Full text of Working Papers (Federal Reserve Bank of Richmond) : mREITs and Their Risks, Working Paper 13-19R

View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

Working Paper Series

mREITs and Their Risks

WP 13-19R

Sabrina R. Pellerin
Federal Reserve Bank of Richmond
Steven J. Sabol
Federal Reserve Bank of Richmond
John R. Walter
Federal Reserve Bank of Richmond

This paper can be downloaded without charge from:
http://www.richmondfed.org/publications/

mREITs and Their Risks*

Sabrina R. Pellerin, Steven J. Sabol and John R. Walter
Federal Reserve Bank of Richmond
November 2013
Working Paper No. 13-19R

Abstract
This paper examines the history of mREITs and their broader role in the REIT industry. Additionally, it reviews how
mREITs operate, how they are regulated, the risks they face, how they manage these risks, and the dangers they pose for the
broader financial system.

JEL classifications: G01, G23, G28
Keywords: Real estate investment trusts, REITs, systemic risk, maturity transformation, shadow banks

*The authors would like to thank Elizabeth Marshall for valuable contributions to this article. The views expressed
in this article are those of the authors and do not necessarily reflect those of the Federal Reserve Bank of
Richmond or the Federal Reserve System.
Corresponding authors: Sabrina.Pellerin@rich.frb.org and John.Walter@rich.frb.org
1

1. INTRODUCTION
Over the last decade, those real estate investment trusts (REITs) that invest predominantly in mortgage-backed
securities (MBS) have grown rapidly; so much so, that some observers have expressed concerns that the largest
might pose systemic risks for the broader economy. The two largest MBS REITs (or mREITs), which account for
54 percent of all mREIT assets, have been the focus of special attention from policymakers and the press.

1,2,3

Size is just one reason for recent scrutiny. Observers have also raised concerns along the following three
dimensions: 1) mREITs invest in fairly long-term assets but fund themselves with short-term liabilities, implying
that they are sensitive to interest rate and liquidity risks; 2) they hold large portfolios of one type of asset, such
that if mREITs became troubled and were forced to liquidate holdings, MBS prices might be driven down; 3) and
the assets that they hold, predominantly government agency-backed MBS, play an important role in the function
of the home mortgage market, implying that if policymakers became concerned that mREITs might fail, these
policymakers might feel compelled to intervene to prevent such failures.
Such concerns have led some observers to speculate that the largest mREITs could become the focus of
4

heightened supervisory oversight. Currently, mREITs are not as tightly supervised as other financial entities that
are thought to pose systemic risks, such as large commercial or investment banks.
This paper examines the history of mREITs and their broader role in the REIT industry. Additionally, we
review how mREITs operate, how they are regulated, the risks they face, how they manage these risks, and the
dangers they pose for the broader financial system.
2. HISTORY AND BACKGROUND
What are REITs?
REITs provide investors a means by which they can invest in a diversified pool of real estate or real estate debt –
in much the same way that mutual funds allow investors to make diversified investments in securities. REIT
payouts and investments must meet certain requirements so that their income is not taxed (REIT distributions are
taxable income for their investors). Also, by limiting themselves to real estate investments, REITs avoid a set of
limitations that the Investment Company Act of 1940 imposes on similar types of entities, such as mutual funds;
these are predominately limitations on the use of debt finance. While REITs have been important players in the
real estate market since the late 1800s or earlier, the rules under which they currently operate were set in place
by legislation enacted in 1960, so many contemporary observers trace the origin of the industry to that 1960
statute.
1

While some observers define mREITs as those REITs that invest in mortgages or MBS, we use the abbreviation “mREIT” to refer only to
REITs that invest in MBS. Additionally, we include in our definition of mREITs only those that finance their assets predominantly with
repurchase agreements (or other short-term debt, such as commercial paper). See Table A4 for a list of REITs that fit our definition.
2
As of Q4 2012, please see table A4 in the appendix for data on other mREITs.
3
For example, Jeremy C. Stein’s speech “Overheating in Credit Markets: Origins, Measurement and Policy Responses” (February 7, 2013),
Adrian, Ashcraft, and Cetorelli (2013), and International Monetary Fund, October 2013 Global Financial Stability Report, Chapter1, Box 1.1.
http://online.wsj.com/news/articles/SB10001424127887324763404578431033270347040
4
http://online.wsj.com/news/articles/SB10001424127887324763404578431033270347040

Traditionally, market commentators have divided the REIT industry into two categories, Equity REITs and
Mortgage REITs. The name refers not to the sources of REIT funding, since both equity and mortgage REITs
gather funds by selling (equity) shares to investors in addition to issuing debt. Instead, the equity and mortgage
distinction refers to the types of investments made by the REITs. Equity REITs purchase or manage rentgenerating real estate. In contrast, mortgage REITS make mortgage loans, purchase existing mortgages from
lenders or in the secondary market, or purchase MBS. Therefore, mortgage REIT income comes from principal
and interest payments on mortgages, either directly to the REIT or funneled through MBS.
The Early Development of REITs: Nineteenth Century to 1956
5

Real estate investment trusts date to the late 1800s or perhaps earlier. They were initially formed to allow
wealthy investors to diversify their real estate holdings while still providing limited liability. Later, REITs opened up
to less-wealthy investors with smaller sums to invest.

The earliest examples were formed in Massachusetts (Kiplinger 1962, p. 27). That state forbade
corporations from owning real estate except for operational purposes, such as the corporation’s office building or
factory building, but allowed trusts to hold real estate for investment purposes, presumably explaining REITs’ use
7

of the trust structure rather than a corporate structure (Valachi, 1977, p. 450; Kiplinger, 1962, p. 28). These
Massachusetts trusts began investing in Boston real estate but then moved on to real estate investments in other
major cities around the country (Valachi, 1977, p. 450).
REITs’ initial exemption from federal taxes, their loss of the exemption, and later reinstatement, played a
fundamental role in the growth of REITs. Indeed, the tax exemption, and the advantage it confers, continues to
play an important role today.
When federal income taxes were imposed on businesses early in the twentieth century – initially through
the Revenue Act of 1909 and then by later revenue acts following the 1913 ratification of the 16th Amendment to
8

the U.S. Constitution (see Table 1) – trusts were exempted. Various court rulings exempted trusts from taxes
5

The earliest entity that operated like a REIT – gathering funds by selling shares to investors, providing limited liability and a diversified
portfolio of real estate, and distributing proceeds to investors as dividends – seems to have been a Boston corporation formed on February 21,
1820, by a special charter granted by the legislature. Originally this entity was named Museum Hall, but was later renamed Fifty Associates,
reflecting ownership by 50 shareholders. (“The Fifty Associates: A Real Estate Syndicate, Boston’s Oldest Corporation,” New York Times,
November 6, 1894; Real Estate Record and Builders’ Guide, F. W. Dodge Corporation, volume 64, October 14, 1899, p. 546). One of the
earliest real estate trusts was the Boston Real Estate Trust, formed in the 1880s. By 1899, there were at least 28 real estate investment trusts
operating in Boston (Real Estate Record and Builders’ Guide, F. W. Dodge Corporation, volume 64, October 14, 1899, p. 546)
6
“The Fifty Associates: A Real Estate Syndicate, Boston’s Oldest Corporation,” New York Times, November 6, 1894.
7
A business trust is: “An unincorporated business organization created by a legal document, a declaration of trust, and used in place of a
corporation or partnership for the transaction of various kinds of business with limited liability… The use of a business trust, also called a
Massachusetts trust or a common-law trust, originated years ago to circumvent restrictions imposed upon corporate acquisition and
development of real estate while achieving the limited liability aspect of a corporation... A business trust is similar to a traditional trust [created
upon the death of an individual, for example] in that its trustees are given legal title to the trust property to administer it for the advantage of its
beneficiaries who hold equitable title to it... The property of a business trust is managed and controlled by trustees who have a fiduciary duty
to the beneficiaries to act in their best interests... A business trust is considered a corporation for purposes of federal income tax [rules]”
(http://legal-dictionary.thefreedictionary.com/Business+Trust).
8

Congress had attempted to impose a tax on corporations in the Revenue Act of 1894, but this tax was ruled unconstitutional by the Supreme
Court in its 1895 Pollock decision. In the Revenue Act of 1909, Congress imposed a different type of corporate tax, and in 1911, the Supreme
Court ruled (in Flint v. Stone) that the Revenue Act of 1909’s corporate tax was allowable. See Pollock v. Farmers' Loan & Trust Company,

imposed under the Revenue Act of 1909 (Durrett, 1961, p. 142). Between 1913 and 1935, the IRS itself declared
that for tax purposes, REITs were not “associations” (associations, as well as corporations and joint stock
companies were taxable) and were therefore exempt from taxation (Kilpatrick, 1974, p. 56, in Hall, 1974). During
this period IRS regulations ruled that “where trustees hold real estate subject to a lease and collect the rents,
doing no business other than distributing the income…” and investors in the trust “have no control except the right
of filing a vacancy among the trustees and of consenting to a modification of the terms of the trust, no association
exists” (Kilpatrick, 1974, p. 56, in Hall, 1974).
Table 1

Year

Timeline of Legislative or Judicial Actions Important to the Development of the REIT Structure
1913

16th Amendment to Constitution allows federal income taxes

1913 - 1935

IRS rulings exempting REITs from taxation

1935
1936
1960

Supreme Court rules (in Morrissey v. Commissioner) that investment trusts (REITs
are such trusts) may be taxed
Under the Revenue Act of 1936, securities investment trusts received protection
from taxation – but REITs did not
Cigar Excise Tax Extension of 1960 (Public Law 86-779) exempted REITs which
met certain rules, from federal income tax

Still, assorted Supreme Court rulings decided between 1919 and 1925 allowed the IRS to impose taxes
on various types of trusts, while in the case of other types of trusts allowed no taxes to be assessed (Durrett
1961, p. 142; Valachi, 1977, p. 451-452; Crocker v. Malley, 1919; Hecht v. Malley, 1924; Burk-Waggoner Oil
Assn. v. Hopkins, 1925). These varied decisions led to opposing taxation decisions in lower courts and
considerable doubt about whether income taxes might be successfully imposed on investment trusts, such as
those earning income from securities holdings and on REITs. This uncertainty was resolved in 1935, when the
U.S. Supreme Court, in its Morrissey v. Commissioner of Internal Revenue decision, ruled that investment trusts
could be subjected to corporate income taxation (Valachi, 1977, p. 452; Jones, 1988, p. 447–48).
In 1936, trusts that invested in securities sought legislation to exempt them from federal taxation, and
9

they received such protections in the Revenue Act of 1936. REITs were not granted such protection. As a result,
REIT investors were burdened with double taxation, such that the REIT itself paid taxes on its earnings, and then
when earnings were distributed to investors, these distributions were taxed as income to the investors.
One observer notes that an important reason REITs did not typically reorganize themselves as
investment companies to achieve the protection from double taxation afforded by the Revenue Act was because

157 U.S. 429 (1895); Flint v. Stone Tracy Co., 220 U.S. 107 (1911); and Durrett 1961, p. 142. The 16th Amendment to the Constitution
authorized broad taxing powers.
9
Open-end mutual funds were granted exemption from federal taxation in the Revenue Act of 1936. Closed-end funds received their
exemption in the Revenue Act of 1942 (Fink, 2005, p. 17, 19; Morley, 2011, p. 18-26, 60)

doing so would mean that they would need to reduce their use of leverage (Durrett, 1961, p. 144). Were REITs
to reorganize as investment companies, they would be required to raise more capital, presumably because of the
leverage limitations imposed on investment companies by the Investment Company Act of 1940. The apparent
importance of leverage in the typical REIT structure will be discussed in greater detail later.
The REIT industry shrank following the imposition of double taxation (Valachi, 1977, p. 452). Some REITs
survived, however, and in the 1950s began lobbying efforts, along with other players in the real estate market,
such as the National Association of Home Builders, to restore REIT protection from double taxation (Valachi,
1977, p. 452-53).

REIT Developments Since 1956
REIT tax exemption legislation passed the House and Senate in 1956, but was vetoed by President Eisenhower
(Valachi, 1977, p. 453). Eisenhower argued that a REIT exemption was unfair (presumably granting REIT-owned
real estate an advantage over corporate-owned real estate), but also that it would lower tax revenues. He argued
that, even though securities investment companies – e.g., mutual funds – were protected from taxes, double
taxation was present for such funds (Durrett, 1961, p 145-46). Specifically, corporations that issue securities held
by mutual funds pay income taxes themselves, and then the investors in mutual funds pay taxes on dividends
earned on their mutual fund shares. He claimed that, in contrast, real estate itself generated no income taxes, so
that protection for REITs would mean that earnings would only be subject to single-taxation – taxation at the final
investor level.

In 1960, an amendment granting tax exemption to REITs was included in a broad bill addressing a
number of tax-related matters – the Cigar Excise Tax Extension of 1960 (Public Law 86-779), which passed the
House and the Senate, and was signed into law by President Eisenhower (Valachi, 1977, p. 454). The politics,
which led to the 1960 passage of a provision equivalent to one that had failed in 1956, is somewhat murky.

In order to maintain its tax exemption, the 1960 law required REITs to meet the following requirements:

Durrett (1961), p.144, says the following, “Growth of the REIT was stymied because investors would not organize them since this type of
venture would require twice the capital needed in organizing a regulated investment company or direct investment in real estate or securities
in order to receive a given return.”
11
Presumably, underlying President Eisenhower’s argument is the idea that the corporation that undertakes an investment – for example the
construction of a building to house a manufacturing operation – funded with a security issue, pays income taxes on the earnings from that
investment, while a REIT, which owns a similar manufacturing building, avoids taxation. Therefore the manufacturing firm that operates in a
REIT-owned building will be unfairly advantaged compared to a firm that issues debt to buy its building. This argument can be questioned
however. The firm that is housed in the building owned by the REIT pays taxes itself on any earnings generated by that manufacturing
operation. As a result, the amount it is willing to pay to the REIT in rent will be diminished, removing much or all of the advantage REIT-owned
manufacturing may otherwise enjoy. Similarly, it is not clear that the tax payments are lowered by the REIT exemption, because the
manufacturer located in the REIT-owned building as well as the manufacturer located in a securities-financed building both pay income taxes
on their earnings. Further, the tax deduction that a corporation receives when it borrows to fund a project, can reduce considerably the taxes
the corporation would otherwise pay on earnings from that project. Therefore debt issuance tends to protect corporations from taxation
(Durrett, 1961, p. 144-46).
12
Durrett 1961, p. 146 notes that: “Apparently the main reason for the change of attitude by the President lies in the economic condition of the
country at that time and the pressing need for private investment capital.”
13
Public Law 86-779, enacted September 14, 1960

Table 2: REITs Requirements to maintain REIT status (from Cigar Excise Tax Extension of 1960)
1.) Distribute at least 90 percent of each year’s income to shareholders.
2.) Earn at least 75 percent of its gross income from real estate investments, specifically from a) rents on real
property; b) interest earned on obligations secured by mortgages on real property; c) gains from the sale or
other disposition of real property or mortgages; d) distributions from other REITs or gains from the sale
shares in other REITs; and e) abatements and refunds of taxes on real property.
3.) Earn at least 90 percent of its gross income from: dividends; interest; rents on real property; gains from the
sale or other disposition of stock, securities, and real property; and abatements and refunds of taxes on real
property;
4.) Less than 30 percent of its gross income is derived from the sale or other disposition of: stock or securities
held for less than six months; and real property held for less than four years.
5.) At least 75 percent of the value of its total assets is represented by real estate assets (which include
mortgages or interests in mortgages), cash and cash items, and government securities; and not more than
25 percent of the value of its total assets is represented by non-mortgage or non-government securities.
6.) The entity issues transferable shares owned by at least 100 persons.
7.) The entity is managed by one or more trustees.

After passage of the 1960 legislation, the REIT industry began to grow.

