One of the oft cited concerns of those opposed to a fully private mortgage finance market is that there will be no liquidity available without a government guarantee. The thinking is that investors will be unwilling to jump into the mortgage market unless the government ensures they won't take a loss. On its face this should be reason to ask why mortgage assets should be treated differently from other assets that investors put money into without a guarantee—though that is beside the point (though for more see this list of 10 reasons we don't need Uncle Sam backing the housing sector).
But what is the true liquidity available for mortgage financing—buying whole mortgages or mortgage-backed securities—in a fully private market? As it turns out, quite a bit.
Consider the following data as cited by Peter Wallison in today's WSJ:
According to the Federal Reserve's flow of funds data, nonbank institutional investors had assets of $28 trillion in the fourth quarter of 2010. About $13 trillion of this amount was invested in fixed-income or debt securities—but only $1.8 trillion was invested in U.S. government-backed securities issued by government agencies or the government-sponsored enterprises Fannie and Freddie.
Thus, even at a time when private housing finance has not yet revived—and most of the investment in housing is flowing through Fannie and Freddie or the Federal Housing Administration (FHA)—less than one-seventh of the funds invested in debt securities by institutional investors were invested in government-backed mortgage securities.
By contrast, at the end of 2010, nonbank institutional investors had assets consisting of $2.6 trillion in both residential and commercial whole mortgages. Whole mortgages are not guaranteed by Fannie and Freddie or the FHA. This means that even after the financial crisis, institutional investors held a larger dollar amount of mortgages that are not backed by the government than the mortgages that are perceived as government-guaranteed.
There are a number of actors in the mortgage financing process, but these are some of the most important. These investors drive the market by providing the cash that filters through the system. And they all are on a constant search for yield.
Here is a visual representation of what Wallison is talking about, and where capital currently goes:
Non-bank Institutional Investor Distibution of Asset Investment
Source: 4Q 2010 Federal Flow of Funds
As Wallison writes: "These data should have a profound effect on the question of whether to replace Fannie and Freddie with another government-backed system. They show that nonbank institutional investors prefer private mortgages and mortgage-backed securities to government-backed instruments, and that Congress is being given the wrong information about the preferences of these large debt buyers."
The reason for this is that privately issued instruments provide market rates of return that government backed assets can't compete with. Treasuries, munis, and agency debt all have low yields because their interest rates, subsidized by the taxpayers, are lower. So with trillions looking for yield there seems to be a demand for private mortgage-backed securities that don't have a government guarantee bringing down investment returns.
The next question is who are these investors?
- Mutual funds make up about $8 trillion of the capital in the above pool and operate in a competitive environment that measures success by high returns on investment;
- Private pension funds have about $6 trillion and are always searching for yield to cover their long-term liabilities; and
- Life insurance companies have about $51. trillion in assets to cover their similar liabilities.
Wallison also cites more detail on where the investment is coming from:
This analysis is confirmed by looking at who the buyers of government-backed securities actually are. In 2006, before the financial crisis, 11% of the holders were foreign central banks, 23% were federal, state and local governments and enterprises and their pension funds, and 21% were insured depository institutions. Thus more than 50% of the demand for Fannie and Freddie mortgage-backed securities came from U.S. and foreign governments, or from organizations the government controls or regulates.
In other words, government-backed mortgage securities are primarily attractive to risk-averse institutions. They buy these securities instead of U.S. Treasurys because they consider them as safe or liquid as Treasurys but with a slightly higher yield. (This reduces the demand for Treasurys, thus raising the interest costs taxpayers have to pay on Treasury debt.)
What all this shows is that—contrary to what Congress is being told—institutional investors are not particularly interested in government-guaranteed assets. Thus, if we want U.S. and foreign institutional investors to invest in our mortgage market, we should be looking to a private system of mortgage finance, and not one run or backed by the government.
Read the rest of the Wallison column here.