Quick. Who was the biggest institutional investor in mortgage-backed securities last year? Did you guess a big mutual fund, or a giant insurance company?

Actually, the largest holder of MBS last fiscal year was Teachers Insurance and Annuity Association--a pension fund. That's according to Capital Access of Murray Hill, N.J., which said New York City-based TIAA held $29 billion in mortgage securities as of March of this year.

Pension funds (corporate, public, and union) are quiet but key players in the mortgage business. Not only are they big investors in mortgages, but some of the bigger ones also have origination efforts themselves. And now a change has been made to their investment powers that may boost portfolios even higher.

In August, the Department of Labor proposed changing the Employment Retirement Income Security Act (ERISA) to allow expanded investments in mortgage securities by pension funds. Subordinate tranches of securities and investment grades as low as BBB will now be eligible.

The move "levels the investment playing field for commercial mortgage-backed securities," says Jeff DeBoer, president of the Washington-based Real Estate Roundtable, one of the members of a consortium that lobbied for the change, which was proposed by The Bond Market Association.

DeBoer thinks the new rules, expected to be enacted by the time this issue of U.S. Banker is published, could cause pension MBS investments to increase by tens of billions of dollars, primarily in the investment-grade commercial mortgage arena.

George Miller, deputy general counsel for TBMA, isn't quite as enthusiastic, saying that the change may be "evolutionary, not revolutionary" as fund managers pause to learn the characteristics of new types of investments. "I think it's going to take time to work its way through," he says.

But he agrees that pension funds want to add to their mortgage portfolios, and says there are "tens and hundreds of billions of dollars" in subordinated tranches newly eligible, particularly in CMBS.

And DeBoer says that investment bankers have told him pension managers show "a substantial appetite" for securities covered by the expanded powers.

Specifically, pension funds now can buy subordinated tranches of MBS, CMBS or asset-backed securities, where before they could only buy senior classes. In addition, BBB-rated tranches of CMBS are now added to the A and higher grades previously eligible.

However, in the ABS sector, which includes subprime mortgages, not all home-equity securities will be affected by the new rule. Only closed-end home-equity loans will be eligible, not securities backed by open-ended lines of credit (HELOCs).

DeBoer notes that the new rules will eliminate a couple of roadblocks that have been hampering any pension investment at all in CMBS, which he says was only a tiny portion of the $67 billion in those securities issued last year.

Pensions had been allowed to invest in CMBS rated A and above, and risks were minimal because the securities were backed by collateral from many different parties. But funds hadn't bought CMBS because of two other provisions, the related-party rule and the prohibited-transaction rule, he says.

Previously, pension funds had to scour each loan in a CMBS pool (and there can be hundreds of them) to check for conflicts with these rules. The costs and time involved led them to shun CMBS and instead buy residential securities, where they didn't have to do such arduous due diligence.

In addition, DeBoer says, pension fund managers feared onerous tax penalties if they ran afoul of those rules.

How big a deal is the mortgage/real estate sector to pension funds? Bigger than you'd think. It represents only a small part of their widely diversified portfolios, but the dollar amounts are significant.

The Council of Institutional Investors, a Washington, DC-based pension fund trade group, has surveyed 68 of its members, and found that on average, a relatively tiny 3.6% of their assets is in real estate, either through securities or direct investments, according to Ann Yerger, the organization's director of research.

But with $1.3 trillion in assets among that survey group of small, medium and large pension funds, that amounts to more than $45 billion in investments.

And Miller notes that of the $4 trillion in assets held by public pension funds, hundreds of billions of dollars is in real estate.

In addition to mortgage securities or direct investments, the funds also have an appetite for mortgage agency debt. In August, for instance, Fannie Mae issued or reopened $11.5 billion of its Benchmark notes, and corporate pension funds took down more than $300 million of the debt.

And, they can be involved in the origination side of the market, as well. CalPERS, the big California state employees pension fund, recently announced an increase in the loan limit available to its 1.2 million members--the state's employees can now borrow up to an incredible $1,080,100 from the fund.

CalPERS members go for mortgages to a consortium of 71 lenders, managed by First Nationwide Mortgage Corp., based in Sacramento. The mortgages are packaged by First Nationwide, mostly into MBS, which CalPERS then buys for its portfolio, effectively funding them by providing a secondary market.

All in, the fund has bought 60,000 mortgages, for a total of $8 billion, since inception of the Member Home Loan Program in 1989 by the old Lomas Mortgage Corp.

In the second quarter of this year, the pension fund bought $238 million in loans. Breaking down the purchases by sector, CalPERS bought $128 million of Fannie Mae and Ginnie Mae MBS, $105 million in private label mortgage securities, and nearly $5 million of personal loans from its members. These last are actually separate loans for downpayments, collateralized by the member's retirement account.

All these numbers were up substantially from the previous quarter, an impressive showing since the general mortgage market has been declining all year.

For its fiscal year 1999-2000, which ended June 30, CalPERS bought about $1.2 billion in mortgages, as well as 2,800 personal loans for approximately $21 million.

Its mortgage portfolio stood at $1.38 billion as of June 30, with nearly a billion of that in Fannie Maes, $100 million in Ginnie Maes, a quarter of a billion dollars in participation certificates (unsecuritized mortgages, mostly jumbos), and $50 million in member loans.

Besides the big boost in limits to million-dollar mortgages, the pension fund also recently instituted a 97% loan-to-value program and a program designed to lower monthly payments and increase tax deductibility.

And if you're wondering about how well those state employees must be doing, to be able to afford million-dollar mortgages, Tom Werder, first vice president at First Nationwide, concedes that there haven't been too many takers yet.

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