By 1971 there were 34 “listed”

REITs (meaning REITs that are listed on a major securities exchange), and there were 75 by 1980 (NAREIT
2013).
REIT growth during the 1970s and early 1980s was somewhat stymied by troubles suffered due to
declining asset values and, for a good number of REITs, mismatches between asset and liability maturities. About
half of REITs (measured by dollars of assets), as of 1970, focused their investments in commercial land
development (CLD) (Schulkin, p. 225–27, in Hall, 1974). Many of these CLD REITs were funded with commercial
paper and other short-term sources of funds, while their assets were longer term (Chan, 2003, p. 18). In the mid1970s real estate values declined, and rising inflation began to push up interest rates in the late 1970s and early
1980s. With long-term assets and short-term liabilities, rising interest rates caused a number of REITs to
experience negative spreads and ultimately fail (Barclays, 2012, p. 22).
Problems in the REIT industry contributed to the already weakened performance of the banking industry
in the mid-1970s. As of 1975, “REITs collectively owe[d] the banking industry some $11 billion,” and six of the
largest New York banks held $3.6 billion in REIT debt, “much of it of doubtful quality.”

Broadly, the REIT industry

struggled in the late 1970s and early 1980s and the number of REITs declined from 75 in 1980 to 59 in 1984
(NAREIT, 2013).
Beginning in 1984 the number of REITs grew fairly steadily for the next decade and peaked at 226 in
1994 (NAREIT 2013). Since 1994, the number of REITs declined fairly slowly until 2008. Since 2008, the
number has begun to increase again (NAREIT 2013).

14
15

Consistent data on the asset size and number of REITs are difficult to acquire for the years prior to 1970.
“Depression-like period challenges nation’s banks”, Miami News, p. 12A, November 24, 1975.

The Development of mREITs
The first of the still-existing mREITs to be founded was Capstead Mortgage Corporation in 1985. At first
Capstead did not invest predominantly in MBS, so it would not have strictly met our definition of an mREIT (REITs
that chiefly hold MBS and finance with repo) (Capstead 1989 Annual Report, p. 3). Instead its focus was on
purchasing jumbo home mortgages (mortgages that exceeded the size Fannie Mae and Freddie Mac could, at
that time, accept) from mortgage brokers and lenders and creating collateralized mortgage obligations (CMOs)
from them and selling these CMOs, through Wall Street brokers, to investors (Capstead 1993 Annual Report, p.
9).

Early on, repos were a small portion of Capstead’s total liabilities (2 percent of total liabilities in 1989).

Instead, securities issued under its CMO program amounted to over 95 percent of its liabilities (Capstead 1989
Annual Report, p. 12). By 1993, however, repos were 39 percent of its total liabilities. Capstead increased the
MBS proportion of its assets through the 1990s (Capstead 1990 Annual Report, p. 2, 12, 16; Capstead 1993
Annual Report, p. 32; Capstead 1998 Annual Report, p. 5, 15, 16). By the early 2000s Capstead was operating in
a manner much more similar to the typical current mREIT. As of 2002, more than half of its assets were agency
MBS and 62 percent of its liabilities were repos (Capstead 2002 Annual Report, p. 5, 14).
The second still-existing mREIT to be formed was Dynex Capital, Inc., which was founded in 1987.

Initially this company’s operations were similar to those of Capstead in Capstead’s early years: Dynex purchased
nonconforming mortgages (mortgages that are not accepted by Fannie Mae or Freddie Mac because the
mortgage is too large or because it does not meet other acceptance requirements) from a set of mortgage
companies, accumulated them, and once it had a sufficient group of such mortgages, created and sold CMOs
that were collateralized by the nonconforming mortgages (RAC Mortgage 1989 Annual Report, p. 11). During the
1990s Dynex originated mortgage loans itself, as well as purchasing them, and then created securities from such
loans (Dynex 2012 Annual Report, p. 1). Still, it was not until early in 2008 that Dynex adopted a typical mREIT
business model. In 2008 it began purchasing agency MBS, as well as financing these with significant amounts of
repo borrowing (Dynex 2008 Annual Report, p. 1, 23).
In contrast to the varied routes these earliest firms took toward becoming mREITs, the current two largest
mREITs, Annaly and Agency, began operations in 1996 and 2008, respectively, following the mREIT business
model and have largely followed that model throughout their histories (Annaly 1997 Annual Report, p. 12 - 13;
Annaly 2006 Annual Report, p. 2; Annaly 2012 10-K, p. F-3; Agency 2008 Annual Report, p. 1 - 3, 60; Agency
2012 Annual Report, p. 6 - 7).

“A CMO is a financing instrument through which [a company] issues multiclass bonds with different maturities using mortgage loans as
collateral. The [issuing company] typically locks in a positive spread between the interest earned on the mortgage loans and the interest and
issuance costs of the bonds issued.” Capstead 1989 Annual Report, p. 3 - 4.
17
Capstead 1989 Annual Report p. 12 and Capstead 1989 10-K, p.22
18
Originally named RAC Mortgage Investment Corporation, it was initially a wholly-owned subsidiary of Ryland Mortgage Company (RAC
Mortgage Annual Report, p. 18).
7

Two other currently existing mREITs were formed in the 1990s (see Table A4). At the end of 2000, REITs
held $12.0 billion

in agency MBS out of a total outstanding amount of $2.5 trillion (SIFMA – “U.S. Agency MBS

Outstanding”), or only about 0.48 percent of all outstanding. Therefore, at the beginning of the twenty-first
century, REITs – and therefore mREITs -- were fairly minor players in the MBS market. Most of the existing
mREITs were formed in the early 2000s or later so that the percentage of outstanding MBS held by mREITs grew
significantly starting in the mid-2000s. Even as late as 2008, mREITs held only 1.2 percent of all outstanding
agency MBS and agency debt, but by mid-2013, they held approximately 4.2 percent (see Figure 3).

As can be seen in Figure 1, mREITs have varied their mix of agency versus non-agency holdings, over
time. Non-agency MBS and other assets have, at times made up a significant portion of mREIT holdings.
However, the figure shows that since the financial crisis, Agency MBS has come to dominate mREIT holdings as
non-agency MBS issuance declined to just a few billion per year starting in 2008.

Agency MBS now makes up

the great majority of mREIT assets.
Figure 1: Non-Agency and Agency Holdings for all mREITs

% of Total mREIT Assets

100

MBS repo QFC
exemption

TSLF and PDCF
creation

100

Fannie Mae and Freddie
Mac placed under
conservatorship

Agencies

Non-Agencies

10
0
1995

10
0

1997

1999

2001

2003

2005

2007

2009

2011

2013

Source: SNL Financial, Richmond Fed.
Note: Quarterly holdings of Non-Agency MBS and Agency MBS as a percentage of total assets of mREITs. Grey shading refers to U.S. Recessions as defined by
NBER. Data from mREITs listed in Table A5.

Consistent data on MBS holdings of mREITs seems to be unavailable in 2000, so the figure $12.0 billion figure is for all REITs and comes
from Board of Governors 2013 (Financial Accounts of the United States, Table L.210, fourth quarter of 2000). mREITs are a subset of all
REITs so their holdings as a percentage of all MBS outstanding will be smaller still.
20
The reasons for the growth of mREITs are examined in the next section.
21
www.sifma.org/research/statistics.aspx, “U.S. Mortgage-Related Issuance and Outstanding.”

Historical Background on MBS
MBSs have been used in the United States as a means of funding real estate investment, off and on,
since the 1870s, but grew to play a huge role in residential mortgage finance by the mid-to-late 1980s
(Snowden in Bordo and Sylla 1995, p. 274–95; Board of Governors 2013).22 During the late 1800s and
again in the 1920s, MBS were significant sources of funds for real estate purchase and construction. For
example, in the mid-to-late 1920s, bonds backed by mortgages amounted to just less than one-third of
total mortgage debt outstanding (White 2009, Figure 14, p. 30). Yet failures of MBS arrangements and
widespread losses suffered by investors, led to a dearth of such issues until they were revived by
government agencies in the 1960s and 1970s (Snowden in Bordo and Sylla 1995, p. 283).
MBS began the initial stage of their revival with the first MBS issue by a government agency in
1965. The Housing Act of 1964 authorized Fannie Mae to pool home mortgages and guarantee and sell
certificates representing flows of payments from these mortgages (U.S. Government Printing Office,
1965, p. 111, 416; Hagerty, 2012, p. 35). Fannie Mae sold $200 million in such MBSs in 1965 and
enlarged amounts in the latter 1960s (U.S. Government Printing Office, 1965, p. 111; U.S. Government
Printing Office, 1968, p. 526)
The Government National Mortgage Association (Ginnie Mae) became the second agency to
issue MBS, when it did so in 1970.23 Ginnie Mae was created by the Housing and Urban Development
Act of 1968 (Public Law 90-448), to encourage the sale of MBS backed by government guaranteed loans
(such as loans backed by the U.S. Department of Veterans Affairs and the Federal Housing
Administration), by placing its own guarantee on these MBSs. 24 Ginnie Mae is a unit of the Department of
Housing and Urban Development, so that its guarantees are obligations of the federal government, and
therefore have the full faith and credit of the government behind them.
Federal Home Loan Mortgage Corporation (Freddie Mac) and was created in 1970, similarly to
encourage mortgage lending by buying mortgages and creating MBSs that it guaranteed.
Unlike Ginnie Mae, Freddie Mac and Fannie Mae are not units of the federal government, so
until 2008, investors in the MBSs they guarantee had a less clear, “implicit,” promise of government
protection.
Freddie Mac and Fannie Mae were both in danger of defaulting on their MBS guarantees in
2008. To prevent such defaults, the two GSEs were placed in government conservatorship in September
2008 and the U.S. Treasury promised to, on a quarterly basis, provide additional capital to the GSEs
whenever their capital became negative (essentially providing an explicit government promise behind
MBS issued by these GSEs).25

The earliest examples of MBS seem to have been largely backed by farm loans rather than home loans (Snowden in Bordo and Sylla, 1995,
p. 275–82). In the 1920s, residential-backed (though perhaps multi-family residential) MBS appeared (Snowden in Bordo and Sylla, 1995, p.
283, 286; White 2009, p. 30, 32).
23
http://www.ginniemae.gov/consumer_education/Pages/ginnie_maes_role_in_housing_finance.aspx
24
http://www.ginniemae.gov/inside_gnma/company_overview/Pages/our_history.aspx Note that Ginnie Mae does not create the MBS it
guarantees, only placing its guarantee on MBS created by financial institutions it approves (GAO 2011, p. 5).
25
http://www.fanniemae.com/resources/file/ir/pdf/quarterly-annual-results/2012/10k_2012.pdf, p. 27 and 28.

The Ginnie Mae, Freddie Mac and Fannie Mae guarantees protect MBS investors from losses
that ensue when mortgagors default on their mortgage loans. Therefore, MBS investors are protected
from credit risk. They are not protected from interest rate or prepayment risks, however.

How mREITs Operate
Because MBS have fairly long maturities, one might imagine that mREITs would tend to fund themselves with
equity and long-term debt. Instead, mREITs typically are funded with short-term instruments: largely repurchase
agreements (repo – discussed below). Indeed, because short-term debt instruments typically pay a lower rate of
interest than long-term instruments, borrowing short and holding long-term assets has tended to earn mREITs a
significant spread that accounts for much of their income. While highly profitable at times, mREITs’ operating
model carries significant risks.
For most of the MBS held by today’s mREITs, there is no credit risk – the danger that the issuer of the
security (the borrowing firm) will be unable to repay all of the principal or interest promised in the security
contract, leading to a loss for the security holder. mREITs, however, are not protected from interest rate or
prepayment risk.
Interest rate risk is the danger that market interest rates might rise, causing a decline in the value of the
security and a loss to the holder. The longer the maturity of a security, the more its value will decline for a given
increase in interest rates. Because MBS tend to be fairly long-term, interest rate risk for them is quite significant.
Prepayment risk exists because most mortgage contracts allow the borrower the option to prepay,
meaning pay back the loan prior to maturity of the loan. The prepayment option can produce losses for mREITs
when interest rates fall or rise. When interest rates fall, homeowners are more likely to refinance their mortgages,
meaning prepay. As a result, MBS holders are paid more quickly than if interest rates remained constant and
therefore may suffer losses because their funds are returned to them and must be reinvested at the prevailing
lower market yields. When interest rates rise, homeowners are less likely to refinance their mortgages, meaning
MBS maturities are extended. Therefore, the value of the MBS declines in response to this rise more than it would
for a plain vanilla bond (one without any call or prepayment features).
On average, as of December 31, 2012, mREITs’ assets are funded 14 percent by equity and 74 percent
by repo.

Repo maturities used by mREITs range from less than 30 days to over one year, but on average are

about 47 days (as of 2012 Q4 –see Table A4 in Appendix). This compares with a much longer average life of
27

MBS (currently around nine years).

Obviously, this mismatch implies that when interest rates increase, mREITs’

earnings will decline because their repos re-price more quickly than their MBS. If rates increase enough, the
value of their liabilities will exceed the value of their assets, and mREITs will become insolvent, similar to the

Figures are for the 29 firms that fit our mREIT definition and are as of December 31, 2012 – except for Chimera Investment Corporation for
which we used September 30, 2012 data, the latest available. All data from SNL Financial.
27
This figure is the weighted average life (i.e. approximated maturity) of a newly issued (November 1, 2013) Fannie Mae 3 percent coupon
MBS using certain prepayment assumptions derived by Bloomberg.

failures of REITs in the 1970s and early 1980s. This interest rate risk, and the amount by which rates must
increase to produce insolvency, is discussed later.
A repurchase agreement (repo) is the sale of an asset, by the borrower, with an accompanying promise
by the borrower to buy back the same (or like) assets upon maturity, which is often overnight. In fact, they
typically are thought of as simply a collateralized loan, with the repurchase assets acting as the collateral. The
predominant assets backing repos are securities issued by the U.S. Treasury (35 percent of all tri-party repo
28

collateral), debt securities issued by Fannie Mae or Freddie Mac (6 percent), and MBS issued by Fannie Mae,
Freddie Mac, or Ginnie Mae (36 percent). Interest rates on repo borrowing are among the lowest in the funding
markets because repos: 1) are typically fairly short-term borrowings, most frequently overnight, usually less than
90 days but occasionally up to several years; 2) because they are backed by highly liquid securities either issued
by the U.S. government or by an agency of the government; 3) and repo borrowing receives especially beneficial
treatment in bankruptcy.
A review of the financial statements of several of the largest mREITs indicates that most of their repo
29

funding comes from broker-dealers.

Broker-dealers also depend on the repo market for financing, and earn a

spread between the interest rate paid to them by mREITs and what they must pay to finance these loans.

Specifically, brokers receive agency MBS as collateral in bilateral repo transactions with the mREITs and then
subsequently use this high-quality collateral to borrow from other financial firms (e.g., money market mutual
31

funds) via the tri-party repo market. It is not clear why broker-dealers are typically able to borrow at lower
interest rates in the tri-party market than mREITs, given that they are both providing similar collateral, but data
indicate a persistent differential. Annaly had a weighted average repo rate of 63 basis points as of Q4 2012 (see
Table A4) whereas the MBS repo rate at the time was around 27 basis points (Wall Street Journal’s DTCC GCF
Repo Index for MBS).

The second reason broker-dealers are willing to provide repo loans to mREITs is that broker-dealers
33

typically face lower “haircuts” on their repo borrowings than do mREITs. A haircut is the difference between the
current market value of the collateral and the amount that the creditor will lend, and it is typically stated as a
percentage of the value of the collateral. It provides a buffer to protect the lender in the case that the market
value of the collateral declines. Because broker-dealers face lower haircuts, they can potentially borrow more for
a given amount of MBS collateral than can mREITs, and thus can invest in additional assets from a starting dollar
amount of MBS – i.e., they can lever up to a greater extent.

Percentage figures from Federal Reserve Bank of New York’s “Tri-Party Repo Statistical Data,” as of June 2013
(http://www.newyorkfed.org/banking/tpr_infr_reform_data.html).
29
For mREITs that disclose details on their repo borrowing in their 10-Qs, broker-dealers appear to be the predominant source of repo
financing. See, for instance, the second quarter 2013 10-Qs of the following mREITs: Bimini Capital Management Inc., p. 15; Invesco
Mortgage Capital Inc., page 21; CYS Investments, p. 41.
30
Board of Governors 2013.
31
A bilateral repo transaction is one in which there are only two parties to the transaction. In contrast, a tri-party repo transaction is one in
which the two counterparties use a custodian bank or clearing organization (the third party) to act as an intermediary, and typically the holder
of the collateral, to settle the transaction. For more information on the tri-party repo market see Copeland 2012.
32
Available at: http://www.dtcc.com/products/fi/gcfindex/
33
For instance, Annaly’s average repo collateral haircut in 2012 was 5 percent (December 31, 2012 10-K) while the median repo haircut for
cash investors in agency MBS in the tri-party market was only 2 percent (see Federal Reserve Bank of New York 2012).

