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This Powerful Washington Figure Is Worried About These mREITs

Amanda Alix
June 12, 2014

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 scrutini