Unlike freddie and fannie however these lcfis had to

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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. 19 As is well documented now by the crisis, credit rating agencies provided inflated ratings to MBS and other asset-backed securities. These inflated ratings allowed increasingly risky credits to receive beneficial capital treatment. Specifically, since AAA-rated securities were given special status with respect to capital requirements, financial institutions such as FDIC-insured depository institutions, too-big-to-fail institutions, and LCFIs, all with artificially low costs of
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40 funding due to explicit or implicit government guarantees – much like Fannie Mae and Freddie Mac -- had a particular incentive to lever up on these AAA-rated securities. 20 Tables 3-2 and 3-3 highlight this race to the bottom. Table 3-2 shows the total asset growth (relative to 2003) and equally-weighted leverage (assets divided by shareholder’s equity) for the five largest commercial banks (Citigroup, JPMorgan, Wells Fargo, Bank of America, and Wachovia), five largest investment banks (Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear Stearns), and the two largest GSEs (Fannie Mae and Freddie Mac) in the U.S. during the period 2003 to 2007. Table 3-3 shows the return on assets (ROA) – an accounting measure of overall profitability of the firm, and return on equity (ROE) – an accounting measure of the performance of just the equity of the firm, again for these three sets of financial firms. In a competitive race to the bottom involving financial risk-taking, we would expect that firms expand their balance-sheets (and off-balance sheet positions if faced with on-balance sheet constraints), do so increasingly with leverage, and finance assets with an increasingly risky profile. Their economic performance as a whole – debt and equity combined – does not rise, and due to the undertaking of excessive risks, may even decline. However, the performance of their equity rises – both due to higher risk that pays off in good times and to greater leverage. As the bets go bad, equity loses value first, resulting in sharp falls in its ROE.
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