The haircut faced by an mREIT will limit the extent to which it can lever up, meaning limit how large it can
grow, given its equity. For example, if an mREIT starts with $10 million in equity from shareholders, and faces a 5
percent haircut, then the maximum size it can reach without raising more capital is $200 million. Here is how the
process for this mREIT would proceed: 1) Starting with the $10 million in equity, the mREIT buys $10 million
worth of MBSs; 2) it then uses the $10 million in MBS as collateral for a repo loan of $9.5 million because the
lender requires a 5 percent haircut; 3) buys an additional $9.5 million in MBSs and repos it out to receive $9.025
million in a second loan; 4) buys an additional $9.025 million in MBSs. This buying and “repoing out” (meaning
borrowing in the repo market) of MBS could go on until the firm has MBS holdings equal to one divided by the
haircut (in this case 1/.05) times the original equity ($10 million), or 20 times the original equity (meaning $200
million).
The borrower not only must provide the lender with extra collateral to cover the haircut percentage at the
time the loan is initially entered into, but also must ensure that the lender’s haircut is maintained throughout the
life of the loan. If the value of the posted collateral falls more than a specified amount, the lender will issue a
margin call requiring the borrower to send the lender additional collateral to reestablish the haircut percentage.
Because of the possibility that the value of MBS collateral might fall – for example, when market interest rates
increase – mREITs do not lever up to the maximum allowed by the haircut.

Instead, they must maintain a

portfolio of unencumbered assets – that is, assets not used to back loans – in order to be prepared to respond to
any margin calls.

As an example, as of the end of 2012, Annaly had unencumbered MBS in its portfolio equal to

16 percent of its repo borrowings (Annaly 2012 Annual Report, p.F-3). If MBS values decline enough that margin
calls exceed an mREIT’s unencumbered assets, that mREIT will be unable to meet its margin calls, and will
default. In such a case, its lenders will keep all posted collateral but will suffer losses themselves to the extent
that MBS values decline more than haircuts.
How mREITs are regulated
Currently, mREITs face very limited regulatory oversight. In addition to complying with the rules associated with
maintaining REIT tax treatment, the mREITs reviewed in this article are registered with the SEC and publicly
traded and therefore must comply with SEC disclosure and reporting requirements and the rules of the exchange
on which they trade (NYSE or NASDAQ).
publicly traded financial companies.

However, these rules are consistent across all SEC-registered,

One feature that makes the mREIT unique among its non-REIT competitors is that its business model
relies heavily upon an exception contained in the Investment Company Act of 1940 (the “1940 Act”) that excludes,
from the definition of investment company (and therefore regulation), certain companies involved in “purchasing
34

Specifically, mREITs are subject to two types of margin calls: valuation and factor calls. Valuation calls occur when the value of the
collateral falls, whereas factor calls occur when prepayment frequencies (prepayment factors) change, based on prepayment tables published
by Fannie Mae and Freddie Mac.
35
Unencumbered assets can include cash, MBS, and other securities.
36
Publicly listed companies must satisfy rules related to corporate governance (including having a majority of independent directors), liquidity,
earnings, share price, and an internal audit function. For the rule manuals of the NYSE and NASDAQ, see http://nysemanual.nyse.com/lcm/
and http://nasdaq.cchwallstreet.com/, respectively.
37
As part of the disclosure requirements of the Securities Act of 1933, REITs must register using Form S-11, which is tailored specifically for
REITs.

or otherwise acquiring mortgages and other liens on and interest in real estate.”

38,39

The rationale behind this

exception is to differentiate companies exclusively engaged in the mortgage banking business from issuers in the
investment company business and allow the former to benefit from less regulatory oversight since their activities
are providing important liquidity into the housing market (SEC, 2011; NAREIT, 2011; SIFMA, 2011). To qualify for
this exception, the SEC requires that the exempt company invest at least 55 percent of its assets in mortgages
and other liens on and interest in real estate (or “Qualifying Real Estate Assets”) and at least 80 percent of its
assets in the more broadly defined, real estate-related assets.

Traditional REITs that predominantly hold mortgages clearly fit the mortgage banking exemption
contained in the 1940 Act (SEC, 2011, p.55301). However, mREITs, the first of which appeared in 1985 (based
on our definition of an mREIT), have relied on SEC staff interpretations of the 1940 Act, which identify “whole
pool” agency and non-agency residential mortgage-backed security (RMBS) as being functionally equivalent to
mortgage loans, and therefore “qualifying real estate assets.”

41,42

Thus, most mREITs hold at least 55 percent of

their assets in whole pool agency MBS and treat any “partial pool” agency MBS as satisfying the broader
requirements of a real-estate related asset.

In 2011, the SEC released a proposal for comment expressing their concerns that certain types of
mortgage pools that exist today, such as mREITs, may not be the type of company they originally intended to
exempt from the rules of the 1940 Act (SEC, 2011).

Moreover, while traditional REITs engage in activities that

are clearly tied to the mortgage banking business, the SEC questions whether the mREIT business model is more
similar to that of an investment company and should therefore face the same regulatory oversight as one. For
instance, both mREITs and investment companies pool investor assets to purchase securities, provide
professional asset management services, publicly offer their securities to retail and institutional investors, and
45

most avoid paying corporate income taxes (SEC, 2011, p.55303). While mREITs generally have a higher

The 1940 Act is the primary law that governs investment companies. Section 3(a)(1) of the Investment Company Act defines an investment
company as any issuer that: “A) is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing,
reinvesting or trading in ‘securities’; B) is engaged or proposes to engage in the business of issuing face-amount certificates of installment
type, or has been engaged in such business and has any such certificate outstanding; or C) is engaged or proposes to engage in the business
of investing, reinvesting, owning, holding or trading in securities, and owns or proposes to acquire ‘investment securities’ having a value
exceeding 40 percent of the value of its total assets (exclusive of government securities and cash items) on an unconsolidated basis.” (1940
Act, p.18).
39
The exclusion is contained in Section 3(c)(5)(C) of the Investment Company Act of 1940.
40
These thresholds are based on SEC staff no-action letters and other interpretations (see SEC, 2011, p.55305) and are broadly recognized
by mREITs as indicated in their 10-K financial statements (see, e.g., CYS Investments Inc.’s 12/31/12 10-K, p.9, available at:
http://www.sec.gov/Archives/edgar/data/1396446/000139644613000004/cys10k2012.htm; and Annaly’s 12/31/12 10-K, p.49, available at:
http://www.sec.gov/Archives/edgar/data/1043219/000115752313001038/a50573546.htm).
41
From Annaly’s 2012 Annual Report (p.50): “This interpretation was promulgated by the SEC staff in a no-action letter over 30 years ago,
was reaffirmed by the SEC in 1992 and has been commonly relied on by mortgage REITs.”
http://investor.annaly.com/Cache/16693252.PDF?Y=&O=PDF&D=&FID=16693252&T=&OSID=9&IID=
42
A whole-pool certificate is a security that represents all of the ownership interest in a specific mortgage pool. From CYS Investments
12/31/12 10-K: “We treat Fannie Mae, Freddie Mac and Ginnie Mae whole-pool residential mortgage pass-through securities issued with
respect to an underlying pool of mortgage loans in which we hold all of the certificates issued by the pool as qualifying real estate assets.”
43
A partial pool certificate is a security that represents partial ownership interest in a specific mortgage pool.
44
The SEC’s stated goals in the release are to: “1) be consistent with the Congressional intent underlying the exclusion from regulation under
the Act provided by Section 3(c)(5)(C); 2) ensure that the exclusion is administered in a manner that is consistent with the purposes and
policies underlying the Act, the public interest, and the protection of investors; 3) provide greater clarity, consistency and regulatory certainty in
this area; and 4) facilitate capital formation.” (p.55301).
45
Under Subchapter M of the Internal Revenue Code, regulated investment companies and REITs can receive specialized tax treatment
(exempt from paying corporate-level federal income taxes on income or capital gains) if they meet certain source-of-income, distribution and
asset-diversification requirements. For instance, in order to remain eligible for this tax treatment, the REIT or investment company must

concentration of their assets in real estate, many other investment companies invest in some of the same kinds of
assets, albeit to a lesser extent.

46,47

Nonetheless, according to a congressional statement associated with the

Investment Company Act Amendments of 1970, mortgage REITs are excluded from the 1940 Act’s coverage
“because they do not come within the generally understood concept of a conventional investment company
investing in stocks and bonds of corporate issuers.”

Most importantly, the 1940 Act places limits on investment

companies’ use of leverage, but it also gives the SEC the authority to monitor the companies’ activities to ensure
that, for instance, they are accurately computing the value of their assets and are not engaging in activities with
affiliates that benefit insiders at the cost of investors (SEC, 2011, p.55303).

In addition, it also restricts affiliate

transactions between the investment company and any affiliate that holds at least 5 percent ownership interest in
the company.

Identifying ownership stake of all parties to a transaction and severing relationships with REIT

affiliates that provide loan servicing may be costly.
These additional restrictions could be very costly for mREITs. However, imposing these additional
restrictions may put them on a more level playing field with competitors engaging in many of the same activities
but that are subject to much greater regulatory oversight. While our focus has been on investment companies,
since REITs (and mREITs) would likely be investment companies if it were not for the composition of their asset
portfolio and other requirements to maintain REIT tax treatment, they also compete with other investor groups,
which face even greater regulatory oversight, such as banks, investment banks, insurance companies and other
lenders. This comparatively light regulatory oversight is likely one of the contributing factors to the growth of this
sector.
3. GROWTH of mREITs
While the first mREIT, Capstead Mortgage Corporation, was formed in 1985, the industry did not show much
growth until 2002.

As can be seen in Figure 2, growth was steady from 2002 until the financial crisis and then in

2009 began rapidly increasing. Since 2006, before the financial crisis, mREITs’ total assets have more than
doubled to a current size of $380 billion (Q3 2013), of which the two largest, Annaly Capital Management (Annaly)
and American Capital Agency Corporation (AGNC), hold the majority. As seen in Figure 2 below, mREIT assets
peaked at $449 billion in the third quarter of 2012 and have been declining since.
distribute at least 90 percent of their income to investors annually. See: http://www.gpo.gov/fdsys/pkg/USCODE-2010-title26/pdf/USCODE2010-title26-subtitleA-chap1-subchapM.pdf
46
According to the National Association of Real Estate Investment Trusts (NAREIT), a national trade association for the REIT industry,
mortgage REITs (of which mREITs are a subgroup) are most closely related to closed-end funds that invest in mortgage-related securities.
Thus, if the mREIT opts to register as an investment company, it would likely register as a closed-end fund (NAREIT, 2011).
47
As of March 31, 2011, registered investment companies (excluding MMFs) held $800.8 billion (or 10.5%) and MMFs held $373.4 billion (or
4.9%) of outstanding agency and GSE-backed securities. REITs held $191.1 billion (or 2.5%) (SEC 2011, p.55303, footnote 27 – from flow of
funds). “As of June 30, 2011, there were 23 registered open-end investment companies with total assets of $70.6 billion that invested ‘at least
65% of their assets in GNMA securities.’ In addition, as of that date, there were 34 series of registered open-end investment companies with
total assets of $26.6 billion, and 11 registered closed-end investment companies with total assets of $1.8 billion, that invested ‘at least 65% of
their assets in mortgages/securities issued or guaranteed as to principal and interest by the U.S. government and certain Federal agencies.’”
(SEC, 2011, p.55300, footnote 3)
48
Investment Company Act Amendments of 1970. House Report 91-1382 (August 7, 1970), at 17.
49
From ICI Factbook (2013) in reference to leverage limitations: “these limitations greatly minimize the possibility that a fund’s liabilities will
exceed the value of its assets.” See Section 2(a)(41) of the 1940 Act to see how registered investment companies are required to value their
assets.
50
See Section 17 of the 1940 Act for prohibitions related to registered investment companies engaging in certain transactions with their
affiliates.
51
http://www.capstead.com/about_us.html. This was the first mREIT we could identify.

500

Billions, USD

450

400

Millions

Figure 2: Total Assets of mREIT Industry, American Capital Agency Corp. and Annaly Capital Management

400
American Capital Agency Corp.

350

350
Annaly Capital Management, Inc.

300

Total Assets

250

200

150

100

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

Source: SNL Financial & Richmond Fed.
Note: Quarterly data from mREITs listed in Table A5.

Among the factors that may have contributed to this rapid growth are their favorable tax treatment,
relatively light regulatory oversight, advantages associated with the use of repurchase agreements to attain
leverage, and federal policies supporting the agency MBS market. These factors made mREITs especially
capable of tapping into the sizeable repo market to capitalize on the market’s interest in holding governmentbacked MBS. mREITs arguably increase liquidity in the MBS market through actively trading and by providing a
convenient mechanism by which investors can purchase MBS. This may improve the functioning of the real
estate market and in turn lower mortgage rates. In 2008, mREITs held $90 billion of agency MBS (1.8 percent),
which grew to $325 billion in Q2 2013, constituting 5.6 percent of all outstanding agency MBS (Z.1 Financial
Accounts of the United States Table L.210; and SIFMA).
However, despite their growing share of total outstanding Agency MBS over the last several years, they
still hold a small proportion compared with other investor groups, such as U.S. depository institutions, mutual
funds, and more recently, the Federal Reserve (see charts below). However, mREITs play a very different role
because they do not buy and hold MBS as do the largest holders. Instead, they buy MBS and indirectly pass it on
to the tri-party repo market (through broker dealers), therefore providing a significant portion (approximately 54
52

percent as of September 2013) of the agency MBS collateral used in this market. In the following, we focus in
on the factors that have likely contributed to the growth of the mREIT and in what ways they have become such a
significant player in the MBS market.

SNL Financial and Federal Reserve Bank of New York, “Tri-Party Repo Statistical Data,” September 2013, available at:
http://www.newyorkfed.org/banking/pdf/sep13_tpr_stats.pdf

Figure 3: Holders of Agency MBS and Agency Debt in 2008 and 2013

Other includes Nonfinancial Corporations, Households, U.S. Government, and Credit Unions.
Nonbanks include security brokers and dealers, ABS issuers, holding companies, and money market mutual funds.
Note: As of the second quarter of 2013, total agency MBS and agency debt equals $7.6 trillion, according to Z.1 data.
Of this total, $5.8 trillion is agency MBS, according to Securities Industry and Financial Markets Association data..
Source: Z.1 Federal Reserve Board of Governors' Financial Accounts of the United States, Table L.210. Q2 2013 (see footnote 1 to this table for
further details on the types of debt included in this chart.)
2

Justifications for exceptional growth of mREITs
The favorable tax treatment provided to REITs has contributed to their growth by giving REITs an advantage over
other financial institutions that do not receive this treatment. However, to maintain this favorable tax treatment, a
REIT must meet the seven requirements previously discussed. Given that one of these requirements is that a
REIT must pass 90 percent of its taxable income to investors in the form of dividends (rather than retaining
earnings), it must fund its growth by acquiring new debt or equity financing.

Unlike many of their competitors,

mREITs are able to rely more heavily on debt financing because they have no statutory leverage limits as a result
of their exemption from the 1940 Act, which will be discussed in greater detail later.
continue to borrow to finance a growing number of assets.

In other words, they can

According to Annaly, the largest mREIT, if they were

subject to regulatory oversight that limited their use of leverage, they “would not be able to conduct [their]
business as described” and their business would be “materially and adversely affected.”
rely, almost exclusively, on the use of term repo financing to attain leverage.

Importantly, mREITs

As seen in the figure below,

almost all of the asset growth that has taken place can be attributed to the increase in securities holdings
(predominantly agency MBS) financed by repos.

