs purchase them, the originators don’t care about quality. And why do investors purchase MBS issued by the GSEs? Because the GSEs guarantee the credit risk, investors don’t face this risk, so they don’t care about the poor loan quality either. But then why do the GSEs still buy these loans? Even though to a private sector financial firm these loans are poor quality, the loans may still be worthwhile investments for the GSEs because they have access to cheap debt financing due to the implicit government guarantee. And ironically the more of these types of
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