Why Are Banks Buying More Fannie-Freddie Mortgage Bonds?

Government-owned mortgage finance giants Fannie Mae and Freddie Mac might be out of favor with the public, but the banks still love them. In fact, they are accelerating their purchases of the mortgage-backed securities issued by the firm ("agency MBS"). This might seem counterintuitive, considering that the housing market is still struggling. It shouldn't.

Jody Shenn of Bloomberg reports:

Commercial banks' holdings of mortgage bonds guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae climbed to a record $1.16 trillion in the week ended May 4, a rise of $42.7 billion since March 30 and $57.1 billion from year-end, according to Federal Reserve data. Yields on benchmark 10-year Treasuries have shrunk to 3.14 percent from this year's high of 3.74 percent on Feb. 8.

There are least five reasons why banks might be fleeing to agency MBS:

A Safe Haven for Cash

As the economy remains relatively slow, there isn't that much demand for loans from high quality borrowers. As a result, banks have a lot of cash that they don't want to just sit stagnant. They could invest it in equities or other higher-yielding opportunities, but they might worry about the uncertainty that lies ahead for the economy. As a result, they want a way for the cash to grow, without being too exposed to risk. Agency MBS provides a safe haven.

Better Yield Than Treasuries

But why not turn to Treasuries instead? Over the time period referenced above, the article says that the yield on Fannie's 30-year MBS moved from 4.5% to 3.97%. That decline was due in large part to the stronger demand for the bonds, but over this period that yield was still much better than that of Treasuries, as you can see from the quoted excerpt, by about 75 to 80 basis points.

Better Stability Than Treasuries

Still, aren't Treasuries a more stable asset in an environment where home prices are declining? Not at all: agency MBS are government-guaranteed securities too. They're just as safe as Treasuries. Moreover, some investors have begun fleeing the market for Treasuries, as they fear that prices will fall once the Federal Reserve removes itself from the market. The same can't be said for agency MBS -- there is no similar market shock that should result in weakening demand for the securities.

Mortgage Exposure, Guaranteed

The other problem is that banks have seen their exposure to mortgages shrink over the past couple of years. Almost all of the mortgages they've originated have gone to Fannie and Freddie. So what you're seeing here is essentially banks repurchasing those assets, but with a government guarantee slapped on.

They Trust the Government's Word

Finally, banks believe that the government will live up to its promise to honor all of Fannie's and Freddie's obligations. This is a pretty key point these days. Some congressional Republicans would like to see taxayers' bailout tab to these firms limited. The banks doubt that will happen. They're right: not living up to this promise would send markets reeling. It would also greatly upset global investors who hold agency securities.

So really, we shouldn't be too surprised to see banks stocking up on agency MBS right now. Their appetite may change if (when) Treasury yields begin to soar. But for now, they figure these mortgage bonds are as good as Treasuries, but more lucrative to hold.