This strategy may be inefficient during unfavorable times when strengthening its balance sheet should be the focus.
Note that repurchase agreements have restrictive covenants that may also put restrictions on leverage.
Although some may specify the amount of leverage that may be used, this amount could easily be increased if approved by the company’s
board of directors or trustees (SEC, 2011, p.55302, footnote 20).
56
Annaly Capital Management, December 31, 2012 10-K, p.49.
57
Term repo lending, by market convention, means repo with a maturity of greater than one day.
54
55

500

Billions, USD

450

450
Total Securities

400

Millions

Figure 4: Total Assets, Repos and Securities of mREIT Industry

400

Repurchase Agreements
350

350

Total Assets

300

250

200

150

100

0
2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

0
2014

Source: SNL Financial & Richmond Fed
Note: Quarterly data from mREITs listed in Table A5

By investing predominantly in agency MBS, not only do mREITs avoid credit risk, but they are reliant on a
sector that has benefited from a large amount of government support. As a result of the recent financial crisis, the
Treasury and the Federal Reserve took actions that stabilized the market for mortgage-related securities (see
Table A1 for a list of policy actions that have supported MBSs). For instance, in an effort to stimulate the
economy, the Federal Reserve has purchased a significant amount of MBSs (holdings total $1.3 trillion as of
58

September 30, 2013). While many sectors were contracting during the financial crisis, existing mREITs
continued to grow and new ones were being formed. Of the 42 mortgage REITs (both listed and unlisted) existing
today, 19 of them were formed between 2008 and 2012 (see figure 5 below).

For instance, a recently formed

mREIT (March 28, 2012), Five Oaks Investment Corporation, states in its registration statement that the “current
conditions in RMBS markets have created attractive opportunities for investment in non-agency and, particularly,
agency RMBS.”

Moreover, they note that a leveraged agency portfolio is currently very favorable, but

uncertainty regarding future actions could quickly change these circumstances, which will be discussed in a later
section on risks. Nonetheless, with no credit risk, the agency MBS market has remained liquid and these
securities can be relied upon as high-quality collateral in repo transactions with broker dealers. Moreover, the
fact that the non-agency MBS market tanked during the crisis is evidence that government support in the agency
MBS market was fundamental to the survival (and growth) of the mREITs.

While Fed purchases of MBS could certainly be viewed as making agency MBS more attractive (enhancing the liquidity and therefore the
safety), they have also driven up agency MBS prices to some extent, which tends to make agency MBS somewhat less attractive. Data for
Federal Reserve MBS holdings from the Board of Governors, Financial Accounts of the United States.
59
Note that these figures include both listed and non listed mortgage REITs. As of December 31, 2012, 24 of these are publicly traded
mREITs (per our definition).
60
From the Five Oaks Investment Corporation’s S-11 (p. 33)
61
See Figure 12 for an illustration of the dramatic decline in non-agency MBS issuance during the crisis.

Hundreds

Figure 5: mREITs in Existence, Issuance of Securitized Mortgages, Repo, Assets, and Major Federal Policies

MBS Repo
QFC status

100 Billions, USD

Fed
GSE conservatorship,
"OpenFed creation of PDCF and Ended"
TSLF,
LSAPS
LSAPS 1

4.5

Issuance of MBS,CMBS and CMOs (Left Axis)

Total Assets (Right Axis)

4
30

3.5

Repurchase Agreements (Right Axis)

25
19

20
13

15
9

10
5

Total in Existence

14
11

2.5

2
1.5

0.5

0
1985 1987 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Source: SNL Financial, SIFMA, Flow of Funds and Richmond Fed. Note: Scales are in hundreds of billions of dollars.
Assets and repo data based on our sample of listed mREITs, whereas total in existence also includes unlisted.

With 87 percent of all mREIT liabilities consisting of repos (as of September 30, 2013), there is good
reason to believe that this financing technique may be an important factor contributing to the significant growth of
this sector (see Figure 6). The repo market is part of the shadow banking system, which has grown significantly
62

over the last several decades.

As can be seen in Figure 5, mREITs’ total assets (predominantly MBS) have

grown in line with total MBS issuance and these assets have increasingly been funded by the repo market (see
also Figure A2). The overall growth in repo usage and MBS issuance over the last two decades can be attributed
to the reduced competitive advantage held by banks for deposits (due to certain innovations and regulations) and
the rise in “securitization and the use of repo as a money-like instrument” (Gorton and Metrick, 2010). As
institutional investors, pension funds, mutual funds, state and municipalities, and nonfinancial firms had a growing
demand for nonbank alternatives for deposit-like products, they turned to the repo market, which allowed nonbank
financial entities to acquire financing for their activities in return for collateral.

The growth in securitization

allowed for an increasing amount of collateral to be used for this type of financing.

The shadow banking system can be defined as a system that “comprises a diverse set of institutions and markets that, collectively, carry out
traditional banking functions--but do so outside, or in ways only loosely linked to, the traditional system of regulated depository institutions.
Examples of important components of the shadow banking system include securitization vehicles, asset-backed commercial paper (ABCP)
conduits, money market mutual funds, markets for repurchase agreements (repos), investment banks, and mortgage companies.” (Bernanke,
2012)
63
“In 2003, total world assets of commercial banks amounted to USD 49 trillion, compared to USD 47 trillion of assets under management by
institutional investors.” (p.1 footnote 2 of BIS 2007). Bank for International Settlements (2007) “Institutional Investors Global Savings and
Asset Allocation,” report submitted by a Working Group established by the Committee on the Global Financial System, p.1, footnote 2.
February 2007. Also see Adrian, Ashcraft, Boesky and Pozsar (2010) for a thorough discussion of shadow banking.
64
The ratio of private securitization to total bank loans grew from zero in the early 1980s to over 60 percent prior to the financial crisis. Much
of this growth is likely attributed to the increased demand for high-quality collateral used in repo transactions (Gorton and Metrick, 2010).

Figure 6: Repurchase Agreements as a Percentage of Total mREIT Liabilities

Percent

MBS Repo Exemption
from Automatic Stay

30
1995

1997

1999

2001

2003

2005

2007

2009

2011

2013

Source: SNL Financial & Richmond Fed
Note: Quarterly observations of repo liabilities as a percentage of total liabilities for mREITs. Data
from mREITs listed in Table A5.

Additionally, mREIT counterparties are likely more willing to finance mREITs due to the limited risks
associated with repo financing in the event of an mREIT’s failure. Due to certain safe harbor provisions contained
in the U.S. Bankruptcy Code (the “code”), the use of repos to finance asset-backed securities, such as agency
MBS, gives the lenders in the transaction disproportionately greater rights than typical borrowers in the event of
default. For example, in a repo transaction, if the borrower defaults, the lender is not subject to the automatic
stay (whereby creditors of a bankrupt firm are prevented, or “stayed,” from making any attempts to collect what
they are owed) provisions of the code and can take possession and immediately liquidate the assets pledged as
collateral under the repurchase agreement. These are called Qualified Financial Contracts (QFCs), which are
exempt from the automatic stay under the U.S. Bankruptcy Code and include repurchase agreements, commodity
contracts, forward contracts, swap agreements and securities contracts. While special treatment for certain
financial contracts has existed since 1978, only in 2005 was the definition of a “qualified financial contract”
expanded to include repos backed by MBS (GAO, 2011, p.14). The U.S. Bankruptcy Code of 1978 applied the
automatic stay exclusion to only commodities and futures, expanding on this definition in subsequent bankruptcy
65

reform acts. Since mREIT counterparties can provide funding on favorable terms (in terms of fees and haircuts)
and have little to no risk of loss as a result of this special treatment, repo financing has been particularly easy for
65

For the types of contracts currently exempt from the stay, see the following sections of the Bankruptcy Code: 11 U.S.C. § 362(b)(6), (b)(7),
(b)(17), 546, 556, 559, 560.

mREITs to attain.

Notably, the vast majority of mREIT asset growth took place after the MBS repo exemption

and, as seen in the figure below, repos have accounted for an increasing share of mREIT liabilities.
Additionally, by holding predominantly agency MBS, mREIT’s assets have limited credit risk and have
historically benefited from government assistance, which has likely led to market expectations that this assistance
would be provided in the future. Thus, creditors do not need to punish (in the form of higher repo rates or
haircuts) their use of leverage to attain growth. Moreover, since mREIT’s creditors are providing financing
through repos, which receive favorable treatment in bankruptcy, they have less of an incentive to undertake costly
monitoring of the risk-taking behavior of these firms. These factors suggest that debt financing (through the use
of repos) is cheaper than equity financing for mREITs.
Through leverage, mREITs have been able to grow rapidly while providing investors with high-dividend
yields compared to both traditional REITs and investment companies whose business models do not rely on the
use of leverage to fund a portfolio of agency MBS. For instance, the average dividend yield for mREITs as of
December 31, 2012, was 13 percent, compared with 4 percent for all equity REITs and 9 percent for investment
companies.

The figure below shows the dividend yield for agency REITs, non-agency/hybrid REITs and the

SNL US REIT Equity Index. Even though non-agency securities tend to pay higher interest rates to compensate
for credit risk, mREITs are still able to pay higher dividends (SIFMA 2011). One possible factor contributing to
higher dividends is the fact that agency MBS are currently treated favorably as compared with non-agency MBS
in the repo markets, and thus Agency mREITs are able to attain greater amounts of leverage due to both lower
haircuts and average repo rates paid.

This ability to lever-up gives the mREIT an advantage over other financial

institutions with leverage requirements, which are unable to rely on debt financing to achieve growth.

mREITs

might benefit from the use of leverage (i.e., find debt financing cheaper) for a couple of reasons. For instance,
the low interest rate environment over the last several years has been favorable for mREITs that rely on acquiring
long-term assets (MBS) at favorable spreads over their funding costs (repos) and utilize leverage to amplify
returns.

Figure 8 shows that during a favorable yield curve environment (when the spread between 10 year and

three-month treasuries is greatest), asset growth and number of formations have increased.
66

For a discussion of potential inefficiencies that might arise because of exemption of QFCs (e.g., repos) from the stay, see Mark J. Roe, The
Derivatives Market’s Payment Priorities as Financial Crisis Accelerator, 63 STAN. L. REV. 539 (2011) -http://www.stanfordlawreview.org/sites/default/files/articles/Roe-63-Stan-L-Rev-539.pdf.
67
Dividend yield for the 28 FTSE NAREIT mortgage REITs and the 131 FTSE NAREIT equity REITs as of December 31, 2012 (see NAREIT
(2012) Exhibit 2, “Investment Performance by Property Sector and Subsector”). Dividend yield for registered investment companies from SNL
Financial as of December 31, 2012 and excludes those that report a zero dividend yield.
68
Indeed, before the crisis the dividend yield as witnessed in Figure 7, was actually higher for non-agency mREITs. This is because MBS
were considered relatively safe investments (many held AAA ratings) and haircuts were relatively similar for non-agencies and agency MBS
alike.
69
While some contend that there is no cost benefit to obtaining debt over equity financing (see Modigliani and Miller, 1958), it’s clearly stated
in the mREITs’ financial statements that their business models rely on the use of debt and that limiting their use of leverage would adversely
affect their business. According to Annaly’s December 31, 2012, 10-K filing: “If we fail to qualify for exemption from registration as an
investment company, our ability to use leverage would be substantially reduced, and we would not be able to conduct our business as
described. Our business will be materially and adversely affected if we fail to qualify for this exemption.”
70
In the same way that mREITs can multiply their size (given a certain amount of equity) due to leverage, they can also multiply their returns.
Building on the previous example used to explain the relationship between haircuts and mREIT size, the following example illustrates how an
mREIT can amplify returns using leverage given a set amount of initial equity investment. An mREIT starts with $10 million in equity, it then: 1)
buys $10 million worth of MBSs, earning an MBS rate of say, three percent; 2) it uses the $10 million in MBS as collateral for a repo loan of
$9.5 million because the lender requires a 5 percent haircut; 3) buys an additional $9.5 million in MBSs and repos it out to receive $9.025
million in a second loan; 4) buys an additional $9.025 million in MBSs, and this process could go on until the firm has MBS holdings equal to
one divided by the haircut (in this case 1/.05) times the original equity ($10 million), or 20 times the original equity (meaning $200 million). In
the case where the mREIT does not lever up, it earns 3 percent (the MBS rate in this example) times $10 million (initial amount of equity),

Figure 7: Dividend Yield for Agency and non-Agency/Hybrid mREITs and Equity REITs

Percent, %

20
Agency mREITs

non-Agency/Hybrid mREITs

SNL US REIT Equity

0
2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

0
2014

2013

Source: SNL Financial & Richmond Fed.
Note: See Table A3 for a full list of the component companies in the Non-Agency/Hybrid and Agency mREIT indexes. SNL US REIT Equity : Includes all publicly
traded (NYSE, NYSE MKT, NASDAQ, OTC) Equity REITs in SNL's coverage universe.

therefore earning $300,000. If they use the maximum amount of leverage given a 5 percent haircut (20 times) and pay say, 0.5 percent on the
repo loans, they would earn $5 million, which is 3 percent (MBS rate) minus 0.5 percent (repo rate) times $200 million (the size of the firm
using maximum leverage).

Figure 8: Formation and Failures of mREITs and the Yield Curve

Current

4.5

Historical

10Yr -3M Spread (Right Axis)

3.5

Total Assets (Right Axis)

6
5
4
3

2
1
0

1
1

1
-1

-1

2.5

-1

-2

1
-1

1.5

1
-1

-2

4
2

-2

0.5

-1

-1
-3

-3

0
-0.5
-1
-1.5

1985 1987 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Source: SNL Financial, FRED and Richmond Fed Note: Historical refers to MBS REITs that were founded but are
currently no longer in existence. Current refers to MBS REITs that are still in existence. Asset data only for listed
mREITs.

However, the interest rate environment shifted some in mid-2012 as long-term interest rates began to
rise. In the third quarter of 2012, mREIT assets peaked at $449 billion (see Figure 4) and declined afterward as
interest rates steadily increased and investors seemed to expect further increases (judged by Fed Funds Rate
predictions derived from futures contracts).

The selloff of mREIT assets over this rising rate period could be

explained by three things. First, to the extent that investors shifted into mREITs when interest rates were low and
falling to “reach for yield,” when interest rates started rising these same investors may have started shifting back
to less risky investments. Second, mREIT managers themselves may have developed concerns about the
adverse effect that rising interest rates would have on their MBS portfolio and therefore reduced leverage to an
extent (by 40 basis points to 7.3 over a period of 9 months) by selling assets and repaying debt.

Third, their repo

counterparties could have become concerned about increased mREIT risks and the risks of holding MBS
collateral in a rising rate environment and therefore may have become less willing to rollover MBS-based repo
funding or may have increased funding-related costs (e.g. interest rates, haircuts and fees).
Although recently mREIT assets have decreased somewhat, their business model has been generally
favorable (provided investors with high dividend yields) in recent years and has contributed to a significant
amount of growth in the sector. However, mREITs carry some significant risks. In the following, we will look more

See for example futures-based forecasts available from: http://www.cmegroup.com/trading/interest-rates/fed-funds.html
Leverage here is assets divided by equity (data from SNL Financial). This figure excludes Chimera Investment Corp. since the latest
reported data from them is from the third quarter of 2012.
72

100 Billions (Assets), Percent (Yield Curve)

Year Failed

closely at how mREITs operate, how they fit into the larger financial system, and the risks inherent in their
business model.

