The nature of the retained portfolio business invites

Info icon This preview shows pages 106–108. Sign up to view the full content.

View Full Document Right Arrow Icon
The nature of the retained portfolio business invites comparison with the hedge fund industry. To put the GSEs’ $1.7 trillion retained portfolio into perspective, the total assets under management of the entire hedge fund industry were $2 trillion at the end of 2009. Given aggregate leverage ratios around five, this means that hedge function industry has a balance sheet on the order of $10 trillion. The largest hedge fund in 2009 was Bridgewater Associates with $38 billion. Freddie and Fannie’s trading operation therefore was around 20% as large as
Image of page 106

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
105 the entire hedge fund industry, and the two GSEs were magnitudes bigger than the largest hedge fund. The level of sophistication of the GSEs’ trading function rivaled that of premier hedge funds. They employed sophisticated quantitative models for predicting the performance of mortgage loans, and they used large derivative positions to manage interest rate and default risk. This trading function generated enormous revenues: about $28 billion in each of 2002, 2003, and 2004. After a dip, the 2009 trading revenue was $31 billion in 2009. In fact, throughout its history net interest income (from such investment activities) has surpassed guarantee fee income (from the traditional guarantee business). Over the past 15 years, trading revenues represented on average 73% of all revenues. Like many hedge funds, the GSEs increased the riskiness of their mortgage portfolios in the years leading up to the crisis. They purchased $227 billion worth of subprime and Alt-A mortgage-backed securities in 2006 and 2007, in addition to possibly $500 billion more of high- risk mortgages that were not classified as such. Until the crisis of 2007-2009, the GSEs appeared to be highly profitable compared to almost any other financial institution including most hedge funds, as witnessed by their return on equity (even though they were losing the race to the bottom, which we outlined in Chapter 3). Freddie’s ROE averaged 23% per year from 1977-2006 and Fannie’s averaged 17%. In the last ten years of this period, Fannie’s ROE was 23%. Part of this stellar performance is attributable to their ability to borrow at below-market rates because of their implicit government backing (see Chapter 1), and part is due to the GSEs’ taking on tail risk, earning consistent spreads in normal times albeit at the risk of significant losses during an economic downturn. Our first long-term policy recommendation is to discontinue the trading function of the GSEs . We believe that there is no role for a gigantic government-sponsored hedge fund that trades in mortgage-related contracts. The trading function in many respects highlights the worst aspects of a “privatize the gains, socialize the losses” entity. By being able to borrow cheaply, the GSEs invested in a highly levered portfolio of increasingly risky mortgages to boost profits. When the credit risk that they took on materialized, the tax payer was stuck with a huge bill, a significant proportion of which represents the losses of the retained mortgage portfolios.
Image of page 107
Image of page 108
This is the end of the preview. Sign up to access the rest of the document.

{[ snackBarMessage ]}

What students are saying

  • Left Quote Icon

    As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

    Student Picture

    Kiran Temple University Fox School of Business ‘17, Course Hero Intern

  • Left Quote Icon

    I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

    Student Picture

    Dana University of Pennsylvania ‘17, Course Hero Intern

  • Left Quote Icon

    The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

    Student Picture

    Jill Tulane University ‘16, Course Hero Intern