The growth of the U.S. subprime mortgage market was made possible only by the willingness of investors to fund that market. The largest single investors in the market for private label subprime securities appears to have been Fannie Mae and Freddie Mac, whose market share reached almost 40% of private label subprime mortgage-backed securties (MBS) in 2004. A less recognized driver was investment demand coming from the European Union. Perhaps the role of EU has been less appreciated due to data limitations, which will soon become apparent.

What we do know is that as of June 30, 2008, just before the crisis hit, almost $460 billion in non-agency residential mortgage-backed securities (RMBS) was held outside the US (see table 24 here). This represented almost a fourth of total US-issued RMBS at that time. Of course not all non-agency MBS is subprime. For instance a significant share are jumbo prime mortgages. Estimates suggest subprime were a little more than half of outstanding non-agency MBS. This breakdown does not appear to be available for EU holdings, which were almost half of non-US holdings. More than $30 billion was held by German institutions.

One reason Germany merits special discussion is that some research has been done on who exactly these institutions were. Germany is also interesting because of the diversity of its financial system and the special role of state-owned banks. Almost half of banking in Germany is conducted by the public sector. The most prominent of this being the Landesbanken, which are owned by the German regional governments. One study found losses from US subprime MBS to be “on average three times as large for state-owned banks compared to privately owned banks.” Overall about two-thirds of losses in Germany on US subprime MBS were from holdings by state owned banks.

What I find to be of particular interest is that the political nature of state-owned banks appears as a statisically significant driver of these losses. The same study found that German state-owned banks had board of directors that were primarily politicians with little experience in finance and that drove losses. Another study has found similar impacts of politics on banking lending in Germany. Even the IMF warned before the crisis of dangers lurking in state-owned German banks.

This German experience offers a number of lessons for financial reform. First, my friends who advocate for an expansion of “public banks” in the U.S. should give a close look to the dismal experience of such in the EU. Second, it appears that a significant portion, perhaps more than half, of the ultimate global investor demand for US subprime MBS came from not from the private sector but from state-controlled institutions. While these entities clearly lack sufficient market discipline, there is growing evidence that their very political nature leaves them open to greater losses with signicant harm to the larger economy. If we truly desire financial stability and economic growth, then a greater role for the private market in finance is badly needed.