4. mREIT RISKS AND RISK MANAGEMENT
mREITs rely on a specific type of highly leveraged business model – financing a portfolio of mostly long-term
agency MBS with short-term repos (and very little equity). This business model leaves them exposed to: 1) risks
created by the maturity mismatch between their assets and liabilities; 2) separate risks for certain assets and
certain liabilities; and 3) risks that policy shifts that might remove government support for agency MBS or mREITs’
ability to use leverage. In addition, some observers are concerned that troubles in the mREIT industry could
produce significant weaknesses for the broader financial system. On the liability side, the heavy reliance on repo
financing and use of leverage subjects these entities to fragilities. For example, a repeat of the problems that
occurred in secured funding markets, similar to those that occurred between 2008 and 2009, would adversely
affect this business model. Additionally, the assets of mREITs, by definition, are largely MBS, which have the
potential for high price volatility. This volatility can be related to interest rate movements or can be driven by
market factors unrelated to shifts in interest rates, as demonstrated during the recent financial crisis. Because
mREITs are major players in the MBS market, they could either exacerbate this volatility or experience a separate
shock that causes them to de-leverage, meaning sell their assets, at a rapid pace. These sales may have an
adverse effect on MBS prices and ultimately the mortgage market.
mREITs take actions to mitigate the risks associated with their asset and liability mix by, broadly
speaking, engaging in hedging activities and taking steps to reduce the fragility of their funding structure.
Moreover, some of the perceived risks associated with this business model were lessened during the crisis due to
government intervention. Some of these risks were illuminated during the financial crisis while others did not play
a role. In the following, we will highlight how the risks played out during the crisis and also how mREITs attempt
to manage their risk.
Risks to mREITs and How They Manage These Risks

What the financial crisis taught us about mREITs
The financial crisis revealed the fragilities inherent in the mREIT business model. Given that agency MBSs are
implicitly backed by the government, one might expect that there would be very little volatility in the agency MBS
market. But in fact, interest rate movements indicate significant volatility in perceptions of credit risk on agency
MBS. In response to this volatility and other perceived market problems, the government intervened in an
unprecedented way to prop up this market, which allowed for mREITs holding predominantly agency MBS to
escape the crisis without failures. Beyond risks that showed up in the MBS market, the fact that these assets

were financed by short-term repos led to funding problems for some mREITs and other financial institutions.
Regardless of these apparent fragilities, mREITs continue to have similar exposures; therefore, if the financial
system were to suffer a significant shock again, and the government does not intervene, failures may take place.
Moreover, mREITs have tripled in size since the middle of the financial crisis making the potential for an adverse
outcome more likely.

Credit risk for Agency MBS? The financial crisis began with the decline in housing prices, which had a
significant impact on the MBS market. The graph below shows the spread between the interest rate paid for repo
borrowing using agency MBS collateral and Treasury collateral (RepoMBS – RepoTreas) from January 2007 through
July 2009. This spread represents the market’s perception of the difference in credit-worthiness between MBS
and Treasury securities. The spread was relatively low and stable prior to the summer of 2007. This is what one
might expect through the financial crisis if agency MBS had no credit risk as people concluded based on the
view that the government stood behind agency MBS. However, the volatility in this spread suggests that market
participants viewed agency MBS as having credit risk. While it’s not clear what generated concerns about the
safety of agency MBS, one reason may be that the troubles in the non-agency MBS market were somehow
transmitted to the agency MBS market.

During this time period there was widespread turbulence in both the agency and non-agency MBS
markets. As can be seen in the figure below, the MBS repo spread remained elevated through the latter portion of
2008. Moreover, the turmoil is evident not only from the high repo rate spread illustrated in the chart below, but
also from the spread between the rate on agency MBS and Treasury securities themselves. On March 4, 2008
the spread between Fannie Mae’s current coupon 30-year MBS and 10-year Treasuries widened to
approximately 200 basis points indicating severe stress in the agency MBS market.

Troubles in the MBS market

continued and accelerated thereafter as many other firms reported financial difficulties related to the declining
value of MBSs.

While mREITs have grown significantly, they also are engaging in more risk management activities, especially hedging interest rate risk,
and therefore may be less exposed in a future adverse market event.
74
One possible explanation for the elevated spread is that market participants were uncertain about the government’s willingness to provide
financial support for Fannie Mae and Freddie Mac, or if any support provided would extend to investors in agency MBS. Still, if this were the
explanation for elevated spreads, when the Treasury placed the agencies in conservatorship in September 2008, the spread should have
declined considerably. Instead the spread increased.
75
“Agency Mortgage-Bond Spreads Reach 8-Year High, Hurt Consumers”, Jody Shenn, Bloomberg.com, March 4, 2008.
76
http://www.jec.senate.gov/public/?a=Files.Serve&File_id=4cdd7384-dbf6-40e6-adbc-789f69131903

Figure 9: Spread between Agency MBS term repo rate and Treasury term repo rate

150

MBS - Treasury Repo Spread,
Basis Points

Major
Downgrades
of Private
Label MBS
by S&P

Thornburg sells $20.5 bil. In
Private Label MBS in response to
rumors about margin calls.

125

150

PDCF Created

125
Treasury
guaranties
MMMFs &
Lehman
Brothers
Failure

TSLF & Fed Lends
to Bear Stearns

100

Citi rescued
TALF Announced and Federal
Reserve announces outright
purchases of Agency MBS

Fannie and Freddie
conservatorship

100

Thornburg fails
to meet margin calls
& Citi announces
it would be liquidating
residential mortgage
portfolio

0
Jan/07

Apr/07

Jul/07

Oct/07

Jan/08

Apr/08

0
Jul/08

Oct/08

Jan/09

Apr/09

Jul/09

Source: ICAP /Bloomberg & Richmond Fed
Note: Five day centered moving average of spread between sixty day Agency MBS repo and sixty day Treasury repo, in basis points.

Funding fragilities Many financial institutions, including mREITs, that relied on short-term funding, such as
repos, to finance long-term assets, such as MBS, experienced significant funding problems. The decline in
housing prices raised counterparty concerns about the value of the collateral underlying the repo funding they
advanced, thus limiting the ability of the borrower to rollover their financing. Therefore, they were no longer able
to fund the assets that they held and in some cases were required to sell them in a down market. For instance,
the mREIT Thornburg Mortgage (Thornburg) financed $29 billion of non-agency MBS it owned in Q2 2007 with
repurchase agreements and asset-backed commercial paper. Between the second and third quarter of 2007,
Thornburg began having trouble rolling over its repos and ultimately had to repay $14.2 billion
borrowings in part by selling assets and such sales led to a $1.1 billion loss.

of its repo

78,79

Some common features of repos that make them especially fragile, as demonstrated in the crisis, include
margin calls, increased haircuts, and contractual terms that provide for cross-defaults.

For example, on

Figure from the difference in repo holdings between Q3 2007 and Q4 2007 from Thornburg’s 10-Qs.
“Thornburg Sells $20.5 Billion in Mortgage-Backed Securities,” By Lingling Wei and Kevin Kingsbury, WSJ.com, August 20, 2007
From class action complaint: Case 1:07-cv-00815-JB-WDS Document 68 Filed 05/27/2008, UNITED STATES DISTRICT COURT,
DISTRICT OF NEW MEXICO,IN RE THORNBURG MORTGAGE, INC Case No. 07-815 JB/WDS, SECURITIES LITIGATION.
80
Repurchase agreements are often undertaken under terms set out in Master Repurchase Agreements (MRAs). These MRAs often include
rules that specify that if the borrower defaults on one repo loan from a particular lender, it is treated as if it has defaulted on all repo loans from
that lender (http://www.sifma.org/Services/Standard-Forms-and-Documentation/MRA,-GMRA,-MSLA-and-MSFTAs/MRA_Agreement/, p. 7).
These agreements also specify a number of events that fit the agreement’s definition of a “default,” such as failure to meet margin
requirements, to make various required payments, and the insolvency of the borrower. In these cases the lender may choose to declare all
78
79

February 28, 2008 Thornburg received a default notice on its repurchase agreements with JP Morgan when they
failed to meet margin calls.

81,82

Other major financial firms, like Bear Stearns, were also forced to sell MBS, which

likely led to a decline in the prices of MBS and thus margin calls for all repo borrowers using MBS collateral (Bear
Stearns’s abrupt decline in MBS holdings can be seen in figure A1). The widespread problems in Agency MBS
markets and fragilities in repo financing revealed during the crisis suggest that the mREIT business model is quite
fragile. Nevertheless, agency mREITs broadly emerged from the crisis largely intact and have grown rapidly ever
since, largely because of government actions that propped up the market for agency MBS.
Government intervention in the MBS market In response to the severe strains in the MBS market, the
Federal Reserve implemented two unprecedented programs to encourage broker dealers to continue to trade in
MBS and other similar securities at a time when market participants had pulled away from these securities.
These programs – the Term Securities Lending Facility (TSLF) and the Primary Dealer Credit Facility (PDCF) –
supported those, like mREITs, who relied on the repo market to fund their holdings of agency MBS. The $200
billion dollar TSLF program began operating on March 27, 2008 and allowed broker-dealers to exchange their
agency MBS for Treasury securities for a term of up to 28 days.

83,84

The program was effectively a swap of

collateral that was avoided by the market for stronger collateral, and is viewed as a primary reason for the decline
85

in the spread between Treasury repo and agency MBS repo starting in the spring of 2008 (see figures 9 & A4).
This program especially helped the agency mREITs. On the other hand, it did little to help the non-agency
86

mREITs because most non-agency MBS were ineligible for the TSLF program. As seen in the figure below, this
program was especially utilized by holders of agency MBS.

amounts outstanding as payable. If the borrower is unable to make requested payments, then the lender may keep pledged collateral on all
loans covered by one MRA. MRAs may therefore expand a default from one loan to many a number.
81
“Thornburg Can't Meet Margin Calls, Survival in Doubt (Update5),” David Mildenber, March 7, 2008, bloomberg.com.
82
Thornburg ultimately declared bankruptcy on April 1, 2009, at which point any remaining repo contracts would have been terminated and
may have been immediately liquidated. See: http://www.bloomberg.com/apps/news?pid=newsarchive&sid=acP.oPOVP3VI
83
For more on this program please see: “The Term Securities Lending Facility: Origin, Design, and Effects”, Michael J. Fleming, Warren B.
Hrung, and Frank M. Keane,Current Issues In Economics and Finance, Volume 15, Number 2, February 2009
,www.newyorkfed.org/research/current_issues.
84
“Schedule 1” collateral is all Open Market Operations eligible collateral. “Schedule 2” collateral is Schedule 1 collateral plus other
investment grade securities such as AAA/Aaa-rated non-agency MBS, CMBS, agency CMOs.
http://www.federalreserve.gov/monetarypolicy/tslf.htm.
85
Fleming, Hrung and Keane (2010) Table 2, reports that agency MBS spreads declined 0.54 basis points for every 1 billion in additional
Treasury securities lent through the TSLF program.
86
Internal Federal Reserve sources indicate that by the spring of 2008 the majority of non-agency MBS had been downgraded to below
AAA/Aaa, which made such securities ineligible for the TSLF program.

Figure 10: Collateral Pledged to Term Securities Lending Facility

200

Billions, USD.

180
160
140
120
Agency MBS & CMO

100
80

60
Non-Agency MBS & CMO

40
20
0

Asset-Backed Securities

03/27/08

05/11/08

06/25/08

08/09/08

09/23/08

11/07/08

12/22/08

02/05/09

03/22/09

05/06/09

06/20/09

Source: Federal Reserve Board of Governors & Richmond Fed
http://www.federalreserve.gov/newsevents/files/tslf.xls
Note: Three day moving average of collateral pledged to the Term Securities Lending Facility.

The PDCF, which was implemented around the same time, may have also had a positive effect on the
agency MBS market. This program allowed the dealers to pledge tri-party eligible collateral in exchange for a
cash loan from the Federal Reserve (see figure 11). The TSLF may have been more attractive to dealers
because it allowed them to participate in a broad-based auction rather than independently borrowing from the
87

Fed, which may have carried some stigma.

See: http://www.newyorkfed.org/research/current_issues/ci15-2.pdf, p.4

Figure 11: Collateral Pledged to PDCF

Billions, USD.

MBS/CMO: agency-backed
MBS/CMO: other

Asset-backed Securities
10

0
Mar-08 Apr-08 May-08 Jun-08 Sep-08 Oct-08 Nov-08 Dec-08 Jan-09 Feb-09 Mar-09 Apr-09 May-09

Source: Federal Reserve Board of Governors & Richmond Fed
http://www.federalreserve.gov/newsevents/files/pdcf.xls
Note: Three day moving average of collateral pledged to the Primary Dealer Credit Facility

Both the TSLF and PDCF supported agency MBS and the repo market during the financial crisis.
Another program, Large Scale Asset Purchases (the Fed’s purchases of up to $500 billion of agency MBS),
initiated in November 2008, also propped up the agency MBS market. Additionally, the long-standing implicit
government support for Fannie Mae and Freddie Mac, and the conservatorship program that made the support
more explicit, allowed agency MBS issuance to continue and even grow, unlike non-agency MBS. Arguably,
without the implementation of TSLF, PDCF, outright purchases of agency MBS and support for the GSEs,
mREITs would have had a challenging time finding the financing necessary to sustain their business models.
While both the agency and non-agency MBS markets suffered turmoil in the crisis, the agency MBS market
recovered rapidly and has grown ever since – along with mREITs. Issuances of non-agency MBS declined
dramatically during the crisis and has yet to recover (see figure 12).

For data on Agency MBS outstanding amounts and total issuance see: http://www.sifma.org/research/statistics.aspx

Figure 12: MBS, CMBS and CMO Issuance from 1985 to 2012

3.5

Trillions, USD.
Agency CMO Issuance

3.5

Agency MBS Issuance
2.5

2.5
Total Non-Agency Issuance (CMBS + MBS)

1.5

0.5

0
1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011
Source: Fannie Mae, Federal Reserve, Freddie Mac, Ginnie Mae, HUD; FHFA; data compiled by SIFMA

Risks to mREITs (other than those identified from the crisis)
mREITs face a variety of risks because of their business model. Some of these were illuminated by the financial
crisis – fragilities in the repo market and perceptions of heightened credit risk for agency MBS – but others that
did not appear during this time can also be important risks for mREITs, including interest rate risk, prepayment
risk, additional risks associated with repo financing, and regulatory risk.
Interest rate and prepayment risk Because of the maturity mismatch between mREITs’ assets and
liabilities, interest rate movements can affect their earnings and, indeed, their solvency. If interest rates were to
increase rapidly, MBS prices would immediately fall, leading to many of the same problems that arose during the
financial crisis as a result of falling asset values. While the mREITs hedge very little against MBS price
movements driven by credit risk, and therefore suffered losses during the crisis (which would have been greater
had it not been for government support of agency MBS), they do hedge against interest rate risk. Additionally, all
mortgage-related investments are subject to prepayment risk, as previously discussed.
Repo fragilities Although some risks associated with the use of repo financing were identified during our
financial crisis discussion, there are additional characteristics of repo financing that may contribute to the fragility
of mREITs. For example, some observers maintain that the special treatment given to repos in bankruptcy
encourages the use of short-term over long-term financing, increasing the fragility of firms (mREITs, for instance)
that rely heavily on repo finance. The idea here is that because qualified financial contracts (QFCs) have an
advantage in bankruptcy, repo lenders have an inefficiently small incentive to monitor and therefore may provide
more credit than would otherwise be appropriate (allowing borrowers to lever up without appropriate fees or
29

penalties).

Additionally, since mREITs’ major funding providers – broker-dealers – also rely significantly on repo

funding, this argument also applies to them (see Figure A3). As a result, broker-dealers may be particularly
fragile, potentially exposing mREITs to a danger of the loss of their funding sources. One further risk, albeit small,
sometimes discussed in mREIT’s financial reports, is the potential loss of the haircut on a repo if the mREIT’s
lender defaults.

Government policy risk Currently, agency MBS enjoys an implicit government guarantee, but legislation
has been proposed that could ultimately undermine, to some extent, this guarantee. The mREITs that exist today
are almost exclusively invested in agency MBS. While at one time some mREITs were large holders of nonagency MBS, these mREITs have disappeared (or failed) as the non-agency MBS market largely dried up (see
Figure 12, SIFMA). mREITs have become highly leveraged and have grown rapidly because their primary asset
has government backing, limiting credit risk.
If legislation were to pass that undermines this guarantee, mREITs’ creditors would certainly respond by
demanding some or all of the following to compensate for the expectation of higher credit losses: higher interest
rates on repos, higher haircuts, and/or a larger equity cushion. As a result, repo financing would become less
attractive, and mREITs would almost certainly shrink. If mREITs’ repo funding costs were to increase, then one of
two things might happen. First, if the rates earned by mREITs on their MBS assets remained unchanged, their
earnings spread would shrink, making them less attractive to investors. Second, if MBS prices increased in line
with repo rates, this would likely translate into higher mortgage rates, thus reducing the attractiveness of
mortgage borrowing and therefore the supply of MBS – likely leading to a decline in mREITs’ holdings.
Additionally, creditors might not necessarily charge higher repo rates to mREITs, but could instead demand
higher haircuts or higher levels of equity relative to debt. Both of these would limit their ability to lever up to the
same extent as they do now, therefore causing them to shrink.
Additionally, mREITs’ access to repo funding might be limited because their assets may no longer be
considered as acceptable collateral to certain counterparties in the tri-party repo market. mREITs obtain a
significant portion of their funding from broker-dealers, and broker-dealers, in turn, are funded to some extent by
institutional investors (e.g., money market mutual funds) that face limits requiring them to hold only the safest
assets, such as those with government guarantees (i.e., repos collateralized by agency MBS). If legislation
removed the government guarantee that agency MBS currently enjoys, broker-dealers may lose some of this
funding and therefore may not be able to finance mREITs to the same extent. As a result, mREITs would be
forced to reduce their purchases of agency MBS and thus shrink.
Moreover, the ability of mREITs to attain leverage is dependent on whether they maintain their exemption
from the Investment Company Act of 1940. If mREITs lose their exemption from the 1940 Act – because the SEC
publishes new guidance as to what qualifies as a “qualified real estate asset” or otherwise revises their
interpretation of who qualifies for the exemption – they would be required to significantly deleverage. As of
December 31, 2012, mREITs had an average leverage multiple of 8 (see Table 3), whereas investment
89

For a discussion of these views, see: Pellerin and Walter (2012), p. 23-24.
See, for example, Annaly’s December 31, 2012, 10-K filing, p.25.
http://www.sec.gov/Archives/edgar/data/1043219/000115752311001180/a6624738.htm
90

companies are limited to a 1.5 leverage multiple (assets-to-equity).

