How Dangerous Is This Investment Practice?

Federal Reserve

Source: http://www.flickr.com/photos/nexeus_fatale/

Mortgage real estate investment trusts (mREITs) are again under scrutiny. The Financial Times reports that the New York Fed is investigating how much exposure banks have to this investment vehicle, which has become increasingly popular since the 2008 financial crisis. The trusts secure long-term real estate investments through short-term borrowing in the repo market, and the practice allows short-term borrowing to finance a long-term investment.

Private discussions by regulars are a “deep dive” into mREITs, according to a source familiar with the matter who spoke to the Financial Times. The discussions and investigation are not the first time this year worry has clouded over mREIT holdings.

Federal Reserve Board Governor Jeremy Stein voiced concern in a speech in St. Louis, Missouri, in February. He said the mREIT sector grew from $152 billion at year-end 2010 to $398 billion at the end of the third quarter of 2012. He also included the following chart, illustrating the rapid growth of mREITs.

Source: http://www.federalreserve.gov/newsevents/speech/stein20130207a.htm

Source: http://www.federalreserve.gov/newsevents/speech/stein20130207a.htm

He went on to explain that the mREIT sector is directly tied to the mortgage-backed securities market and the repo market. When mortgage-backed security yields decline or the repo rate increases, mREITs are not able to generate as much income.

The International Monetary Fund’s October Global Financial Stability Report explained how this threat can materialize in the market. MREITs want to sell off holdings when interest rates rise or repo lenders reduce funding. As a result, mREITs attempt to sell in a declining market. As an example, the IMF report points to when a small-scale version of this occurred between May and June. In one week, the report says, $30 billion worth of mortgage-backed securities were sold by mREITs.

The sale was kicked off because higher interest rates and a widening spread on mortgage-backed securities were leading to a decline in portfolio values. The conditions, higher interest rates, or a quick shock to the market could produce similar or worse results.

The concern for catastrophe is not reaching investors. Earlier this month, Keefe, Bruyette & Woods – an investment bank and subsidiary of Stifel Financial Corp. (NYSE: SF) — called mREITs the “best value opportunity in a long time.” Barrons covered the analysis by KBW’s Michael Widner and Sean Tillman, who found that mREIT portfolios were trading at 15 percent discounts.

Zacks Equity Research also sees opportunity for investing in mREITs. Provided the Fed does not end its bond-buying program, Zacks saw potential growth in the iShares FTSE NAREIT Mortgage Plus Capped Index Fund as well as the Market Vector Mortgage REIT Income ETF. In both funds, two firms held the majority of mREITs: Annaly Capital Management Inc. (NYSE: NLY) and American Capital Agency Corp. (NASDAQ: AGNC)

American Capital Agency Corp. was also highlighted by Widner and Tillman as an investment opportunity. It, like Annaly Capital Management, is an mREIT. American Capital Agency Corp. was established in 2008, and Annaly Capital Management in 1996.

The IMF wants to continue examining this market because “the repo funding of the two largest mREITs is comparable to Lehman Brothers’ precrisis repo book, at the very least the mREITs point to a microcosm of fragilities in the shadow banking system that deserve closer monitoring.”

A Fed official speaking to the Financial Times gave this view: “There is definitely interest in how to figure out the systemic relevance of mortgage REITs in the repo market and ascertain how, in a period of stress, withdrawal from the market might impact it — almost like money funds in September 2008.”

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