Regulators should boost oversight of the largest real-estate investment trusts that use borrowed money to invest in mortgage-backed securities because rising interest rates may push the firms into asset sales that destabilize markets, the International Monetary Fund said.
A version of that scenario occurred during the rise in rates that began in May, the IMF said. Repercussions might roil the REITs’ lenders, disrupt the $5.3 trillion market in which they invest and damage the broader U.S. economy, according to its Global Financial Stability Report released today.
Further rate rises might “lead to a more destabilizing unwinding of positions,” with a surge of 0.5 percentage point or more reducing the portfolio values at the biggest mortgage REITs “enough to generate at least temporary dislocations in the MBS market,” the Washington-based group said.
The IMF joins Federal Reserve Governor Jeremy Stein and the U.S. Financial Stability Oversight Council in saying this year that the companies led by Annaly Capital Management Inc. and American Capital Agency Corp. pose risks to markets. The FSOC, the board of regulators established after the 2008 financial crisis, failed to label any of the firms “systemically important” and in need of greater oversight, after mentioning the mortgage REIT industry in its annual report in April.
Annaly, based in New York, had $102.4 billion of assets on June 30 and $13.3 billion of shareholder equity, while Bethesda, Maryland-based American Capital Agency had $98.7 billion of assets and $10.3 billion of equity, according to data compiled by Bloomberg.
With the amount of repurchase agreement, or repo, financing used by the two largest mortgage REITS comparable to that of Lehman Brothers Holdings Inc. before its 2008 collapse that roiled the global economy, “at the very least the mREITs point to a microcosm of fragilities in the shadow banking system that deserve closer monitoring,” the IMF said today.
The reliance by the industry on short-term loans to invest in government-backed mortgage securities with strategies involving interrelated risks mean their sales as prices decline might create a “fire sale ‘risk spiral,’” according to the report.
Sales may reduce the value of holdings among other investors such as banks and potentially cause declines big enough to “induce repo lenders to pull back funding or raise rates more broadly (or both), with negative consequences for other leveraged short-term borrowers,” the IMF said.
“Sizable disruptions in secondary mortgage markets against a backdrop of rising mortgage rates could also have macroeconomic implications, jeopardizing the still-fragile housing recovery,” according to the report.
Increased oversight of mortgage REITs and firms involved in the repo market that they turn to for financing “would help reduce the risk of a cascading failure of counterparties.” A review of repo “haircuts,” or down payments, would be “desirable,” along with greater disclosure, the IMF said.
Authorities also “could consider changing the exemption status” for certain mortgage REITs, or label the largest as systemically important and in need of more oversight, the group said. The U.S. Securities and Exchange Commission, after asking in 2011 for comments on the companies’ exemption from the Investment Company Act that allows them to use unlimited leverage, didn’t announce any adjustments to the rule.
“There are no surprises for us in the issues they raised” in the IMF report, Annaly Chief Risk Officer Eric Szabo said in a telephone interview. Mortgage REITs, other investment managers and banks are already “actively engaged with policy makers” to strengthen the resilience of the repo market, he said.
Justin Cressal, a spokesman for American Capital Agency, didn’t return an e-mail message seeking comment on the report.