Therefore, in order to reduce leverage to

the levels acceptable for an investment company, an mREIT would have to increase its equity or reduce its
assets by a significant amount. As an example, Hatteras Financial Corp has a leverage multiple of 8.6. They
would have to reduce their assets by 82 percent, holding equity constant; or increase equity by nearly six times its
existing levels, holding assets constant; to meet these leverage requirements. Many mREITs heavily rely on this
exclusion and note the risks associated with losing this exception in their financial statements. For instance, one
mREIT noted that their business would be “materially and adversely affected if we fail to qualify for this
exemption,” and another stated that it would “substantially change the way we conduct our business.”

92,93

Table 3

Five Largest mREITs
Annaly Capital Mgmt Inc.
American Capital Agency Corp.
Hatteras Financial Corp.
CYS Investments
ARMOUR Residential REIT Inc.
TOTAL (includes all other mREITs)
AVERAGE (includes all other mREITs)

Total Assets
2012Y ($000)

Agency
Securities
2012Y ($000)

Repurchase
Agreements
2012Y ($000)

Total Equity
2012Y ($000)

133,452,295
100,453,000
26,404,118
21,057,496
20,878,878
434,218,236
14,973,043

127,724,851
85,245,000
24,057,589
20,842,142
19,096,562
360,093,454
12,860,481

102,785,697
74,478,000
22,866,429
13,981,307
18,366,095
319,514,935
11,017,756

15,924,444
10,896,000
3,072,864
2,402,662
2,307,775
58,763,733
2,026,336

Leverage
Multiple
(assetsto-equity)
8.4
9.2
8.6
8.8
9.0
8.3

Source: SNL Financial. Note: Data for Chimura Investment Corp. (included in Total and Average) is from 3Q 2012 when they last reported.

However, for the largest mREITs, being subjected to the Investment Company Act is minor compared
with the possibility of coming under the Fed’s oversight. Because of the potential risks associated with their size
and use of short-term financing, the largest mREITs (Annaly and Agency) are under consideration by the
Financial Stability Oversight Council (FSOC) to be designated as systemically important financial institutions
(SIFIs).

94,95

Among the factors currently under review are firm size, fragility, interconnectedness with other

financial institutions and markets, and existing regulatory scrutiny. Designation as a SIFI would subject these
companies to enhanced prudential measures, including capital and liquidity requirements, leverage limits,
enhanced public disclosures, and risk management requirements. Additionally, SIFIs are required to produce so-

This leverage ratio is calculated based on the 300 percent asset coverage ratio (the amount of assets required to cover their debt), required
of investment companies in Section 18 of the Investment Company Act of 1940.
92
From Annaly Capital Management and Northstar Realty Finance Corp’s December 31, 2012, 10-Ks, respectively.
93
From NorthStar Realty Finance Corp (has subsidiaries that rely on the exception from the 1940 Act) 2012 10-K: “If we are required to
register as an investment company under the Investment Company Act, we would become subject to substantial regulation with respect to our
capital structure (including our ability to use leverage), management, operations, transactions with affiliated persons (as defined in the
Investment Company Act), portfolio composition, including restrictions with respect to diversification and industry concentration and other
matters.”
94
As of December 31, 2012, Annaly had assets and outstanding repo financing totaling $133.5 billion and $102.8 billion, respectively; and
Agency had $100.5 billion and $74.5 billion, respectively. These levels exceed the FSOC’s stage one thresholds for SIFI designation in terms
of asset size (greater than $50 billion) and holdings of short-term debt (greater than 10 percent short-term debt to assets ratio). FSOC’s stage
one thresholds are in place to identify those nonbank companies that are likely to receive a comprehensive review to determine whether the
company poses risks to financial stability, which could be mitigated by imposing enhanced prudential standards and oversight by the Federal
Reserve. See FSOC’s Final Rule, which describes how FSOC intends to make SIFI determinations.
95
American Capital Agency had listed designation as a SIFI as a risk factor in its Form 10-K for 2011, but the warning appeared to be absent
from its 10-K for 2012.

called “living wills,” which must contain a firm’s plans for an orderly resolution in the event of financial distress.

While FSOC is currently in the process of making nonbank SIFI designations, which may or may not include
designating Annaly and Agency as SIFIs, they will continuously monitor financial firms into the future to identify
any perceived risks that may result in a future SIFI designation.

Risk Management
The risks that we have just outlined are all a function of taking advantage of maturity transformation. Banks are
the prime example of institutions engaging in maturity transformation. In other words, they finance a portfolio of
long-term assets (loans) with short-term liabilities (deposits), taking advantage of depositors’ strong preference for
immediate access to their funds (so that these depositors are willing to accept very low interest rates) while still
97

providing borrowers funding for long-term projects. Maturity transformation naturally subjects those firms using it
to severe risk of loss when interest rates move unexpectedly. Taking Annaly as an example, given 1) its maturity
mismatch as of December 31, 2012; 2) the amount of unencumbered assets it has available to meet margin calls
should the value of its assets decline; and 3) assuming no hedging activities; if interest rates were to immediately
rise by 440 basis points

or more, Annaly would face insolvency. However, Annaly’s and other mREITs’ risk

management activities are intended to limit this risk. Whereas banks’ risk-taking and fragility is limited by
regulation and the grant of deposit insurance, mREIT activities are largely constrained only by market forces.
mREIT risk management activities include spreading out the maturities of their financing (laddering), so all of their
liabilities do not come due at once. Beyond laddering they also hedge using simple and complex derivativesbased strategies to address interest rate risk and the risks associated with the prepayment option embedded in
MBS.

Additionally, mREITs limit their leverage to less than haircuts would otherwise allow as a means of

reducing fragility.
The following chart (figure 13) provides an illustration of the magnitude of the asset-liability mismatch of
one of the largest mREIT’s (AGNC) and to what extent it hedges. The vertical axis represents the interest rates
earned on assets (positive numbers), repo rates (positive numbers), implied cost of financing (TBAs), and net
96

Given their reliance on the use of repos, which are exempt from the automatic stay provisions of the bankruptcy code, resolution of an
mREIT would likely be fairly straightforward in that creditors would immediately take control of the MBS collateral and the mREIT would be left
with very few unencumbered assets to be handled in the bankruptcy process.
97
See Diamond and Dybvig (1983) for a discussion of why depositors have a strong preference for investments that allow them immediate
access to their funds.
98
This figure is calculated as follows. According to its December 31, 2012, 10-K (p. F-3), as of the end of 2012, Annaly had $129.9 billion in
MBS and other similar securities and $109.2 of these assets were pledged as collateral on its repo (and other) loans. Therefore it had $129.9
– $109.2, or $20.7 billion of MBS and other holdings that are unencumbered. It also had about $2.4 B in cash or other liquid assets, but had
about $8.3 billion in payables associated with its investments. So – in total – it had about $14.8 billion to meet margin calls. Calculated, based
on the broad figures provided in Annaly’s 2012 10-K, its average MBS maturity appeared to be approximately three years (see page F-16 of
Annaly 2012 10-K). We are assuming its other securities have a similar maturity. Using a standard present-value-of-a-bond formula (therefore
assuming no prepayments) to determine the effect of a change in interest rates on the value of Annaly’s MBS (i.e., PV = Face value/(1 + I) n),
one can determine that market interest rate would need to rise by about 440 basis points to wipe out the extra MBS and cash so that it
couldn’t repay its loans.
99
One might imagine that mREITs would need to address prepayment risk associated with declining interest rates (the chance that falling
interest rates will cause mortgage borrowers to refinance, and therefore repay their mortgages, forcing mREITs to need to reinvest these
received funds at the new lower interest rate) because MBS contains such risk. However, because mREITs’ have longer term assets than
liabilities, such that a decline in interest rates would reduce their funding costs tending to offset any losses produced by prepayments.

swap rates on hedges (fixed pay less floating receive rate).

100

The horizontal axis represents the maturity (in

days) of assets, liabilities or derivative contracts. The size of the “bubble” indicates the size of either the notional
(with respect to derivatives) or market values of hedges, assets, or liabilities.
Figure 13
Yield, %

5
4

Repurchase Agreements

Agency MBS

Payer Swaptions

Interest Rate Swaps

30-Year TBA securities

15-Year TBA securities

$49,750

$17,428

$8,322

2
$29,461
1

-1000

$12,060
0
-500
0
$14,208
-1

Term Till Maturity, days
500

1000

$14,950

1500

2000

2500

3000

3500

4000

4500

$19,750

-2
-3

-4
-5

Note: For swaps and swaptions the yield is the recieve rate minus the pay rate, the size of the bubble
refers to the notional in millions. For Agency MBS the value is their fair value, the yield is the current
yield and the life is the estimated average life. Repos: Notional is the size, yield rate is the repo rate.
The term till maturity for ARMS was their average number of days till reset. TBAs are net notionals, rate
is dollar roll implied financing rate and maturity is 60 days. Source: Richmond Fed & AGNC 2013 Q1
10Q.

From the figure it is clear that the assets AGNC holds have a much greater maturity than their repo liabilities. It
also reveals that their hedges are offsetting some of their profits because they are, on net, cash outflows.
Laddering
Repo financing is typically thought of as being very short-term – having an overnight maturity.

101

If all mREITs’

repo financing was overnight, they would be highly exposed to bank-like runs, since all of their liabilities would
mature daily. In other words, it is possible that all mREIT creditors could, on a given day, refuse to rollover their
repo financing; just like all depositors of a bank could demand their funds on a given day – producing a bank run.
To mitigate the possibility of bank-like runs, mREITs typically will arrange their repo funding such that their
contracts have various terms to maturity.
100

Interest payments on repos are expressed as a positive number, rather than a negative number, to allow readers to more easily visualize
the net interest margin (spread).
101
Investopedia defines a repo contract as: “A form of short-term borrowing for dealers in government securities. The dealer sells the
government securities to investors, usually on an overnight basis, and buys them back the following day.”
http://www.investopedia.com/terms/r/repurchaseagreement.asp

Figure 14: mREITs Share of Repo Borrowing by Maturity and Federal Funds Rate

100
90

7
Share of Total Repurchase
Agreements

Federal Funds Rate (%)

0 - 30 Days

80
5

70
60

50
3

31 - 90 Days

40
30

20
1

90 Days +

10
0

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Source: SNL Financial, Haver Analytics, Richmond Fed.

While over the last couple of decades the majority of mREITs’ repo contracts have had maturities of less
than 30 days, still, a large portion of their repo financing has been for greater than 30 days, particularly in periods
when interest rates were expected to rise.

102

As seen in Figure 14, mREITs increased the proportion of repos with

maturities greater than 30 days beginning in 2002 and again in 2009, periods during which it seemed clear that
interest rates could only increase. In addition to protecting them, to some extent, from interest rate risk,
lengthening repo maturities also protects them from rollover risk, which could be higher when interest rates are
rising rapidly. For example, creditors may have greater concerns about the health of firms, such as mREITs,
which have significant maturity mismatch, when rising interest rates are expected to produce losses. Despite the
fact that mREITs enter into repo contracts that are longer than overnight, as seen in Figure 14 the overwhelming
majority of their liabilities still have significantly shorter maturities than that of their assets, represented by the blue
bubbles. Thus, while laddering can mitigate some of the rollover risk mREITs face, it still leaves them highly
exposed to interest rate risk.

102

The decline in the use of repos with maturities greater than 30 days during the 2007-09 financial crisis could have been, in part, due to
broker-dealers’ efforts to shorten the maturities of their repo loans.

Fixed-for-floating interest rate swaps
Of all their risk management activities, mREITs rely most heavily on interest rate swaps to manage
interest rate risk. In fact, the notional value of their swaps at the end of 2012 totaled $160 billion (37 percent of all
mREIT assets) (see Figure A4). Because mREITs’ funding costs (determined by repo rates) adjust more quickly
than their interest earnings on their MBS portfolio, when interest rates rise, their net income declines. To
compensate for the increased funding costs, mREITs enter into fixed-for-floating rate swap contracts that are
intended to pay off when interest rates rise. Fixed-for-floating swaps, in this case, will pay the mREIT’s swap
counterparty a fixed rate while the mREIT receives a floating rate tied to some short-term market interest rate
index, such as LIBOR. Since short-term interest rates tend to move together, the income that an mREIT receives
on its contract will increase at the same time that their repo costs are increasing. The average swap ratio for all
mREITs – total notional value of swaps divided by total repos – was only 50 percent as of December 31, 2012.
This means that approximately 50 percent of any rise in mREITs’ repo funding costs resulting from an increase in
market rates will be offset by the income received on these swap contracts. However, given that the two largest
mREITs have recently added, rather aggressively, to the amount of their interest swaps, this figure is larger than it
was in recent years and appears to continue to trend upward. Combined, these mREITs increased the notional
amount of their swaps by $68 billion from 2010 to the second quarter of 2013, providing evidence that their
expectations of future rising rates are increasing (see Figure A5).

Other commonly used hedging activities
Beyond laddering and entering into interest rate swaps, mREITs engage in a number of other activities to hedge
interest rate risk, or, in other words, limit the risk associated with the significant maturity mismatch their balance
sheet carries. The way in which mREITs determine how significant this mismatch is, is by using a measure called
duration.103 Specifically, mREITs control their duration gap (duration of assets minus duration of liabilities) by
engaging in hedging activities such as swaptions, options, futures, and short sales.104
The table below shows the market values and durations of all of AGNC’s assets and liabilities as of Q1
2013 and the resulting net duration gap. A positive duration gap, such as AGNC’s, means that a firm will
experience losses when interest rates rise. The larger the positive duration gap, the larger the losses. For
example, starting with the same duration gap, if there are two firms – one holding all plain vanilla bonds and the
other holding all MBS – an increase in interest rates will create more losses for the second firm than the first.
This is because the increase in interest rates extends the duration of the MBS firm – due to the embedded
prepayment option in mortgages – thereby increasing their duration gap and producing more losses. mREITs
identify this special MBS-related risk (often referred to as convexity risk) and hedge for it.

105

103

“Duration is a measure of the maturity of a fixed-rate security or, equivalently, its sensitivity to movements in interest rates. A duration of
four years implies that a 1 percent change in yields is associated with a 4 percent change in price. Note that this market rule-of-thumb
estimate of MBS duration is approximate—because future prepayment rates are unknown, the expected duration of an MBS will fluctuate over
time because of variation in market conditions and the term structure of interest rates.” From: Vickery and Wright. “TBA Trading and Liquidity
in the MBS Market.” FRBNY Economic Policy Review. May 2013. http://www.newyorkfed.org/research/epr/2013/1212vick.pdf
104
mREITs may also modify their portfolio holdings as a means of controlling their duration gap.
105
Some observers argue that there exists a feedback between hedging for convexity and volatility in interest rates. This convexity hedging is
seen as one way mREITs potentially pose risks for the broader financial system. See Fernald, Keane and Mosser (1994), Duarte (2008), and
Perli and Sack (2003).

