Does the Market Want the Government to Back Mortgages?

There's only one thing the market fears as much as risk: a paltry return. In finance, the more calculated risk you are willing to take, the more potential reward that can follow. Advocates for the government maintaining a very strong influence in housing finance argue that the market will not tolerate the risk that mortgages pose. Poppycock! proclaims Peter Wallison, senior fellow at the American Enterprise Institute. In a Wall Street Journal op-ed, he explains that the market actually demands more risk than a fully-government guaranteed mortgage market would provide.

Wallison analyzes investor holdings data from the Federal Reserve. He finds that about $1.8 trillion was invested in either U.S. government-backed securities or those issued by government-sponsored enterprises at the end of 2010. Meanwhile, investors held at least $2.6 trillion in non-guaranteed residential and commercial mortgages. This leads Wallison to conclude:

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.

He argues this point further in what follows, explaining who these investors are and why they aren't as interested in government-backed debt.

Of course, if you look at the market before the housing bubble, then this point is almost trivial. The has never been a time when the supply of debt available to investors has consisted of as large a percentage of explicitly government-backed bonds as there would be if the government stands behind most mortgages. Even when Fannie and Freddie were chugging along as quasi-private corporations, their federal guarantee was only implicit. That meant that its debt wasn't quite considered to be truly risk-free. Its yield was, thus, generally higher than that found on explicitly government-guaranteed debt, like Treasuries.

This is an important point for two reasons.

First, it does seem plausible that you could end up in a situation where there is just too much government-guaranteed "risk-free" debt. Although risk-free debt sounds great, it also provides the lowest return possible. So investors who are looking for a more significant yield on their debt must turn to riskier securities.

We've already begun to see this problem, as subprime mortgage-backed bonds are becoming popular again. Almost all newly originated prime mortgage debt is now explicitly government-backed, which means that its return will be relatively small. That might have been okay during the financial crisis, when investors fled to investments providing the least risk possible, as uncertainty was very high. But now that the economy is recovering, they want to take on more risk to obtain a better return.

Second, if the government floods the market with debt-free securities, then it could actually face higher debt costs. In order to conjure up enough investor demand for that excess supply, yields must rise. This would make its government borrowing more expensive, imposing a new cost to taxpayers for backing the mortgage market.

Wallison's analysis suggests that a private mortgage market would be embraced by investors and benefit taxpayers. At this time, however, the private mortgage securitization market remains mostly closed. So how can Wallison possibly be correct? It's all about timing and risk.

Right now, investors are still very cautious about mortgages. Home values continue to decline, and it's generally not a great idea to invest in an asset when you don't know how much its price will decline. The uncertainty is just too great.

But once the housing market settles at a bottom, if loans are originated more prudently, then prime mortgage should again look very appealing to investors. Remember, under normal market conditions prime mortgages are historically very, very safe assets. Yet, they aren't technically risk-free, which means investors will still get a higher return from them than they would government securities. That's the perfect formula for large institutional investors who need some yield but want very low risk. The demand for a private securitization market will return, if the government doesn't prevent it by guaranteeing most mortgages instead.