41 systemic risk and the gses systemic risk has been

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4.1 Systemic Risk and the GSEs Systemic risk has been a term much used in the current financial crisis to describe “hazardous” financial institutions; but what exactly is it, and in what sense were the GSEs systemic? Between the fall of 2008 and the winter of 2009, the world’s economy and financial markets fell off a cliff. Stock markets in the United States, Asia, Europe, and Latin America lost between a third and half of their value; international trade declined by a whopping 12 percent;
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49 and the size of the global economy contracted for the first time in decades. When economists and Wall Street types toss around the term systemic risk, that’s pretty much what they’re talking about. Systemic risk emerges when the financial sector at large doesn’t have enough capital to cover either its debts or its bets. As a result, when those bets go sour and debts cannot be paid, many institutions fail or the credit markets freeze -- and without credit, commerce plummets and economies fall into recession. That is precisely what happened with some of our largest institutions in September and October of 2008: Lehman Brothers, AIG, Merrill Lynch, Washington Mutual, Wachovia, Citigroup, and, of course, the two largest GSEs, Fannie Mae and Freddie Mac. What matters for understanding the systemic risk of any given financial institution is how much that firm contributes to an aggregate sector-wide failure. To determine how an individual firm contributes to systemic financial risk, we must be able to estimate the size and variability of its assets and liabilities, how the asset losses mirror those of the overall financial sector in a crisis, and how interconnected the institution is with the rest of the financial system. Except for this last factor, all can be calculated from publicly available data. Indeed, with our colleagues at the Stern School of Business, we have created a systemic risk ranking of the 100 largest financial firms historically through today (see, for example, ). As an illustration, on July 1, 2007, just before the financial crisis erupted, Fannie and Freddie were estimated together to hold 15.3% of the systemic risk in the system -- an amount that was greater than any other financial institution. Even as the crisis spread and other firms became systemic, on March 1, 2008, just prior to the Bear Stearns collapse, these two GSEs combined captured 13% -- again, an amount greater than any other financial firm. And in the week before being put into conservatorship, on August 31, 2008, Fannie and Freddie again show up as most systemic with a total % contribution of 11.3%. These numbers suggest the enormity of Fannie and Freddie’s systemic risk. But they obscure the underlying economics of their systemic risk production. Generally, systemic risk can emerge in one of four ways: 1. Counterparty risk: If a financial institution is highly interconnected to many other financial institutions, then its failure can impose losses on others and have a ripple effect throughout the system.
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