As Congress prepares to debate how to replace Fannie Mae and Freddie Mac, those in politics and real estate who support a government-backed housing finance system are predicting calamity. Institutional investors, they say, will not buy U.S. mortgages or mortgage-backed securities unless they are guaranteed by the government. The numbers tell a different story.
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.
The Fed's flow of funds data also includes a $4.6 trillion category called "corporate and foreign bonds," which includes privately issued mortgage-backed securities. Although this category is not further broken down, the mortgage-backed securities within it would add to the total of mortgage assets not guaranteed by the government.
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.
Who are these institutional investors, and why do they prefer whole mortgages and private mortgage-backed securities over U.S. government-backed mortgage securities? The biggest members of this class fall into three categories—life insurers ($5.1 trillion in assets), private pension funds ($6 trillion) and mutual funds ($8 trillion). What these institutional investors have in common is a desire for yield. Life insurers and pension funds have long-term liabilities they have to cover, and mutual funds function in a competitive environment in which yield is important to retaining their investors.
Privately issued instruments provide market rates of return that allow these institutions to meet their long-term obligations. U.S. government agencies, by contrast, don't pass this test. Their yields are low because their interest rates, subsidized by the taxpayers, are lower. That doesn't mean they have figured out how to escape from market risk. Instead, as we know from experience, the taxpayers eventually have to compensate for this risk through bailouts of Fannie and Freddie and other government housing finance ventures.
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.
Private U.S. institutional investors have $13 trillion invested in fixed income or other debt securities. Much of this investment is going into corporate debt, including junk bonds, because mortgages or mortgage-backed securities yielding market rates are not available—and were not even in 2006. If there were good private mortgage-backed securities available, institutional investors would be eagerly backing the U.S. housing market.
Accordingly, in addition to eliminating Fannie and Freddie, Congress should create the legal framework for a private system of mortgage finance—a system that will supplant the government-sponsored enterprises and mobilize trillions of dollars in private investment for housing.
This can be done by basing a securitization system solely on prime mortgages, backed by mortgage insurance. The Obama administration has already recognized, in a recent white paper, that a properly designed private system could work. All that is necessary now is for Republicans in the House to define the terms of a prime mortgage and how Fannie and Freddie can gradually be withdrawn from the market.
Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies at AEI.