Cancer it is not aigs failure that leads to the

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cancer, it is not AIG’s failure that leads to the collapse of the financial system but the havoc caused by such a failure. And to keep with the analogy, there was no greater cancerous growth than the GSEs. As we explained in Chapter 2, they had a “mission” to expand and to serve the most vulnerable pocket of credit risk of the economy. And they were more interconnected than any other financial institution not only because of the size of their assets but also the depth of their activities, especially (i) their mortgage guarantee business, (ii) their presence in OTC derivatives, and (iii) the banking sector’s holdings of significant portions of the GSEs’ debt obligations. We discuss each of these below. On March 3, 2009, after testimony to the U.S. Senate budget committee, and, in responding to Senator’s questions on the bailout of AIG, Chairman Bernanke stated: “We have been doing what we can to break the company (AIG) up, to get it into a saleable position and try to defang it… If there’s a single episode in this entire 18 months that has made me more angry, I can’t think of one (other than) AIG.” Chairman Bernanke is referring to the Financial Products Group at AIG that wrote the aforementioned $450 billion of CDS on AAA-rated products with little or no capital. His anger is understandable, but perhaps should have been carried through to the GSEs as well. AIG’s CDS positions were peanuts in comparison to the GSEs’ writing $3.5 trillion worth of credit guarantees on much riskier assets -- residential mortgages -- and similarly with little capital (albeit in accordance with regulatory requirements) and all in one direction. If Fannie and Freddie were allowed to fail, $3.5 trillion worth of guarantees held by the banking sector, pension and mutual funds, foreign governments, etc., would now be in a state of flux. There was no bankruptcy procedure in place to say how these guarantees might be paid relative to the debt of Fannie and Freddie. All of this risk would be transferred immediately to counterparties who most likely had not allocated any risk capital for this purpose. And, by the way, this risk would be passed on during the greatest housing collapse in the U.S. history. In addition to the high-profile collapse of Bear Stearns, by the time Fannie and Freddie’s insolvency was imminent, many of the nation’s largest mortgage lenders had gone out of business or merged under distress, including IndyMac Bank, Countrywide Financial
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52 Corporation, and New Century Financial. Letting Fannie and Freddie fail would have been the equivalent of a financial “End of Days”. Though sufficient to top the systemic risk charts, the mortgage guarantee business was not the only interconnection of the GSEs to the financial system. Fannie and Freddie presented considerable counterparty risk to the system through its large OTC derivatives book, similar in 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
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Christopher Reinemann
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