Mortgage REITs such as Annaly Capital (NYSE:NLY) and American Capital Agency (NASDAQ:AGNC) have come under regulatory scrutiny this year as their expanding stable of agency mortgage-backed securities and high levels of leverage spark worries about their stability.
The interest rate sensitive trusts make heavy use of mortgage-bond financing through repurchase agreements, and regulators fear that rising interest rates could decrease the value of the MBSes used as collateral, sparking a sell-off by mREITs that could put the entire financial system at risk.
Last week, the International Monetary Fund added its voice to that of the Financial Stability Oversight Council, urging closer regulation of mREITs to minimize their destabilizing effects on the $5.2 trillion repo market.
This past spring, the FSOC released a report in which it highlighted agency mREITs as contributing to the chances of a convexity event, in which long-term interest rates are driven upwards by MBS investors trying to hedge risk against higher rates by selling Treasuries, or buying interest rate swaps. The report notes that this scenario could pose a systemic risk, but it did not name any specific mREITs as needing additional regulation.
Still, concern is growing, likely because of the inevitable winding down of QE3 by the Federal Reserve, which will surely result in higher long-term interest rates. As a recent report by TD Bank notes, this event will cause legacy MBSes, used by mREITs as repo collateral, to lose value. In turn, lenders might refuse to roll over repo contracts, an event that could prompt mREITs to sell large quantities of securities in order to make their margin calls -- which could, theoretically, destabilize the entire financial system.
How great is the risk?
In answer to these concerns, hybrid mREIT Two Harbors (NYSE:TWO) compiled a report, noting that mortgage REITs hold a very small share of outstanding MBSes, ranking seventh out of the nine biggest players. Although Two Harbors also holds non-agency paper, it is the third-largest trust after Annaly and American Capital Agency -- and could find itself coming under regulatory scrutiny, as well.
Even the FSOC echoes Two Harbors' assertion, noting that agency mREITs hold only 4.8% of mortgage bonds, while commercial banks hold 24.3%, and mutual funds retain 17%. The risk from mREITs alone, it seems, is not great.
The bigger issue may be the repo market itself, something that the current debt-ceiling crisis is bringing front and center. A recent article in Bloomberg notes that, after the close shave two years ago regarding raising the debt limit, controls were put in place to prevent a credit meltdown. The Treasury Market Practices Group has fashioned a system to ensure the smooth operation of the repo market in case an agreement isn't reached, though the committee admits this is still a work in progress.
Also notable during the debt limit negotiations in August 2011: Both Annaly and American Capital Agency experienced a momentary flash crash, plunging 19% and 22%, respectively. This phenomenon was attributed to investors' fears that mREITs would be shut out of the repo market -- the exact scenario that afflicted Lehman Brothers, triggering the financial crisis.
The incident starkly demonstrates the power of the shadowy repo market system, which, as the financial crisis so clearly proved, poses a greater overall risk to the economy than any one of its isolated components ever could.
Fool contributor 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.