The Federal Reserve currently pays banks 0.25% per year on funds banks hold in reserve at the Fed. It also pays on excess reserves -- funds that aren't required to be held at the Fed.
This policy counteracts the effects of quantitative easing. When the Fed buys U.S. Treasuries and MBSes from financial institutions, most sellers just park their cash at the Federal Reserve to collect that lucrative 0.25% annual risk-free return.
And as a result, trillions of excess reserves have piled up.
Some are saying the Fed should stop paying banks 0.25% not to lend as a way to boost the economy. Janet Yellen is open to the idea. It's a big debate, but if the Fed ends its free money policies, mREITs could be the biggest winners.
How mREITs win
American Capital Agency (NASDAQ:AGNC) and Annaly Capital Management (NYSE:NLY) use repurchase agreements to borrow cheap money. As of the last quarter, American Capital Agency paid 0.41% per year to borrow more than $30 billion in less than 30 day capital from banks via repurchase agreements. Annaly Capital paid 0.35% for nearly $24 billion from similar financing agreements.
Very short-term repurchase agreements are at the core of American Capital Agency's and Annaly Capital's funding sources.
But because the Fed pays banks 0.25% on excess reserves, banks have no incentive to make loans -- even short-term repurchase agreements -- at a rate less than 0.25%. A real market rate would undoubtedly be lower than 0.25%. Why else would banks pile so much cash in the Federal Reserve?
Real rates are much lower
If the Fed pulled the rug out from under the 0.25% rate it pays banks to keep reserves at the Fed, Annaly Capital and American Capital Agency would score much, much cheaper financing. The one-month U.S. Treasury bill will become the new, short-term risk-free rate. That rate is currently 0.03% per year.
Thus, it's possible that mREITs would see an immediate 0.22% change in their borrowing costs if the Fed stopped paying so darn much for excess reserves. That, of course, would have an immediate impact on the spreads mREITs earn by borrowing cheap and investing at higher rates, juicing profitability.
Will it happen? For now, it seems unlikely. Banks warned they would start paying negative interest on checking and savings accounts if the Fed ended its handout to the banking system. However, if Yellen decides to lower the rate the Fed pays banks not to lend, mREITs would be some of the biggest beneficiaries.