friday, 8 november of 2013

Danger: US mortgage market whiplash risk


US mortgage market whiplash risk

This week, the US government was handed one small reason to smile. A survey by the National Association of Realtors suggests house prices rose in nine out of 10 US cities in the year to October, growing on average by 14 per cent.

This represents the most broad-based increase seen since 2007. And since it comes hard on the heels of other upbeat housing data, there is growing optimism in some policy quarters that the scars from the 2007 housing crash may be healing, boosting overall economic growth.

So far, so cheering. But before realtors get too confident about the future, it is worth looking at some sobering research from the International Monetary Fund, buried deep inside this autumn’s Global Financial Stability Report. This analysis, which looks at mortgage real estate investment trusts (M-Reits) – which invest in packages of mortgage bonds – did not make headlines when the IMF met last month, because M-Reits are a fairly specialist sector. That is a pity, given that the IMF says the rapidly expanding world of M-Reits has the potential to deliver nasty surprises if, or when, US interest rates rise.

Most notably, even a modest increase in rates could spark fire sales of mortgage-backed bonds, which would raise mortgage interest rates sharply for consumers. And that could not just hurt housing markets but produce knock-on waves of instability in other areas of finance.

“Rapid M-Reit deleveraging has important spillover implications,” the IMF report warns. “Sizeable disruptions in secondary mortgage markets against a backdrop of rising mortgage rates could also have macroeconomic implications, jeopardising the still-fragile housing recovery.”

The IMF’s concern arises from the business model of M-Reits. Until a few years ago, these were relatively small entities, and because they operated in the “shadow banking world” (ie outside banks) they received scant regulatory scrutiny. However, in the past five years they have exploded in size, partly because they have rushed to fill gaps created by banks reducing their lending activities (to comply with new regulatory capital rules). Indeed, M-Reits now hold more mortgage bonds than government state enterprises such as Fannie Mae.


In spite of this rapid growth, it is not the overall size of the sector that prompts the IMF concern; it is still “only” $500bn in total, and the largest two companies, Annaly Capital and American Capital Agency, had $ and $98.7bn of assets respectively, according to Bloomberg data.

For the moment, then, investors had better keep watching those M-Reits, and brace themselves for a nasty mortgage market whiplash if – or when – US rates do finally start to rise

The problem is that the sector is plagued by liability mismatches and other vulnerabilities. Most notably, M-Reits hold long-term mortgage assets, but rely heavily on short-term funding from repurchase markets. Worse still, they do not have much of a capital cushion, because they are required by law to return profits to investors.

This leaves them facing the same risks that plagued shadow banking credit vehicles before 2007. If a shock occurs, M-Reits will be forced to embark on fire sales of assets to meet investor demands. That, in turn, could cause a surge in mortgage-backed security rates. Indeed, that is exactly what happened this spring. When mere speculation of a looming “taper” in the Federal Reserve’s easing policy sparked an increase in Treasury yields, this caused so much stress in M-Reits that they furtively dumped $30bn of mortgage bonds in a single week. Mortgage finance costs jumped more than 100 basis points.

No action

This could be a mere foretaste of what will happen when the Fed does finally act. “Further interest rate increases could lead to a more destabilising unwinding of positions, with higher leverage magnifying losses,” the IMF warns, noting that “such a scenario of rapid M-Reit deleveraging has important spillover implications” for other areas of finance, such as repurchase markets.

The good news is that this scenario still seems a long way off, given that the Fed seems unlikely to taper soon. And entities such as the IMF already openly talking about the dangers is welcome. Better still, a debate is under way about these risks among US policy makers: six months ago the Financial Stability Oversight Council issued warnings about M-Reits.

But the bad news is there has been precious little action to address these vulnerabilities since that FSOC report – partly because of a widespread hope that interest rate rises are still some way off. In any case, because M-Reits sit in the shadow banking world, the level of regulatory involvement is still being debated. For the moment, then, investors had better keep watching those M-Reits, and brace themselves for a nasty mortgage market whiplash if – or when – US rates do finally start to rise.


(Published by Financial Times – November 7, 2013)

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