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Spirit to long term capital management(ltcm in the

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Unformatted text preview: spirit to Long Term Capital Management (LTCM) in the summer of 1998 and to the investment banks during this current crisis. While often criticized for not adequately hedging the interest rate exposure of their portfolios, Fannie and Freddie were nevertheless major participants in the interest rate swaps market. In 2007, Fannie and Freddie had a notional amount of swaps and OTC derivatives outstanding of $1.38 trillion and $523 billion, respectively. The failure of Fannie and Freddie would have led to a winding down of large quantities of swaps with the usual systemic consequences. The mere quantity of transactions would have led to fire sales and invariably to liquidity funding problems for some of Fannie and Freddie’s OTC counterparties. Moreover, counterparties of Fannie and Freddie in a derivative contract might need to re-intermediate the contract right away, as it might be serving as a hedge of some underlying commercial risks. Therefore, due to counterparties’ liquidating the existing derivatives all at once and replacing their derivative positions at the same time, the markets would almost surely be destabilized due to the pure number of trades, required payment and settlement activity, and induced uncertainty, and the fact that this was taking place during a crisis. Finally, Fannie and Freddie were interconnected to the financial system because so many financial firms held significant portions of their debt obligations and guaranteed securities. Figure 4-1 plots the holders of Agencies and GSE-backed securities between 2003 and 2010. To get an idea of the magnitude, combining all of GSE debt and GSE-backed securities (and including the FHLB System and other GSEs), there was $8.1 trillion outstanding at the end of 2009, making this one of the largest fixed income markets in the world. For comparison, the federal government owed $7.8 trillion, and all non-financial companies combined owed $7.1 trillion at the time. As is clear from the figure, the holdings of Fannie and Freddie debt and securities by the government (federal, but also state and local) and the Federal Reserve (starting in 2009) have been on the rise. The financial sector holds more than half of these assets. Banks hold $1.6 trillion, broker/dealers $128 billion, and ABS issuers $113 billion. Focusing on just the debt obligations, 53 according to the FDIC, insured banks and thrifts held almost 17% of Fannie and Freddie’s outstanding debt. Other financial companies holding GSE debt and securities are money market and other mutual funds, which hold $1.1 trillion; government and private retirement funds, which hold $559 billion; and insurance companies, which hold $480 billion. Given the size of these holdings, a default, or even a 10% loss in the value of these securities, could devastate the U.S. financial sector....
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spirit to Long Term Capital Management(LTCM in the summer...

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