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Tottering towers

8 May 2012 By Martin Hutchinson, Agnes T. Crane

The Federal Reserve’s low interest rates are manna for investors borrowing to buy other assets. U.S. mortgage real estate investment trusts (REITs), which invest in home loan bonds guaranteed by Fannie Mae and Freddie Mac, are a case in point. But the sector that holds about $265 billion in mortgage bonds relies on short-term repo borrowing – widely exposed as dangerous in the 2008 crisis. Something needs to give.

Investors in mortgage REITs like their double-digit dividend yields – especially when safe debt returns and typical stock dividend yields are less than 3 percent. Yet they may be overlooking a potentially dangerous flaw in the vehicles’ structure. They sink or swim on the availability of funds in the repurchase, or repo, market where they pledge securities in return for short-term loans.

Annaly Capital Management and American Capital Agency are the two largest mortgage REITs by market value and assets. They alone had tapped the repo market for $162 billion at the end of the first quarter, more than three times the amount they were borrowing at the end of 2008. Because short-term funds by definition can dry up quickly, this is a precarious position. During the height of last year’s political debt-ceiling impasse – scarcely a real financial crisis – the two companies’ shares nose-dived on fears their repo lifeline would dry up.

The attraction, of course, is that when markets are functioning the REITs churn out easy money. They can earn 2 percent on their assets just by investing in longer-dated government-guaranteed mortgage bonds that yield over 3 percent while borrowing short-term at around 1 percent. Borrowing typically eight times their equity means they can deliver dividend yields north of 15 percent. As well as pleasing investors, REITs are lucrative for their bosses, whose pay may be tied to book value. Michael Farrell, the chief executive of Annaly, pulled down $35 million in 2011.

However, borrowing short to invest in longer-term securities – known as a carry trade – has a history of being upended unexpectedly when the Fed lifts interest rates. Not only does the cost of funding go up, but the value of the REITs’ mortgage portfolios goes down, assuming both short and long-term rates rise. If that happened, it could damage their credit and force them to put up more securities as collateral. Both Annaly and AGNC have extensive hedging programs to protect against higher rates, but if they squeeze out all the risk they also severely crimp their ability to make money.

And a mortgage REIT funding jam would be messy. The demise of Carlyle Group’s listed mortgage fund, Carlyle Capital, in 2008 is instructive. Margin calls on its repo borrowings cratered the fund that invested in up to $22 billion of seemingly safe mortgage bonds backed by government-sponsored enterprises Fannie and Freddie. Carlyle Capital had to dump its holdings, exacerbating shockwaves already shaking the mortgage and credit markets at the time. The fact that Carlyle was leveraged more than 30-to-one worsened the problem.

Annaly and AGNC have four times the assets or more but use much less aggressive leverage, making them less vulnerable. Farrell and his team at Annaly, which was founded in 1997, navigated the financial crisis despite being exposed to the mortgage market at the center of the meltdown. And although his firm aims for eight to 12 times leverage, at the end of both last year and the first quarter the ratio was significantly lower. Fast-growing AGNC, meanwhile, managed to go public as the crisis gained steam in early 2008, and its leverage has been running about eight times of late.

Moreover, markets in general aren’t as fragile now as when Carlyle Capital ran into trouble. Even so, mortgage REITs represent the kind of potential trouble-spot that watchdogs like Fed Governor Daniel Tarullo are talking about when they highlight concerns about shadow banking – the world of relatively lightly regulated non-bank financial firms that undertake bank-like activities. As with banks, regulators might think about limiting leverage, reducing the mismatch between borrowing and investing timeframes, or requiring more diverse sources of funding. Otherwise – especially with interest rates so enticingly low – they risk fueling future conflagrations.


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