When an investment gets hot, investors plow money into it as
fast as they can. As long as a market is big enough, that doesn't
necessarily pose a problem. But in the aftermath of the housing
bubble of the mid-2000s, could investors be stampeding into an
area that's just as likely to fall
as home prices were at the peak of the housing boom?
The increasing importance of mortgage REITs
The housing market relies on mortgage financing to function
properly, and the mortgage market in turn has come to depend on
securitized investment vehicles in order to maintain the free
flow of trillions in mortgages. Along the way,
real estate investment trusts that specialize in
buying mortgage-backed securities
have arguably become more important than the big banks that
actually create those mortgages in the first place.
You can see one sign of the role reversal in mortgages by
looking at executive pay in the industry. As Bloomberg reported
late last month,
) CEO Mike Farrell received $35 million in compensation last
year, eclipsing pay levels at the six biggest banks in the
nation. Given how much smaller mortgage REITs are than big U.S.
banks, that compensation may seem upside down.
But when you look at growth figures in the industry, you can
see that mortgage REITs are now a huge magnet for
mortgage-related capital. Annaly's balance sheet shows that its
assets have multiplied more than sevenfold since the end of 2005.
Similar trends exist at Annaly's rivals:
||649% (December 2005)
American Capital Agency
||1,811% (December 2009)
||557% (December 2008)
||5,025% (December 2008)
Two Harbors Investment
||4,225% (December 2008)
Source: S&P Capital IQ.
Many mortgage REITs just started operating within the past few
years, becoming substantial operations from the ground up in a
very short time. All told, Bloomberg estimates the size of asset
holdings among mortgage REITs at $270 billion, having tripled in
less than three years.
Many analysts at the Fool and elsewhere have warned of the
potential problems that mortgage REIT
shareholders will likely face when short-term interest rates
start going up. Mortgage REITs derive much of their profits from
highly leveraged bets on mortgage securities, and that leverage
in turn depends on favorable spreads between the rates they pay
to borrow money and the returns they earn by investing it. If
those spreads get narrower, it squeezes profits and reduces the
amount of money the REITs have to distribute to shareholders,
reducing their dividend yields.
But another potential problem goes further than just mortgage
REIT shares to go to the heart of the mortgage industry itself.
During the financial crisis, two sets of stakeholders ended up
bearing the brunt of the housing collapse: banks and the
. In both cases,
those groups needed taxpayer support to
This time around, mortgage REITs have taken on an
ever-increasing role in maintaining the health of the mortgage
industry. With sales of $5 billion in shares so far in 2012 and
$16.8 billion last year, mortgage REITs are able to leverage up
equity capital as much as 10 times or more. If things go badly a
second time, then it will be shareholders of those mortgage REITs
who will suffer the most, as forced liquidations of
mortgage-backed securities could potentially create wave after
wave of mortgage-bond declines that once again bring systemic
risk back into the equation.
Get out now?
With mortgage REITs currently in a regulatory blind spot, the
increasing size of the market has attracted the attention of
regulators of related entities. The SEC has looked into
provisions that could limit mortgage REITs' use of leverage,
while the Financial Stability Oversight Council could determine
that mortgage REITs pose a systemic risk and justify supervision
in the name of preserving the mortgage markets.
One possible saving grace for mortgage REITs is that their
leverage levels have actually come down from their highest levels
a few years ago. But if interest rates start going up, then we
could see very quickly just how exposed mortgage REITs are to
changing conditions in the mortgage market -- and we could
discover too late that they held the key to the next
If you like strong, dependable income from your portfolio,
mortgage REITs aren't your only choice. Accept this invitation to
read the Motley Fool's special free report on nine promising
dividend stocks. Your free look is on us -- just click here to
Fool contributor Dan Caplinger decided mortgages weren't for
him. You can follow him on Twitter here. He doesn't own shares of
the companies mentioned in this article. The Motley Fool owns
shares of Annaly Capital. Motley Fool newsletter services have
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