Table 4

Assets

Market Value

Duration

Fixed

74.8

4.2

ARM

0.8

1.8

CMO*

0.7

6.7

TBA

27.3

4.4

Cash

3.3

Total

106.9

4.1

Liabilities & Hedges

Market Value/ Notional

Duration

Liabilities

-66.3

-0.3

Liabilities (Other)**

-0.9

-7

Swaps

-51.3

-4.5

Preferred

-0.2

-8.4

Swaptions

-22.9

-1.9

Treasury / Futures

-13.6

-6.8

Total

-3.6

Net Duration Gap

0.5

*CMO balance includes interest-only, inverse interest-only and principal-only securities
**Represents other debt in connection with the consolidation of structured transactions under GAAP
Source: American Capital Agency Group, Investor Presentation, June 12,2013, pg. 24
+

The Net Duration Gap is derived from the weighted duration of assets and liabilities and is not calculated by
simply summing the various durations listed here in the table.

Risks mREITs Pose (Systemic Risks)
As previously discussed, a sudden rise in interest rates, a decline in MBS prices caused by other market forces,
or any event that causes mREITs to lose a significant portion of their funding, could lead to rapid deleveraging by
mREITs and possibly default.

106

Because mREITs are significant holders of MBS, deleveraging or default could

have consequences well beyond the mREIT sector.
In the case in which MBS prices decline as a result of rising interest rates or some other market force,
mREITs would be hit with margin calls and be forced to sell their unencumbered assets until they exhaust these,
and then subsequently would default. Even if the mREIT can meet its margin calls by rapidly selling
unencumbered assets, these sales might fetch unusually low prices (fire sale prices) compared with what such

106

Begalle, Martin, McAndrews and McLaughlin (2013) document that the tri-party repo market is subject to fire sales which are differentiated
by pre-default and post-default fire sales.

sales might generate over time. Margin calls could easily force an mREIT to sell its unencumbered assets rapidly,
but these are only a small portion of total mREIT MBS holdings (and therefore a very small portion of total
outstanding MBS); therefore, it seems unlikely that the rapid sale would have a significant impact on market MBS
prices.

107

On the other hand, if an mREIT defaults and is forced into bankruptcy, its counterparties are able to terminate
their repo contracts (due to the bankruptcy QFC exemption), take possession of all of the MBS collateral and
perhaps liquidate it.108 For any of the largest few mREITs, immediate liquidation of all of the defaulting mREIT’s
collateral may release a sufficient amount of MBS, relative to total MBS outstanding, to impact market prices, at
least to an extent. If the MBS market is already in turmoil so that a number of mREITs default, this will exacerbate
that turmoil and may lead to broad scale MBS fire sales, having an even greater impact on market prices of MBS.
Moreover, if the value of MBS declines to such an extent that mREIT counterparties are not able to meet their
own commitments, losses might cascade to their counterparties and their counterparties’ counterparties, therefore
spilling over to the broader economy.

109

Even if there is no spillover, MBS prices are likely to be driven down (and

in turn interest rates on MBS driven up) to some extent by mREIT defaults and the concomitant MBS sales. As a
result, mortgage rates are also likely to be driven up, damping housing affordability, thus having an adverse
impact on the broader economy.
mREITs appear to be important suppliers of MBS collateral to the tri-party repo market through brokerdealers. If a number of mREITs were to default, some of this collateral might be removed from the tri-party market
and market efficiency could decline somewhat. As illustrated in Figure 15, over the last several years the amount
of the increase in broker-dealer lending (approximately $300 billion between June 2010 and December 2012) is
almost exactly equivalent to the amount of the increase in mREIT borrowing, supporting the notion that broker
dealers have provided the vast majority of funding used by mREITs. In turn, as can be seen in Figure 16, the
amount of agency MBS collateral posted to the tri-party market by broker-dealers – the dotted line – increased by
about this same $300 billion between June 2010 and December 2012. The total value of agency MBS collateral in
the tri-party repo market – the solid line – appears to mirror movements in the dotted line and both increase by
about $300 billion over the same period, So Figures 15 and 16, taken together imply that the agency MBS that
mREITs have pledged for most of their recent borrowing, has flowed through to the tri-party market via brokerdealers, and accounts for much of the growth over the last several years in that market. Total agency MBS
collateral in the tri-party repo market amounts to $535 billion (34 percent of all tri-party repo collateral – more than
any other collateral type) as of September 2013. In the same period, mREITs, through broker dealers, supplied
$300 billion, or 54 percent of all agency MBS collateral, to the tri-party repo market.

110

Thus, if mREITs defaulted

on a large scale, a significant portion of their MBS collateral would likely become unavailable to the tri-party repo
107

Annaly total unencumbered assets equaled 16 percent of repo borrowings. From Annaly’s 12/31/12 Annual Report, p. F-3.
An mREIT could default on a counterparty without being forced into bankruptcy. Instead, the default could be handled through terms of the
repo contract. See: http://www.icmagroup.org/Regulatory-Policy-and-Market-Practice/short-term-markets/Repo-Markets/frequently-askedquestions-on-repo/26-what-happens-to-repo-transactions-in-a-default/.
109
Table A4 in the appendix lists the mREITs that name repo counterparties in their 10-Ks.
110
The total amount of repos at all mREITs equaled $286 billion as of September 30, 2013. However, to better estimate the true amount of
MBS collateral flowing through broker-dealers to the tri-party repo market, we inflate the $286 to account for the additional haircuts posted to
broker-dealers in repo transactions. mREIT haircuts on agency MBS-backed repo loans from broker-dealers average 5 percent, thus the
amount of agency MBS collateral flowing to the tri-party repo market from mREITs is probably closer to $300 billion ($286 billion*1.05).
108

market, eliminating a heavily relied upon form of collateral. The collateral could become unavailable for tri-party
use if the following two conditions are met: 1) broker-dealers are unwilling to hold MBS collateral outright and
therefore sell it to investors; and 2) the investors acquiring the MBS hold it outright rather than using it as
collateral in the repo market.

111

Some investors, those who are not well-suited to perform credit analysis, will lend only if they can receive
high-quality collateral in return. If high-quality MBS collateral is withdrawn from tri-party use, these lenders may
refrain from making loans that if collateral were available, would be efficient for them to make.

112

Beyond this

simple efficiency loss, if MBS collateral were withdrawn from the tri-party market, and certain lenders in that
market (such as money market mutual funds) reduced their lending, borrowers who typically borrow in that market
might suffer losses, and some might fail.

Thousands

Figure 15: mREIT Repo Borrowing and Broker-Dealer Lending

550

350

Billions, USD

500

mREITs Repurchase Agreement
Borrowings (Right Axis)

300

450

Dealer-provided term repo funding
collateralized by MBS (Left Axis)

250

400

200

350

150

300

100

250

200
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Sources: Federal Reserve Bank of New York FR2004 Form, SNL Financial & Richmond Fed
Note: Quarterly data from mREITs listed in Table A5.

2013

0
2014

111

Some observers refer to this as a reduction in “collateral velocity.” See “Velocity of Pledged Collateral” Manmohan Singh, IMF Working
Paper (2011) for more information on collateral velocity.
112
There are some observers who believe that the tri-party market is bigger than it otherwise would be due to past government interventions
to prop up this market in times of financial distress. Therefore, events such as the failure of mREITs that would shrink the size of the tri-party
repo market, may actually not be efficiency reducing.

In fact, there was a significant reduction of agency MBS collateral in the tri-party repo market (see Figure
16) over the same period that long-term interest rates increased (in the nine months prior to the third quarter of
2013). As was previously discussed, mREITs provide a substantial amount of agency MBS collateral to the triparty repo market and have been shrinking their MBS-based borrowing (as seen in the red line in Figure 15).
However, other market participants are reducing their MBS-based repo borrowing even more (as seen in the blue
dotted line in Figure 15). Surprisingly, given mREITs’ heavy reliance on leverage and significant maturity
mismatch, mREITs don’t seem to have reacted as strongly to rising interest rates as some other players.
However, if interest rates were to rise suddenly, the mREIT structure could lead to a rapid MBS selloff.

Figure 16: Broker-Dealer Agency MBS Financing and Tri-Party Repo

500

800

Billions, USD.

450

750

400

700

350

650

300

600

250

550

200

Dealers Term: Securities out: MBS (Left Axis)

500

150

Agency MBS Collateral in Tri-party repo market
(Right Axis)

450

100
J-10

400
S-10

D-10 M-11

J-11

S-11

D-11 M-12

J-12

S-12

D-12 M-13

J-13

S-13

Source: Federal Reserve Bank of New York FR2004 Form, Tri-party Repo Task Force, Richmond Fed, Haver
Analytics

5. Conclusion
Policymakers, the press, and other observers have raised concerns about possible systemic risks that may flow
from mREITs, especially given the speed with which they have grown over the last five years. mREITs invest
heavily in MBS, a long-term asset, and fund these investments largely with term repo, a fairly short-term liability.
The recent financial crisis highlighted the risks that might cascade beyond troubled nonbank institutions when
those institutions engage in the types of maturity transformation being undertaken by mREITs.

Clearly investors in mREITs have reason to be concerned given that this asset-liability mix leaves
mREITs critically exposed to interest rate risk. In fact, recent interest rate increases have caused mREITs to
shrink and have produced significant declines in the mREIT stock prices.
Still, the danger to the financial system more broadly is less clear. For one thing, interest rates would
need to increase significantly and rapidly to cause widespread mREIT insolvencies. Additionally, mREITs’ share
of all MBS outstanding, while not insignificant, is only about 6 percent, so that any problems at mREITs would
have to be magnified by counterparty actions in order to produce system-wide problems.

References
Adrian, Tobias and Ashcraft, Adam B. and Cetorelli, Nicola, “Shadow Bank Monitoring” (September 1, 2013). FRB of New
York Staff Report No. 638. Available at SSRN: http://ssrn.com/abstract=2334918 or http://dx.doi.org/10.2139/ssrn.2334918
Adrian, Tobias, Daniel Covitz, and Nellie Liang. "Financial Stability Monitoring." (No. 601). Federal Reserve Bank of New York,
Staff Working Paper, (2013).
Bank for International Settlements. 2010 “The Role of Margin Requirements and Haircuts in Procyclicality.” CGFS Papers, no.
36, March.
Barclays. 2012. “U.S. REITs. REITs 101: An Introduction.” Barclays Capital Inc., Equity Research. July 17. Available at:
http://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=1&ved=0CCkQFjAA&url=http%3A%2F%2Furbanland.uli.
org%2Fwp-content%2Fuploads%2F2013%2F10%2FUSREITs_REITs_101_An_Introduction.pdf&ei=w1d1UqGxG_esAT4voHoAw&usg=AFQjCNHs2Jv1oqye6y9KALxDDLlWkhJZUg&bvm=bv.55819444,d.cWc&cad=rja.
Bernanke, Ben S. 2012. “Some Reflections on the Crisis and the Policy Response.” At the Russell Sage Foundation and The
Century Foundation Conference on “Rethinking Finance,” New York, New York. April 12, 2012. Available at:
http://www.federalreserve.gov/newsevents/speech/bernanke20120413a.htm
Board of Governors of the Federal Reserve System. 2013. Federal Reserve Statistical Release Z.1, Financial Accounts of the
United States (formerly named Flow of Funds Accounts). Available at: http://www.federalreserve.gov/releases/z1/.
Bordo, Michael D. and Richard Sylla. 1995. Anglo-American Financial Systems: Institutions and Markets in the Twentieth
Century. Irwin, New York.
Case 1:07-cv-00815-JB-WDS Document 68 Filed 05/27/2008 Page 1 of 196 UNITED STATES DISTRICT COURT DISTRICT
OF NEW MEXICO IN RE THORNBURG MORTGAGE, INC SECURITIES LITIGATION Case No. 07-815 JB/WDS
CONSOLIDATED CLASS ACTION COMPLAINT
Chan, Su Han, John Eriickson and Ko Wang. 2003. Real Estate Investment Trusts : Structure, Performance, and Investment
Opportunities: Structure, Performance, and Investment Opportunities. Oxford University Press.
Claessens, Stijn, Zoltan Pozsar, Lev Ratnovski, and Manmohan Singh. 2012. "Shadow Banking: Economics and Policy." IMF
Staff Discussion Note. SDN/12/12: n. page. Print. <http://www.imf.org/external/pubs/ft/sdn/2012/sdn1212.pdf>.
Copeland, Adam, Darrell Duffie, Antoine Martin, and Susan McLaughlin. 2012. "Key Mechanics of the US Tri-Party Repo
Market." Economic Policy Review: 17-28.
Duarte, Jefferson. 2008. "The causal effect of mortgage refinancing on interest rate volatility: Empirical evidence and
theoretical implications." Review of Financial Studies 21, no. 4: 1689-1731.
Dudley, William C. 2013. ,“Fixing wholesale funding to build a more stable financial system.” Remarks at the New York
Bankers Association's 2013 Annual Meeting and Economic Forum, New York City, February 1.

Duffie, James Darrell, and David Skeel. 2012. "A dialogue on the costs and benefits of automatic stays for derivatives and
repurchase agreements." U of Penn, Inst for Law & Econ Research Paper 12-02 (2012).
Durrett, A. Overton. 1961. A. Overton Durrett, “The Real Estate Investment Trust: A New Medium for Investors,” William and
Mary Law Review. Volume 3, Issue 1, Article 8: 140-61. Available at: http://scholarship.law.wm.edu/wmlr/vol3/iss1/8.
Federal Reserve Bank of New York. 2012. “Tri-Party Repo Statistics as of 12/11/2012.” Available at:
http://www.newyorkfed.org/banking/pdf/dec12_tpr_stats.pdf
Fernald, Julia D, Frank Keane, and Patricia C Mosser. "Mortgage Security Hedging and the Yield Curve."Federal Reserve
Bank of New York Quarterly Review. Volume 19.Number 2 (Summer-Fall 1994 ): 92-100. Print.
<http://www.newyorkfed.org/research/quarterly_review/1994v19/v19n2article5.pdf>.
Fink, Matthew P. 2005. “The Revenue Act of 1936: The Most Important Event in the History of the Mutual Fund Industry.”
Financial History: The Magazine of the Museum of American Finance. Fall: 16-19. Available at:
http://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=1&ved=0CCsQFjAA&url=http%3A%2F%2Fwww.moaf.org
%2Fpublications-collections%2Ffinancial-history-magazine%2F84%2F_res%2Fid%3DFile1%2FRevenue%2520Act%2520%2520mag%2520article.pdf&ei=K0J1UtipOYjOsATPvoGYBQ&usg=AFQjCNGb-4IBoA1vuWt1zgUxMreC9uXMw&bvm=bv.55819444,d.cWc&cad=rja
Fisher, Mark. "Special repo rates: An introduction." Economic Review-Federal Reserve Bank of Atlanta 87, no. 2 (2002): 27-44
Fleming, Michael J. and Garbade, Kenneth, The Repurchase Agreement Refined: GCF Repo. Current Issues in Economics
and Finance, Vol. 9, No. 6, June 2003. Available at SSRN: http://ssrn.com/abstract=682701
Fleming, Michael J., Warren B. Hrung, and Frank M. Keane. "The Term Securities Lending Facility: Origin, Design, and
Effects." CURRENT ISSUES IN ECONOMICS AND FINANCE 15.2 (2009).
Fleming, Michael, Warren Hrung, and Frank Keane. "Repo market effects of the term securities lending facility." FRB of New
York Staff Report 426 (2010).
Fuster, Andreas, Laurie Goodman, David Lucca, Laurel Madar, Linsey Molloy, and Paul Willen . "THE RISING GAP
BETWEEN PRIMARY AND SECONDARY MORTGAGE RATES ." Federal Reserve Bank. November 28 (2012): n. page.
Web. 8 Jun. 2013. <http://www.newyorkfed.org/research/conference/2012/mortgage/primsecsprd_frbny.pdf>.
Geanakoplos, John, “Solving the Present Crisis and Managing the Leverage Cycle” (February 1, 2009). Economic Policy
Review, Vol. 16, No. 1, p. 101, August 2010. Available at SSRN: http://ssrn.com/abstract=1678171 or
http://dx.doi.org/10.2139/ssrn.1678171.
Government Accountability Office (GAO). 2011. “Bankruptcy: Complex Financial Institutions and International

Coordination Pose Challenges.” U.S. Government Accountability Office, Report to Congressional Committees,
GAO-11-707. July 2011. Available at: http://www.gao.gov/assets/330/321213.pdf (accessed December 18, 2012)
Gorton Gorton, Gary B. and Metrick, Andrew, “Regulating the Shadow Banking System” (October 18, 2010). Brookings Papers
on Economic Activity, Fall 2010.
Hagerty, James R. 2012. The Fateful History of Fannie Mae: New Deal Birth to Mortgage Crisis Fall. The History Press.
Charleston, S.C.
Hall, John T. 1974. REITS: The First Decade, A Collection of Writings. John T. Hall, Inc. Mequon, Wisconsin.
International Monetary Fund. 2013. “Global Financial Stability Report: Transition Challenges to Stability.” World Economic and
Financial Furveys. Washington, DC. October. Available at: http://www.imf.org/External/Pubs/FT/GFSR/2013/02/index.htm
Investment Company Act of 1940. Pub. L. No.76-768. 15 U.S.C. Section 80a-1 – 80a-64.
Investment Company Institute (ICI). “2013 Investment Company Fact Book.” “Appendix A, How U.S. Registered Investment
rd
Companies Operate and the Core Principles Underlying their Regulation.” 53 Edition, 2013.
Jones, Sheldon A., Laura M. Moret and James M. Storey. 1988. “The Massachusetts Business Trust and Registered
Investment Companies.” Delaware Journal of Corporate Law. Volume 13: 421-58.

