An October 27th article in the FT (sorry, behind the pay wall) reported that the Fed, last Spring, had done a “deep dive” into broker/dealers involvement with Mortgage Real Estate Investment Trusts (MReits). The article connected the dots between the impact of what happens (if and when) the Fed tapers their purchases of mortgage backed securities and the leverage those MReits have via the repo market.
REITs have long been a fixture in the investment world. Originally these funds were flogged as a way for individuals to own a diversified pool of real estate while avoiding a layer of corporate taxes. By creating a fund-like structure that passes through at least 90% of their income, the REIT offsets any corporate taxes. (Disclaimer: We are not lawyers nor accountants, so don’t confuse this for legal or accounting expertise.)
But, in true Wall Street innovation fashion, a good idea was extended to another use. MReits, being invested in real estate related assets, are able to take advantage of the favorable tax provisions the REITs enjoy. But instead of buying bricks and mortar real estate, MReits bought securitized mortgages. And they leveraged them via repo.
Any cold winds coming from the Fed tapering their purchases of MBS means the MReits will catch a cold. While tapering isn’t on the agenda this month, the financing exposure — now highlighted by the Fed — is still there. Given the high leverage often available to big MReits, any volatility in MBS won’t be pretty. And the ultimate owner of the risk will be the repo desks doing the financing. The fear is that a disruption to the MReit repo financing will throw a wrench into the overall repo markets.
The MReit story has all the market buzzwords. It is classic maturity transformation — buying long dated assets and financing them short. MReits can se seen as shadow banks with no one there to regulate them or be a lender of last resort. An implosion of asset values along with not very deep pockets to dip into could easily lead to fire sales if the MReit’s equity is wiped out . And with lots of leverage, falling off that cliff can happen quickly. It doesn’t seem like the greatest business model in the world. The press is eager to make the connection starting with Fed tapering and ending with the repo market hitting the skids and fire sales. But it is probably a bit more nuanced than that. The paper that the MReits own and finance can be of varying liquidity. Agency and private label CMOs are on the less liquid part of the spectrum versus deeper markets like agency MBS. Financing desks change haircuts, shorten terms, and raise rates they charge MReits (although we have heard very little has actually happened and we wonder why).
So far the primary result has been a drop in the stock prices of MReits. According to an October 29th story in thestreet.com, Annaly Capital Management — one of the bell weather names in MReits — is down 23.59% from a year earlier.
Annaly Capital Management (NLY)
Oct 2012 to Oct 2013
