They say they can't stomach the default risk, but what's the alternative?

600 fannie mae diag REUTERS Jason Reed.jpg

Nobody wants to see taxpayers responsible for another $150 billion bailout of the mortgage market. That was the consequence for the government implicitly backing the mortgage finance companies Fannie Mae and Freddie Mac. Unfortunately, a quick, clean exit strategy for the government doesn't exist: when the crisis hit, the private credit market rejected mortgage risk. So the government stepped in to fill the gap, backing nearly every new mortgage. Now, investors are saying that their appetite for mortgages may never return. Do they really mean it?

The Threat

In a House subcommittee hearing on Thursday, investors said that foreign investors would not provide capital to fund U.S. mortgages unless the government backing was in place. But that's not all: many domestic investors would shun mortgages as well. Here's Jon Prior at Housing Wire reporting:

Michael Farrell, CEO of the real estate investment trust Annaly Capital Management, which has been investing heavily in agency MBS since the crisis, told the House subcommittee Thursday the private market would unable to fill the gap should the government-sponsored enterprises are removed.

"Many, if not most, investors in agency MBS won't invest in private-label MBS at any price or only in reduced amounts because of their need for liquidity or the restrictions of their investment guidelines," Farrell said.

He cited Credit Suisse analysts, who recently estimated the U.S. housing market would lose between $3 trillion and $4 trillion in funding both domestically and globally if agency MBS was replaced by products such as Alt-A mortgages or other credit sensitive instruments.

The problem is that these investors want ultra-high quality debt, and they presumably would worry that mortgage default risk would taint mortgage-backed securities. They don't have to look back far to make their point: mortgage securities nearly brought down the global financial system in 2008 because they became toxic when home prices started plummeting.

But What's The Alternative?

While investors' attitude is somewhat understandable here, what would they buy instead of private label U.S. mortgage securities if the government left the market? The reality is that there's a finite amount of virtually risk-free debt. In this case, they want U.S. denominated debt, in particular. So that only leaves Treasuries or other debt implicitly backed by the government. Considering that the Congress will likely be on an austerity kick for at least the next decade, the nation's debt issuance might also begin to decline in coming years.

So you've got a situation where supply of effectively risk-free U.S. dollar-dominated debt would decline sharply if the government stopped backing mortgages. Meanwhile, supply is likely to decline further through austerity. If investors need safe bonds to purchase, then wouldn't prime mortgage securities be their best bet -- even without the government's stamp? These investors will have no where else to turn.

Moreover, in time investors will come to appreciate private label mortgage securities again. As technology progresses, analyzing the bonds will become easier and transparency will become better. That will lead to more due diligence on the part of investors and less reliance on the rating agencies. This should help to prevent another bubble where investors blindly bought AAA-rated mortgage securities that were actually very risky.

Normal Demand Could Match Weaker Supply

Through the reasoning above, it seems plausible that most investors will come to embrace private label mortgage securities again. But some won't. However, there are some other options that could interest those other investors that won't necessarily require a government backing.

For example, through some government reforms, the U.S. might be able to create a covered bond market. This is a funding mechanism that is popular in Europe, where banks sell debt backed by their credit worthiness but also secured by mortgages. So it's a lot like mortgage-backed securities, but has an extra layer of protection: even if the mortgages perform badly, a highly-rated bank will be standing behind the bonds. On the other hand, if the bank goes bad, investors still have the mortgage collateral to rely on to avoid losses.

Covered bonds and prime private label mortgage-backed securities should be able to eventually account for most of the current funding out there. But still, some investors wouldn't be interested in either product. But that might be okay.

The U.S. had such a massive housing bubble due to overinvestment in housing. If funding becomes a little bit harder to get and a little bit more expensive, then this could actually be positive. This new funding environment could serve as a check for risk. In reality, mortgages aren't totally risk free, so they shouldn't be treated like they are by investors. This distortion is part of the reason why investors loved mortgage exposure during the bubble.

So I wouldn't get too worried about the threat by investors above. Through well-crafted housing policy reform, the government shouldn't need to back most mortgages in the future. Getting there might take some time, as investors need to become comfortable with mortgages again. But eventually, there should be plenty of funding available to accommodate a good-functioning mortgage market.

Image Credit: REUTERS Jason Reed.jpg

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