Mortgage REITs Vulnerable to ‘Repo Effect’

By Steven Marks, Head of U.S. REITs, Fitch Ratings: Given their reliance on reverse repurchase (repo) funding, residential agency mortgage REITs could face pressures to liquidate some of their MBS holdings if repo lenders were to tighten the terms and availability of funding.

REIT-Steven-MarksGiven their reliance on reverse repurchase (repo) funding, U.S. residential agency mortgage REITs could face pressures to liquidate some of their MBS holdings if repo lenders were to tighten the terms and availability of funding. Such a deleveraging scenario could, in turn, create a ripple effect that extends to the broader mortgage markets as a whole.

The potential catalyst for agency repo disruptions could be market-driven, such as a short-term spike in interest rates. Or, the disruption could be precipitated by increased risk aversion among repo lenders. In any event, a repo market disruption could compel agency mortgage REITs to liquidate some MBS holdings, given repos on average comprise about 90 percent of their liabilities.

The repo effect begins right at the top. Short-term cash investors (including money market funds) provide funding for dealer banks’ MBS holdings through tri-party repo lending. Dealer banks in turn provide term repo funding to mortgage REITs. Any risk aversion by the aforementioned short-term funding providers could result in tighter repo terms and availability.

Though mortgage REIT holdings encompass a relatively small piece ($340 billion) of fixed-rate agency MBS, even a marginal amount of forced selling may reduce MBS valuations, which could result in further forced selling. If repo funding is disrupted, MBS investors may need to liquidate some holdings, which could create negative knock-on effects for the $6.7 trillion agency MBS market in general.

MBS price declines, if rapid and sizable, could, in turn, affect other institutional holders. This includes U.S. commercial banks, which hold more than $1.3 trillion in agency MBS as of March 2013. This risk is potentially greater for assets financed within the “shadow banking” system, in particular publicly-traded mortgage REITs. Non-regulated shadow banks characteristically have a difficult time accessing central bank liquidity support, which could exacerbate the need to liquidate assets if short-term funding markets become strained.