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In comparison to any other financial institution

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In comparison to any other financial institution, Fannie and Freddie were afforded extraordinarily light capital requirements. For example, the capital requirement for federally insured banks and thrifts to hold residential mortgages was substantially greater: 4%. As a result, Fannie and Freddie had much higher leverage ratios – total assets to shareholder equity – than did comparable banking institutions. To many fixed-income practitioners and analysts, the GSEs’ growth and the expansion of securitization markets for mortgage finance should be considered a success story. But there was a darker side to the interaction between the GSEs and the banking sector: While banks were charged a 4% capital requirement for holding a portfolio of mortgage loans, they were charged only 40% of this, or 1.60%, if they held GSE MBS instead. Within the financial sector, this creates perverse incentives for banks to load up on GSE MBS, thereby increasing leverage all the way around the sector. To see this, note that if a bank originated $100 worth of mortgage loans, they would have to hold a minimum $4 of capital to be considered adequately capitalized. If the bank sold these loans to the GSEs and the GSEs securitized them into MBS, however, the banks could buy back the GSE MBS and hold only $1.60 in capital, even though their portfolio holdings are identical. Because the GSEs are only required to hold $.45, this means that, for the same level of risk, the capital requirement for the financial sector as a whole now is just $2.05, or 51% of what it used to be. There is little doubt that the growth in securitization is related to this type of regulatory arbitrage. In terms of data to support this point, consider the first year of the crisis in 2007. According to Inside Mortgage Finance, of the $5.2 trillion in MBS guarantees by Fannie Mae, Freddie Mac, and Ginnie Mae, approximately 37% was held by the banking sector -- $817 billion by commercial banks, $790 billion by Fannie and Freddie themselves, $257 billion by thrifts, and $91 billion by the FHLB. And just six firms – Bank of America, Wachovia, JP Morgan Chase, Citigroup, and Wells Fargo – contributed 48% to the commercial bank holdings, and just
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22 three thrifts – ING Bank, Washington Mutual and Hudson City Savings – 40% to the thrift portfolios. This is substantive evidence against capital markets’ holding the credit risk -- i.e., the “originate-to-distribute” model -- and much more support for banks’ taking on the risk, albeit as a counterparty to the highly levered GSEs. To document the leverage of the GSEs, Figure 1-2 below graphs the ratio of total assets on the balance sheet divided by the shareholder equity of the combined Fannie and Freddie (dashed line). The figure takes as a starting point the date of the 1992 legislation that set the capital requirements, and continues the ratio until the end of 2007. (Note that by the end of 2008, shareholder equity had gone negative, and the GSEs were taken into conservatorship.) Over this period, the GSE leverage ratios generally ranged between values of 20 to 40 whereas the commercial banking sector had ratios of 10 to 15. The only match to emerge for GSE
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