The asset bubbles the Fed’s money-printing and bond-buying binge has created are spectacular, the risk-taking on Wall Street with other people’s money a sight to behold. Among the big winners were mortgage Real Estate Investment Trusts – and those who got fat on extracting fees. But now the pendulum is swinging back, and the bloodletting has started.
Mortgage REITs are highly leveraged. They borrow short-term in the repo market at near-zero interest rates, thanks to the Fed, then turn around and buy long-term government-guaranteed mortgage-backed securities issued by bailed-out Fannie Mae, Freddie Mac, and Ginnie Mae. Along the way, they issue more stock and borrow even more. By distributing 90% of their profits, they avoid having to pay income taxes. Hence double-digit dividends. A phenomenal business model. Instead of getting their hands dirty in the real economy, they manufacture dividends, fees, and all sorts of goodies for insiders – while the party lasts.
But now the Fed, leery of the risks these drunken partiers were taking on, knocked on the door of that party and threatened to crash it. Annaly Capital Management, the largest mortgage REIT with $126 billion in assets as of March 31, dropped 34% from its September high to $11.53 on Wednesday; most of it since mid-March. American Capital Agency, the second largest, is even better: its entire history is linked to the Fed’s zero-interest-rate policy and money-printing binge.
It went public in May 2008 at $20 a share. As of September 30 that year, it had $1.7 billion in assets. By December 31, 2012, it had $100.4 billion in assets. It had ballooned by a factor of 60 in 4 years. Its stock hit a high of $36.77 in September last year, all along paying out dividends sometimes exceeding 20%. On Wednesday, the stock closed at $20.74, down 43.6% from its September high. Just about the price at which it went public.
Issuing stock is what REITs do on a routine basis. So on February 28, in an example of impeccable Wall Street timing, American Capital Agency priced its most recent offering at $31.60 a share and raised $2 billion. Those who got bamboozled into buying it are sitting on a loss of 34.3%.
It wasn’t the only one. During the first quarter, in a last-minute flurry before the air started hissing out of the greatest bond bubble in history, mortgage REITs raised a total of $7.4 billion. The more equity they raise, the more securities they buy, and the more they borrow to maintain leverage. At every step, fees are extracted by Wall Street – a veritable bonanza. This is where the Fed’s money went. Instead of jobs, it created asset bubbles, risks, and fees.
Now the swoon has set in. Yet, the Fed hasn’t even begun tapering its bond purchases of $85 billion a month, including $40 billion in mortgage backed securities. It’s only talking about it. And when the Fed actually stops buying those securities and allows long-term rates to go back to normal? Last time a bubble burst, so from 2007 to 2008, REITs caved nearly 70%, and some, such as New Century Financial, American Home Mortgage Investment, or Luminent Mortgage, went bankrupt.
Bond-fund investors yanked $60 billion out of their funds in June alone, the largest monthly redemptions ever. But REITs don’t face that flood of redemptions; investors have to sell their shares, at plunging market prices. Where REITs get in trouble is when the prices of mortgage-backed securities decline, and when loan terms change. Then they get margin calls. And they have to dump their assets.
That happened massively, Bloomberg reported, citing JPMorgan Chase: in just one week in June, they “needed to sell about $30 billion” in agency debt “to maintain the amount of borrowing relative to their net worth.” Forced sales aggravated the hemorrhaging in the mortgage-bond market, “which had the worst quarter since 1994.”
Turns out, REITs have tripled their holdings of agency debt since 2009, and in gobbling up everything in sight, they were in part responsible for creating the mortgage bubble and in the process forcing mortgage rates down to ridiculously low levels. Leverage accelerated the run-up. Now, leverage is accelerating the plunge. The process has reversed: forced sales are pushing up mortgage rates.
And they have soared: average interest rates for 30-year fixed-rate mortgages with loan balances of $417,500 or less jumped to 4.68% in the week ending July 5, up over a full percentage point from 3.59% in early May, according to the Mortgage Bankers Association.
Now there’s the threat of a negative feedback loop: if lenders to mortgage REITs get antsy and change the terms or if rates go up, it could lead to more margin calls and forced sales that would further push down those mortgage-backed securities, causing further margin calls and forced sales…. And further upward pressure on mortgage rates (with consequences for the housing market).
This is the insidious backside of the asset bubbles the Fed has blown. The necessary consequence of any “wealth effect” – the Fed’s stated policy goal – is capital destruction. And wealth transfer from those who end up holding the bag to those who got rich off the fees, stock-based compensation, and bonuses, and to all those who, knowing what the Fed would do and what impact it would have, got out early.