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There was blood in the water yesterday for the mortgage REIT sector, with Annaly Capital Management Inc. (NYSE:NLY), Two Harbors Investment Corp. (NYSE:TWO) and Invesco Mortgage Capital (NYSE:IVR) sinking fast amid proposed regulation of the trusts' use of the Federal Home Loan Bank system.

These mREITs, in addition to jumbo-loan investor Redwood Trust Inc. (NYSE:RWT), have been allowed access to the FHLB's lending window, obtaining secure loans just as member banks do. The trusts have managed this by setting up captive insurance subsidiaries, which are then placed under the oversight of insurance regulators.

But the head of the Federal Housing Finance Agency, Mel Watt, hasn't liked this idea from the start – and it now looks like something might be done about it.

Long-term commitment to mortgage lending
The crux of Watt's concern is valid: the insurance subsidiaries are borrowing on behalf of the mREITs, which differ greatly from banks. Unlike banks, they have no deposits on hand as security – and, with the FHLB network being backed by the American taxpayer, some regulators feel that mortgage REITs inject too much uncertainty into the system.

Captive insurers are very often used as a stand-in for the parent company, particularly in the insurance industry, so it is natural that mREITs' use of them would raise red flags. In June, the FHLB put the brakes on non-bank entities like Annaly and Two Harbors gaining access to the system, implementing a three-month moratorium on the practice.

But, insurers have been allowed membership since the system was set up in the early 1930s, buying stock in the network of banks in order to access reliable, wholesale loans. Often, mortgages are used as collateral, as well.

The proposed rules, which would take effect at all 12 Federal Home Loan Banks, would change all that. New requirements would state that borrowers would be required to make long-term mortgage loans, holding a minimum of 10% of their assets in residential mortgages. Captive insurers would no longer be granted membership, although those that are currently members can stay for five years – with restrictions on borrowing.

Too harsh?
Not everyone agrees with this new paradigm. A spokesman for the Council of Federal Home Loan Banks says that these captive insurers serve a vital purpose, supporting home mortgage lending at a time when the home-loan financing model is facing difficulties. 

Similarly, analyst Michael R. Widner of KBW believes that captive insurers are not outside of the FHLB's mission, and can actually help expand mortgage credit to both individuals and businesses.

For their part, Redwood Trust has indicated that the change would not affect them negatively. But investors in all four of the aforementioned mortgage trusts seemed to disagree, and all four mREITs saw a dip in their share values after the news of the proposed changes broke. 

On the plus side, the changes are simply proposals at this point, and the open comment period runs until November 1. Even if mREITs lose their ability to join the FHLB, Annaly, Two Harbors, Invesco, and Redwood will have a five-year grace period in which to weather some of the headwinds that an increase in short-term interest rates is bound to inflict – which may have been the main reason for mREITs joining the system in the first place. 

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.