Government includes federal state and local

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Government includes federal, state, and local government. The banking sector includes commercial banks, savings institutions, credit unions, brokers and dealers, ABS issuers, and REITS. Other finance includes government and private retirement funds, money market and other mutual funds, as well as property, casualty insurance, and life insurance companies. Commercial and investment banks were heavily exposed to mortgages through direct holdings of whole loans, but also through holdings of tranches of MBS. In particular, of the $10.7 trillion of mortgage debt outstanding in the United States at the end of 2007, the GSEs held $1.5 trillion and banks held $4.2 trillion (39%). 25 The banks held $852 billion in GSE MBS, $380 billion in AAA-rated tranches of non-GSE MBS, and $90 billion in below-AAA-rated tranches that were packaged in collateralized debt obligations (subprime CDOs).
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54 In effect, a lot of the mortgage risk was never passed on by the banking sector to other areas of the financial system (insurance, asset managers, and foreigners). Instead, the risk remained either directly on the books of the banks, with AAA-rated tranches attracting a favorable capital treatment of 20% relative to similar-risk corporate loans, or the risk was held in off-balance sheet vehicles that were set up by these banks. These so-called “special purpose vehicles” (“conduits” and SIVs) were typically given some form of liquidity or credit guarantees by the bank that set them up -- guarantees that were triggered during the crisis. Regulatory arbitrage made it profitable for banks to set up these off-balance sheet structures and to earn the small excess return on AAA-rated MBS tranches compared to Treasuries. 26 In addition, there is the special treatment of GSE debt as eligible collateral in the Federal Reserve’s open market operations and the statutory leniency that allowed banks and thrifts to hold unlimited quantities of the GSEs’ debt. This meant that the banking sector had a preference for holding GSE debt as opposed to other assets because it allowed for much greater leverage and had “convenience yield” as liquid assets. Finally, all investors that held the GSE debt had assumed that the U.S. government would most likely – even if not surely – make good on these implicit promises, as suggested by the name “(government) agency” debt. Of course, ironically, if the GSEs were not bailed out, and the debt losses were passed onto the banking sector, the losses would be all the more painful since little or no capital was held against the debt in the first place. In fact, the banking sector would be on the hook for over $300 billion, albeit backed by the GSEs’ mortgage portfolios. Given the impact of Lehman’s failure on hedge funds and money market funds in particular, it is reasonable to assume that debt losses of the magnitude of the GSEs would have had far greater consequences and potentially triggered a run on the worst-hit firms, followed by a full-scale panic.
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