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paper about MBS

But this is not the whole story as it still does not

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Unformatted text preview: But this is not the whole story, as it still does not explain why anyone would purchase high-risk MBS in the first place. The standard argument in the media is that securitization markets failed because originators and private firm securitizers of mortgages did not have skin in the game, and naïve investors – such as the proverbial Norwegian village -- were left holding the bag. But the evidence does not bear this out. A Lehman Brothers study from 2008 showed that over 50% of AAA-rated non-GSE MBS were held within the financial sector, which was highly concentrated in just a few LCFIs. For example, in June 2007, just prior to the start of the financial crisis, a dozen firms held almost two-thirds of all of the assets of the top 100 firms ($21 trillion) and 39 constitute a “who’s who” of the crisis that subsequently emerged: in order, Citigroup, Bank of America, JP Morgan Chase, Morgan Stanley, Merrill Lynch, AIG, Goldman Sachs, Fannie Mae, Freddie Mac, Wachovia, Lehman Brothers, and Wells Fargo. (Bear Stearns and Washington Mutual come in at No. 15 and 17, respectively.) All of these LCFIs were actively engaged in the mortgage market, and, of these 15 firms, one could convincingly argue that at least 9 of them either failed or were about to fail in the absence of government intervention. Of course, the GSE firms and these LCFIs were not identical in form. The LCFIs had a more diversified product line, were afforded greater flexibility, and increasingly were perceived to have a too-big-to-fail government guarantee -- while the GSEs had a public mission, received a more explicit government guarantee, and were subject to lighter capital requirements. But when one digs beneath the surface, the failure of the LCFIs and the GSEs is quite similar – a highly leveraged bet on the mortgage market by firms that were implicitly backed by the government with artificially low funding rates only to differing degrees. Unlike Freddie and Fannie, however, these LCFIs had to resort to regulatory arbitrage tricks, in particular: 1. They funded portfolios of risky mortgage loans via off-balance sheet vehicles (conduits and special investment vehicles [SIVs]) that received favorable capital treatment under the Basel standards. 2. They made outright purchases of AAA-tranches of non-prime securities, which were treated as having low credit risk and zero liquidity and funding risk. 3. They enjoyed further capital relief on AAA-tranches if they bought “underpriced” protection on securitized products from monoline insurance companies and AIG (which were not subject to similar prudential standards). 4. In August 2004, investment banks successfully lobbied the SEC to amend the net capital rule of the Securities Exchange Act of 1934, which effectively allowed for leverage to increase in return for greater supervision....
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But this is not the whole story as it still does not...

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