Recently Federal Reserve Chairman Ben Bernanke decided to consider “tapering” off the massive amount of money the Fed has been printing to buy up mortgages. The news threw the market in for a shock. After all, if printing massive amounts of money has not spurred the economy the way it was supposed to, why isn’t Bernanke printing even more?
Okay, I’ll stop being so snarky. The point is, the signal the Fed supposedly gave have caused recent interest rates to rise in mortgages, Treasuries, and even municipal bonds. It seems as if the police have started knocking on the door on the endless cheap money party. Undoubtedly the Fed has just caused some major havoc across the financial world, but let’s just for now focus on mortgage REITs.
Mortgage REITs (real estate investment trust) seem to be a relatively recent phenomenon. Mortgage REITs were established back in 1960s but it only recently grew extremely popular. These REITs invest in residential and commercial mortgage backed securities guaranteed by Freddie Mac and Fannie Mae.
Their main way of making money is to use short-term debt to buy longer-term mortgage securities, earning the spread between the rates. For example, if a 30-year mortgage backed security is earning 3.75% but the mortgage REITs can borrow short term at 2%, then the REITs can make a spread of 1.75%. And by adding leverage to the mix, the REITs can make even more money.
Thanks to the massive quantitative easing the Fed has undertaken, the mortgage REITs have been able to make a lot of money because all of a sudden their cost of borrowing short term funds have dropped tremendously. The nearly free money allowed these REITs to earn a relatively good returns on investing in long term mortgage backed securities. And since they are barely regulated, their ability to nearly leverage themselves to the hilt further increases their earnings.
The Connection to the Savings and Loans Crisis
I haven’t lived through the savings and loans crisis, so correct me if I am wrong, but aren’t mortgage REITs just like S&Ls? S&Ls back then took in short term deposits and made long term loans. The swift rise in short term interests destroyed the entire industry since the cost of capital surpassed the rate of returns. Could the same be happening with the mortgage REITs as well?
Mortgage REITs as a whole now have assets of over $400 billion. That is a huge chunk of money. And they are all heading for danger right now given the fact that interest rates may continue to rise. Frankly, I don’t like their reactions right now. What mortgage REITs executives have been saying is that, “so our spread is thinning? That’s okay. We will be taking on MORE leverage so we can earn more money.” Doubling down on shaky grounds? Oh boy.
Realistically, I do not think Bernanke would really have the courage to raise interest rates. The whole world’s economy has been bent out of shape by easy money and no one is going to want the party to stop. Sudden increase in interest rates (or should I say, a return to normality?) would decimate many investments and the economy as a whole that have been so used to cheap money. Mortgage REITs would be one of those industries in danger. If these REITs collapse, then there could be forced liquidation of billions of mortgage back securities. Are the taxpayers going to pay for that as well? And if it happens will it again slow down this “magical housing recovery” we’ve been having?