In the latest sign of Washington's growing concern with market bubbles US financial regulators are setting their eyes on mortgage real estate investment trust companies as a potential risk to the country’s financial system, the Wall Street Journal reported on Thursday. The Financial Stability Oversight Council is expected to cite mortgage REITs as a point of vulnerability in the real estate market in its annual report next week, according to an inside source quoted by The Journal.
Mortgage REITs (mREITs) are publicly traded companies that borrow funds to invest in real-estate debt. Unlike regular real estate investment trust (firms that invest in physical properties), mREITs buy mortgage securities backed by Fannie Mae and Freddie Mac and offer returns to investors of as much as 15 percent. Assets of mREITs quadrupled in the past four years and currently are worth more than $400 billion (₤260 billion). The market capitalisation of mREITs more than doubled over the past three years - from $22.1 billion (₤14.4 billion) to $59 billion (₤38.4 billion), according to KBW Research. Of particular concern to regulators are the two largest mREITs, Annaly Capital Management (NYSE:NLY) and American Capital Agency (NASDAQ:AGNC), which hold approximately $234 billion (₤152 billion) in assets.
MREITs take advantage of the low-interest rate environment to buy long-term mortgage backed debt. Then they use those securities as collateral to get additional short-term funding, or leverage, to boost their returns. Regulators worry that the real estate investment trust firms finance their holdings with very cheap short-term debt which they have to renew on a regular basis. The Wall Street Journal quoted Stijn Van Nieuwerburgh, director of New York University's Stern Center for real estate finance research, as saying that the biggest risk for mREITs is a sudden spike in interest rates, which would hamper the firms’ ability to repay their loans. Yet, Van Nieuwerburgh added, he was “not convinced there's a big problem because these REITs are holding relatively liquid securities and represent a modest part of the mortgage market.” The mREITs industry still holds less than 10 percent of all mortgage backed securities products.
Many experts also note how important management is in the real estate investment trust business. One mREIT that seems to worry some market observers is Armour Residential (NYSE:ARR). The company holds less than $21 billion (₤13.7 billion) in assets, but it has seen its asset base jump by nearly 30 percent year-on-year, and some question the ability of management to keep up.
MREITs managers have repeatedly tried to assure investors and regulators that they are properly equipped to face market uncertainties. "Many of us have operated through challenging markets, including the financial crisis, and we continue to support and are helping to implement the regulatory changes that are being put in place to make the markets safer for all participants. This low-rate environment poses risks that investors in every market must be prudent about managing. In general, the mortgage REIT sector does so through a range of hedging tools, like interest-rate swaps, reducing leverage and conservative balance-sheet management activities,” said Annaly Capital’s chief executive Wellington J. Denahan, as quoted by The Wall Street Journal.