This Powerful Washington Figure Is Worried About These mREITs

Regulators are turning their scrutiny upon Annaly – and others – for shadow banking activities

Jun 12, 2014 at 9:40AM

Over the past few months, mortgage REITs like Annaly Capital Management (NYSE:NLY), Invesco Mortgage Capital and Two Harbors (NYSE:TWO) have been using the Federal Home Loan Banking system to access funding, and new Federal Housing Finance Agency chief Mel Watts is worried.

By setting up so-called captive insurance units, these mREITs have accessed FHLB windows in order to borrow at lower rates than they might find at other banks, all while enjoying the implicit government guarantee that the federal banking system represents.

Shadow banking, revisited
Regulators have noted that more entities that fall under the heading of "shadow banks" – companies that use funds other than consumer deposits for their lending activities – have been using FHLB funds more heavily over the past several months. Watts is concerned because mREITs are not considered banks, and are thus not regulated as such, making their access to taxpayer-backed funding worrisome.

This isn't the first time U.S. financial regulators have trained their steely gaze upon mREITs, particularly Annaly. Last spring, chatter sprung up in regards to reining in these companies through new rules and regulations – with Annaly of particular concern, due to its enormous stable of assets.

Two Harbors, which was also feeling some pressure, quickly responded to the perceived threat by noting just how small the mREIT sector really was in the mortgage debt market – especially compared to Fannie Mae and Freddie Mac.

Things simmered down for a while, until the International Monetary Fund piped up last fall, calling for additional regulatory oversight of mREITs. The IMF was particularly concerned about the trusts having a destabilizing effect upon the $5 trillion repurchase agreement market, where mREITs usually obtain their short-term funding. If interest rates spiked, the theory went, companies like Annaly might sell off their huge stores of mortgage bonds as their values plummeted.

Should Watts worry?
Though regulators have often voiced concerns over the possible threat mREITs pose to the financial system, nothing has been done – and, of course, the sky hasn't fallen, either. But Watts would be remiss if he did not call attention to this issue, especially since it may impact an area under his jurisdiction.

Agency-heavy mREITs like Annaly Capital have always loved the added security of MBSes backed by Fannie and Freddie, so it stands to reason that they might be inclined to make their sources of funding a bit safer, as well.

But the method they are using is questionable. Captive insurers have been scrutinized by regulators for some time, particularly their use by large life insurance companies. Because these "reinsurance" units are often created to serve some specific purpose for the parent company, regulators usually look askance at these subsidiaries.

Around this time last year, a report pointed out how insurance companies could use these entities to stow liabilities that they wanted to keep off of their own balance sheets.

Here, too, the captive insurers seem to have been established for a particular reason – to borrow money from Federal Home Loan Bank members, something that Annaly Capital and Two Harbors apparently would not have been able to do on their own.

According to Bloomberg, two of the FHLB members have noted that the risks are minimal, due to their own housekeeping rules. In addition, this type of lending could conceivably give a boost to the housing market.

For its part, the FHFA announced that it is looking into the subject of mREITs using captives in order to borrow from member banks. Considering how much noise has been made on the issue of mortgage REIT regulation – and how much has actually been done – Annaly, Two Harbors, and their investors probably don't have too much to worry about.

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Amanda Alix has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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