Housing: Who is buying Mortgage Securities?
This is a question that Col Lounsbury asked, and since it was relevant to a discussion my readers have been having on this blog I decided to repost the hilights.
Who is buying mortgage securities? People who buy government backed bond funds.
At least some of the record amount of cash flowing into bond mutual funds is going the right direction -- into mortgage-backed securities.
“We don’t really like Treasurys now,” says Mark Kiesel, a member of Pimco Funds’ investment committee. “We’re buying mortgages.”
Commonly called Ginnie Mae funds, shorthand for the Government National Mortgage Association, these are something we rarely see these days: government bond funds that don’t appear overpriced. Another attractively priced group: municipals. And an even prettier bird on that roost: the sovereign debt of European countries.
Traditionally, most of these buyers have been institutions.
Investors in the $1.7 trillion agency mortgage securities market include institutions of all sizes: corporations, commercial banks, life insurance companies, pension funds, trust funds, mutual funds and charitable endowments. In recent years, individual investors have also become significant purchasers of mortgage securities.
Over the years, foreign buyers like China have subsidized our mortgage rates as well over the years.
In the 12 months ended in April (2001), Chinese financial institutions gobbled up nearly $30 billion in dollar-denominated securities issued by Fannie Mae and Freddie Mac, the two big mortgage-finance companies chartered by the U.S. government. That was more than was purchased by U.S. commercial banks and nearly three times as much as was bought by U.S. insurance companies during roughly the same period, says James Bianco, a market analyst with Bianco Research LLC.
Banks have been buying these mortgage-backed securities like these people:
Annaly Mortgage Management, Inc. owns and manages a portfolio of mortgage-backed securities to generate net income for distribution to its shareholders. All of the mortgage-backed securities it owns are issued by agencies of the United States government and carry an actual or implied AAA rating. It is self-advised and self-managed, and it performs similar investment strategies through its affiliate, Fixed Income Discount Advisory Company (FIDAC).
To give you the idea of the exposure that a bank might have this bank here seems to have $5 billion out of $42 billion in mortgage-backed securities
The Federal Home Loan Bank of Boston (the Bank) is a $41.9 billion wholesale bank for housing finance and economic development. It is cooperatively owned by eligible financial institutions that become members of the Bank by purchasing its stock. These members are community and regional financial institutions with headquarters in New England...
The Bank's investment portfolios are comprised of fixed-income securities and money-market investments. The Bank currently owns over $5 billion in mortgage-backed securities and an even greater amount of money-market investments, which include overnight and term fed funds, commercial paper, certificates of deposit, repurchase agreements, and bankers' acceptances. Other investments include U.S. Treasury and agency obligations and bonds issued by state and local housing-finance authorities. [emphasis added]
The WaPo had a good article out on Freddie Mac and Fannie Mae out as of May of 2004, indicating that the market has matured already moving from growth to value investors. However an interesting trend has been for banks to buy these mortgage-backed securities because they yeild more in a lower interest rate environment than Treasuries. This is the so-called "carry trade" at work, borrow at low and invest at higher rates.
But the biggest factor may be that the professional investors who own about 90 percent of Fannie's and Freddie's shares are coming to the conclusion that they are no longer growth stocks.
When you look at who owns Fannie and Freddie, you see "a transition from some of the higher-growth guys to some of the value guys," said analyst Paul Miller of Friedman, Billings, Ramsey Group Inc., the Arlington investment firm. FBR, which rates both stocks "buys," does not do investment banking business for either firm but has extensive investments in mortgage-backed securities guaranteed by Fannie and Freddie...
Recently, banks and savings-and-loan associations have invested much more heavily in mortgages than usual. Demand for loans is soft because of the slow economy, so the banks have extra deposits that need to be put to work. They have been so eager to invest in mortgages that they have driven up the prices of mortgage securities to the point where Fannie and Freddie consider them overpriced. [emphasis added]
So you can probably get a better micro picture by looking into who owns Freddie Mac and Fannie Mae.
