If Not Fannie, then Who?

A common defense offered for keeping Fannie Mae and Freddie Mac, or something like them, is that the market simply cannot absorb the same level of mortgage lending without them.  The central flaw in this argument is that Fannie and Freddie themselves must be funded by the market.  So if the financial markets can absorb X in GSE debt, then the financial markets can absorb X in mortgages.

Different market participants currently face different capital requirements for the same assets.  To some extent, Fannie and Freddie were a vehicle for shifting mortgage risk from higher capitalized institutions to less capitalized.  If the Obama administration and bank regulators are serious about closing “regulatory gaps” then all entities backed by the govt, implicit or otherwise, should hold the same capital against the same risks.  In the following I will thus assume that differences in capital requirements behind mortgages are irrelevant.

So to determine who could absorb the GSEs’ buying of mortgages, let’s look at who holds GSE debt.  Of the approximately $5 trillion in GSE debt and mortgage backed securities (MBS), about a trillion is held by commercial banks and thrifts.  Another trillion is held by insurance companies and pension funds.  Close to a trillion is held by mutual funds.  That quickly gets one to 3 trillion.  Households and state/local governments also hold close to a trillion.  That leaves us with about a trillion left, held mostly by foreign governments (usually central banks).  For this analysis, I am using data pre-Federal Reserve purchases of GSE debt/MBS.

Given that banks hold about a trillion in excess reserves and over 9 trillion in deposits, I think its fair to assume commercial banks could easily absorb another $1 trillion in mortgages, as represented by foreign holders.   Some holders of GSE debt are legally prohibited from holding mortgages.  These entities can generally hold bank commercial paper (think mutual funds) which could then fund the same level of mortgages.  

The point here should be clear, by swapping out GSE debt for mortgages, our financial markets have sufficient capacity to replace Fannie and Freddie.  In fact, we are the only advanced country that does not fund our mortgage market primarily or exclusively with bank deposits.  This analysis also does not assume any reduction in the size of our mortgage market, which should actually be an objective of reform.  We devote too much capital to mortgages, at the expense of more productive sectors of our economy.