The only match to emerge for gse leverage was in the

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the commercial banking sector had ratios of 10 to 15. The only match to emerge for GSE leverage was in the form of investment banks, especially during 2003-2007 -- a competitive race to the bottom that we will explain in detail in Chapter 3. Figure 1-2: Leverage Ratios of GSEs Source: FHFA However, these ratios do not tell the entire story. As shown by Figure 1-1, most of the credit risk of GSEs is in the form of guarantees of defaults on mortgages sold to MBS investors. These guarantees do not appear on the balance sheet of the GSEs. As a useful exercise, the solid line in Figure 1-2 sums up all of the credit risk that is contained in both their mortgage portfolios and their credit guarantees of MBS (i.e., the “credit” numerator is the sum of their on-balance sheet assets plus their outstanding MBS). This is roughly equivalent to what the banking sector
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23 does when it holds “whole loan” mortgages (i.e., the mortgages themselves, and not MBS) and hedges the interest rate risk in those mortgages. The numbers are simply startling. The credit-based leverage ratios now range between levels of 50 to 100 over the period. 7 Even more troublesome was the GSEs’ behavior from 2002 onwards. As regulators became more aware of the mere size of the GSEs, coupled with accounting scandals in 2003 and 2004, there was a general recognition that their size and leverage had to be curtailed. And, in fact, there was some apparent success. From the end of 2001 to 2007, the “official” leverage ratio dropped from 38 to 23 and the portfolio stopped growing. But the credit-based leverage ratio that also included the off-balance sheet guarantees – the total credit risk divided by shareholder equity shown in Figure 1-2 -- barely budged from 72 to 69. As Figure 1-1 shows, the GSEs had simply replaced growth in their mortgage portfolios with growth in guarantees of MBS. 1.5 One Big Fat Subsidy The mortgage credit risk of Fannie Mae and Freddie Mac combined grew at an astonishing 16% (11%) annual growth rate from 1980 (1992) through 2007. We saw that this growth was financed using borrowed money and levels of leverage far in excess of other financial institutions. Why would debt investors finance such growth? Because of the special status and treatment of the GSEs that were described earlier in this chapter, the financial markets have historically treated them specially: The financial markets believed (correctly, as it turned out, or as a self-fulfilling prophesy) that if either company ever experienced financial difficulties, the federal government would likely intercede to make sure that the company’s creditors did not suffer any losses. This belief persisted despite the explicit statement on all GSE securities that these securities were not full-faith-and-credit obligations of the U.S. Government. The belief seems largely rational given that for most practical purposes, GSE debt is on par with Treasuries as “liquidity” or “risk-free securities” and therefore is held in hoards by financial firms much like Treasuries (in fact, 50% of GSE debt was held by financial firms in 2008). The “halo” effect of all of the special features of the GSEs was just too strong for them not to be deemed as too-big-to-fail.
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