Clearly we have a large degree of foreign exposure, and as I've commented there's clearly exposure to banks and savings and loans to the Fannie Mae / Freddie Mac bloat. Combine this with hedge fund credit line exposure and the consolidation of many local banks into national syndicates and conglomerates and its entirely possible if a bust were to occur that the banking system would be at systemic risk from the two ends of its carry trade - the mortgage securities end and the hedge fund end. The middle part of their business loans, municipal/state/corporate bonds, and consumer credit would just be generally hit by the hard economy and an increase in the already stratospheric bankruptcy rate.
Clearly there is some banking system risk here. Part of the reason why those "old-fashioned" anti-consolidation laws were on the books, is that they were "firewalls" leftover from the Great Depression era. Yes, they lowered the financial sector productivity but in return they created greater financial sector stability. Whenever regulatory changes like in the S&L industry that have removed these "firewalls" we've had debacles. In the late 80's it was opined that the options markets would prevent any systemic risk. They were wrong. Today the claim is that derivatives can guard against such systemic risk. In fact they can provide more flexibility in financial market transactions, or they can destabilize the market depending on how they are framed, or at least that's what Greenspan says:
Despite worries about derivatives, regulators should not impose heavier burdens on banks using the complex contracts to manage risk, Federal Reserve Chairman Alan Greenspan said Friday.
Indeed, the central bank chairman said that derivatives -- contracts that derive their value from an underlying stock, commodity or financial instrument -- have helped create wealth and improve standards of living by better allowing companies and financial markets to spread and manage risk.
Here Greenspan is talking in 1997 about derivatives. Here is a more skeptical view from 1999, discussing Greenspan's optimistic view of derivatives given their role in unraveling the Asian currency stability in the "Asian Financial Crisis" of the late nineties. Here is the speech that the critical piece refers to by Greenspan on derivatives again in 1999. Here's a commentary including comments on the money supply, Greenspan, and the potential problem with derivatives.
The picture however isn't that simple.
This paper critically reviews the literature examining the role of central banks in addressing systemic risk. We focus on how the growth in derivatives markets might affect that role. Analysis of systemic risk policy is hampered by the lack of a consensus theory of systemic risk. We propose a set of criteria that theories of systemic risk should satisfy, and we critically discuss a number of theories proposed in the literature. We argue that concerns about systemic effects of derivatives appear somewhat overstated. In particular, derivative markets do not appear unduly prone to systemic disturbances. Furthermore, derivative trading may increase informational efficiency of financial markets and provide instruments for more effective risk management. Both of these effects tend to reduce the danger of systemic crises. However, the complexity of derivative contracts (in particular, their high implicit leverage and nonlinear payoffs) do complicate the process of regulatory oversight. In addition, derivatives may make the conduct of monetary policy more difficult. Most theories of systemic risk imply a critical role for central banks as the ultimate provider of liquidity. However, the countervailing danger of moral hazard must be recognized and addressed through vigilant supervision.[emphasis added]
The GAO issued a report in 1994 examining the risk of a derivative market default creating systemic risk. However since then we've discovered LTCM. The problem isn't derivatives, but moral hazard. Derivatives can be used to hedge against risk, or to maximize leverage in arbitrage trades. The later actually increases market default risk as LTCM proved in fact rather than theory.
In any case it seems that foreign countries, banking conglomerates and syndicates, and even small investors are piling in on mortgage-backed securities. Given a booming real estate market and historically low interest rates, it seems a simple money play that even the most depraved stock-broker or fund manager can grasp as profitable. The problem therein is what happens when those trades unwind? Has Greenspan averted systemic risk? Or are there more dark secrets lurking in Fannie Mae and Freddie Mac accounting? Well I guess we're about to find out. If it didn't take a genius to realize that a simple "carry trade" could make money from these deals, then it also doesn't take a genius to figure out that the esteemed Chairman has been frantically signaling to people to lower their exposure.
Hopefully a lot of people listened. Hopefully.