Juks, Reimo. "Asset encumbrance and its relevance for financial stability."SVERIGES RIKSBANK ECONOMIC
REVIEW (2012): 3.
Kingsbury, Kevin, and Lingling Wei. "Thornburg Sells $20.5 Billion In Mortgage-Backed Securities." Wall Street Journal. N.p.,
20 Aug 2007. Web. 10 Jun 2013. <http://online.wsj.com/article/SB118761442268302762.html>.
Kiplinger Magazine. 1962. “Real Estate Investment Trusts.” Changing Times. January: 27-30.
Mildenberg , David. "Thornburg Can't Meet Margin Calls, Survival in Doubt (Update5)." Bloomberg. N.p., 07 Mar 2008. Web.
10 Jun 2013. <http://www.bloomberg.com/apps/news?pid=newsarchive&sid=abu461kYcx0Y&refer=home>.
Morley, John D. 2011. “Collective Branding and the Origins of Investment Management Regulation: 1936-1942.” University of
Virginia School of Law John M. Olin Law and Economics Research Paper Series No. 2011-01. March. Available at SSRN:
http://ssrn.com/abstract=1762217 or http://dx.doi.org/10.2139/ssrn.1762217
National Association of Real Estate Investment Trusts (NAREIT). 2011. Comment letter submitted in reference to the SEC’s
Release: “Companies Engaged in the Business of Acquiring Mortgages and Mortgage-Related Instruments, Release No. IC29778; File No. S7-34-11.” November 7, 2011. Available at: http://www.sec.gov/comments/s7-34-11/s73411-159.pdf Accessed
September 9, 2013.
National Association of Real Estate Investment Trusts (NAREIT). 2012. “REITs Continue to Outperform Equity Market in
2012.” January 8, 2012. Available at:
http://www.reit.com/~/media/PDFs/NAREIT%202012%20REIT%20Market%20Review.ashx. Accessed December 18, 2013.
National Association of Real Estate Investment Trusts (NAREIT). 2013. “Historical REIT Industry Market Capitalization: 19722012” Table. Available at: http://www.reit.com/DataAndResearch/US-REIT-Industry-MarketCap.aspx, accessed August 28,
2013.
Nayak, Rodger, and Dhaval Patel. "Annaly externalization to lower costs, pressure competition."www.snl.com. N.p., 25 Mar
2013. Web. 10 Jun 2013. <http://www.snl.com/InteractiveX/Article.aspx?id=17252317>.
Perli, Roberto, and Brian Sack. "Does mortgage hedging amplify movements in long-term interest rates?." The Journal of
Fixed Income 13, no. 3 (2003): 7-17.
Pozsar, Zoltan, Tobias Adrian, Adam B. Ashcraft, and Haley Boesky. "Shadow Banking." FRB of New York Staff Report 458
(2010).
Quinn, Lawrence Richter, “A New Operating Structure,” Mortgage Banking, June 1998, pp. 82-87.
Roe, Mark J. “The Derivatives Market’s Payment Priorities as Financial Crisis Accelerator,” 63 STAN. L. REV. 539 (2011) -http://www.stanfordlawreview.org/sites/default/files/articles/Roe-63-Stan-L-Rev-539.pdf.
Securities and Exchange Commission. “Companies Engaged in the Business of Acquiring Mortgages and Mortgage-Related
Instruments; Concept release.” Federal Register, Vol. 76, No. 173. (September 7, 2011), pp. 55300- 55308.
Shenn, Jody. "Agency Mortgage-Bond Spreads Reach 8-Year High, Hurt Consumers." Bloomberg. N.p., 04 Mar 2008. Web.
10 Jun 2013. <http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aixgVeqlkbW4>.
SIFMA. Comment letter submitted in reference to the SEC’s Release: “Companies Engaged in the Business of Acquiring
Mortgages and Mortgage-Related Instruments, Release No. IC-29778; File No. S7-34-11.” November 7, 2011. Available at:
http://www.sec.gov/comments/s7-34-11/s73411-159.pdf. Accessed October 8, 2013.
Singh, Manmohan. "Velocity of Pledged Collateral IMF Working Paper ." IMF Working Paper. WP/11/256 (2011):
<http://www.imf.org/external/pubs/ft/wp/2011/wp11256.pdf>.
Stein, Jeremy C. 2013. Remarks on “Overheating in Credit Markets: Origins, Measurement, and Policy Responses” at the
"Restoring Household Financial Stability after the Great Recession: Why Household Balance Sheets Matter" research
symposium sponsored by the Federal Reserve Bank of St. Louis, St. Louis, Missouri, February 7. Available at
http://www.federalreserve.gov/newsevents/speech/stein20130207a.htm
Stulz, René M. "Credit default swaps and the credit crisis." The Journal of Economic Perspectives 24.1 (2010): 73-92.

U.S. Government Accountability Office (GAO). 2011. “Ginnie Mae: Risk Management and Cost Modeling Require Continuing
Attention.” Washington, DC. Report number 12-49, Nov 14, 2011. Available at: http://gao.gov/products/GAO-12-49.
U.S. Government Printing Office. 1965. “The Budget of the United State Government for the Fiscal Year Ending June 30,
1966.” Washington. Available at: http://fraser.stlouisfed.org/publication/?pid=54.
U.S. Government Printing Office. 1968. “The Budget of the United State Government: Fiscal Year 1969.” Washington.
Available at: http://fraser.stlouisfed.org/publication/?pid=54.
Valachi, Donald J. 1977. “REITs: A Historical Perspective.” The Appraisal Journal. July: 449-55.
Vandell, Kerry D. "The Mortgage REITs: Dynamos or Duds?." Wharton Real Estate (1999).
White, Eugene N. 2009. “Lessons from the Great American Real Estate Boom and Bust of the 1920s.” NBER Working Paper
No. 15573. National Bureau of Economic Research. Cambridge, Massachusetts. December 2009. Available at:
http://www.nber.org/papers/w15573.

Appendix

Table A1: Policy Interventions

Date

Agency

Policy

Description

Mar-08

Federal
Reserve

Primary Dealer Credit
Facility (PDCF)

Overnight loans by the Fed against essentially tri-party eligible collateral.

Mar-08

Federal
Reserve

Term Securities
Lending Facility
(TSLF)

The TSLF loaned Treasury securities to primary dealers for one month against
eligible collateral. For so-called "Schedule 1" auctions, the eligible collateral
comprised Treasury securities, agency securities, and agency mortgagebacked securities. For "Schedule 2" auctions, the eligible collateral included
schedule 1 collateral plus highly rated private securities.

Jul-08

FHFA

HERA established
FHFA as New
regulator for Fannie
Mae and Freddie Mac

FHFA becomes the new regulator and overseer of Fannie and Freddie.

Sep-08

FHFA

Sep-08

Federal
Reserve

FHFA appointed as
conservator of Fannie
Mae and Freddie Mac
Asset-Backed
Commercial Paper
Money Market Mutual
Fund Liquidity Facility

Oct-08

Federal
Reserve

Commercial Paper
Funding Facility
(CPFF)

Oct-08

Federal
Reserve

Money Market
Investor Funding
Facility (MMIFF)

Increase the availability of mortgage financing by allowing these institutions to
grow their guarantees without limit, while limiting the size of retained mortgage
and security portfolios and requiring these portfolios to be reduced over time.
Lending facility that financed the purchases of high-quality asset-backed
commercial paper (ABCP) from money market mutual funds by U.S. depository
institutions and bank holding companies. The program was intended to assist
money funds that hold such paper to meet the demands for redemptions by
investors and to foster liquidity in the ABCP market and money markets more
generally.
The CPFF provided a liquidity backstop to U.S. issuers of commercial paper
through a specially created limited liability company (LLC), the CPFF LLC. This
LLC purchased three-month unsecured and asset-backed commercial paper
directly from eligible issuers.
Intended to provide liquidity to U.S. money market mutual funds and certain
other money market investors, thereby increasing their ability to meet
redemption requests and hence their willingness to invest in money market
instruments, particularly term money market instruments

Nov-08

Federal
Reserve

Term Asset-Backed
Securities Loan
Facility

Nov-08

Federal
Reserve
Treasury

Large Scale Asset
Purchases
Home Affordable
Modification Program
(HAMP)
Large Scale Asset
Purchases

Mar-09

Issued loans with terms of up to five years to holders of eligible asset-backed
securities (ABS). The TALF was intended to assist the financial markets in
accommodating the credit needs of consumers and businesses of all sizes by
facilitating the issuance of ABS collateralized by a variety of consumer and
business loans; it was also intended to improve the market conditions for ABS
more generally.
$500 billion in purchases of Agency MBS
Provides homeowners with assistance in avoiding residential mortgage loan
foreclosures

Mar-09

Federal
Reserve

Additional $750 billion in purchases of Agency MBS

2008

FHA

Hope for Homeowners
Program (H4H)

Allows certain distressed borrowers to refinance their mortgages into FHAinsured loans in order to avoid residential mortgage loan foreclosures

2009

FHFA

Home Affordable
Refinance Program
(HARP)

Allows borrowers current on their mortgage payments to refinance and reduce
their monthly mortgage payments at loan-to-value ratios of up to 125% and
without new mortgage insurance

Sep-11

Federal
Reserve

Re-investments

Begin Reinvesting Interest and Principal Payments in Agency MBS

Oct-12

FHFA

HARP 2.0

Increase HARP LTV ratio above 125%. Enables borrowers to go to any lender
to refinance

Sep-12

Federal
Reserve

“Open-ended” LSAPs

Begin open-ended purchases of Agency MBS at a pace of $40 billion per
month.

Table A2: Making Home Affordable Program
Making Home Affordable Program
Principal Reduction
Alternative (PRA)

Provides Principal forgiveness on eligible underwater loans
that are modified under HAMP

Home Affordable
Foreclosure
Alternatives (HAFA)

Provides transition alternatives to foreclosure in the
form of a short sale or deed-in-lieu of foreclosure.

FHA-HAMP and
RD-HAMP
modification
programs
Unemployment
Program (UP)

Provides first lien modifications for distressed
borrowers in loans guaranteed through the Federal
Housing Administration and Rural Housing Service.

Second Lien
Modification
Program (2MP)

Provides modifications and extinguishments on
second liens when there has been a first lien HAMP
modification on the same property.

Provides temporary forbearance of mortgage principal to
enable unemployed borrowers to look for a new job without
fear of foreclosure.

Source: Treasury.gov/ Richmond Fed

Figure A1: Bear Stearns Repo Financing and MBS/ABS Holdings

Figure A2:

350

MBS REITs Repo Liabilities

Billions, USD.

300

350
300

Current
Historical

250

200

150

100

0
1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

Note: Historical refers to repo liabilities of MBS REITs no longer in existence. Current refers to
MBS REITs still operating. Source: SNL Financial, Richmond Fed

Figure A3:

300

Net Repo Liabilities of Broker-Dealers

Billions, USD.

300

Current

250

Historical
200

200

150

100

-50

-50
1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

2011

Note: Net repo liabilities is defined as repurchase agreements less reverese repurchase agreements. Historical
refers to repo liabilities of Broker-Dealers no longer in existence. Current refers to Broker-Dealers still in
operation. Source: SNL Financial, Richmond Fed

Figure A 4
FNMA/FHLMC 30 YR - 10 YR Treasury Spread
MBS - Treasury Spread, Basis
Points

215

Major Downgrades by
S&P of Non-Agency
MBS

Thornburg Sells 20.5 Bil
in Non-Agency MBS

195

TSLF/PDCF
& Fed Lends
to Bear
Stearns

Fannie & Freddie
Conserv atorship

Treasury
Guarantees
MMMFs and
Lehmans
Failure

215

TALF/ Federal
Reserv e
Purchases of
Agency MBS &
Citi Rescued

195

Thornburg
Fails to
Meet
Margin
Calls

175

155

135

115

95
Jan/07

95
Apr/07

Jul/07

Oct/07

Jan/08

Apr/08

Jul/08

Oct/08

Jan/09

Note: Spread betw een BofA Merrill Lynch Mortgages: All FHLMC & FNMA 30 Year: Yield to Maturity (%) and 10 Year Treasury , in basis points. Source: Haver Analytics,
Richmond Fed

Figure A 5

Swap Ratio

80
75

Swap Ratio NLY
Swap Ratio AGNC

80
75

30
2005
2006
2007
2008
2009
2010
2011
2012
Note: Swap Ratio is defined as the notional amount of swaps divided by the repo borrowings outstanding. Source:
Agnce & NLY 10K/10Q's, Richmond Fed

Table A 3

non-Agency/Hybrid mREITs sub-components
Symbol
MITT
ARI
AMTG

Company
AG Mortgage Investment
Trust
Apollo Commercial Real
Estate
Apollo Residential
Mortgage

Exchange Weight (%)

Agency mREITs sub-components
Symbol

NYSE

2.193

AGNC

NYSE

2.1207

MTGE

NYSE

2.0178

NLY

BXMT

Blackstone Mortgage Trust

NYSE

2.6081

ANH

CIM

Chimera Investment Corp.

NYSE

10.9881

ARR

NYSE

0.5781

CMO

Company
American Capital
Agency Corp.
American Capital
Mortgage Inv
Annaly Capital Mgmt
Inc.
Anworth Mortgage
Asset Corp.
ARMOUR Residential
REIT Inc.
Capstead Mortgage
Corp.

Exchange Weight (%)
NASDAQ

30.1356

NASDAQ

3.6671

NYSE

38.0067

NYSE

2.4556

NYSE

5.4574

NYSE

3.5523

NYSE

8.7448

CYS

CYS Investments

NYSE

5.4212

JERT

Ellington Residential
Mortgage
Invesco Mortgage Capital
Inc.
JER Investors Trust Inc.

OTC Pink

0.0008

NYSE

1.7025

MFA

MFA Financial Inc.

NYSE

11.0038

HTS

NYSE

7.5389

NRZ

New Resdl Invt Corp
New York Mortgage Trust
Inc.
Newcastle Investment
Corp.
NorthStar Realty Finance
Corp.
PennyMac Mortgage
Investment
Redwood Trust Inc.
Resource Capital Corp.
Starwood Property Trust
Inc.
Two Harbors Investment
Corp.
ZAIS Financial Corp

NYSE

5.7167

JMI

NYSE

0.6094

NASDAQ

1.5234

ORC

NYSE MKT

0.1218

NYSE

4.8526

WMC

Dynex Capital Inc.
Hatteras Financial
Corp.
JAVELIN Mortgage
Orchid Island Capital
Inc.
Western Asset Mrtg
Cap Corp

NYSE

1.3314

NYSE

6.1139

NYSE

4.4908

NYSE
NYSE

5.2888
2.79

NYSE

14.6452

NYSE

13.8335

NYSE

0.49

EARN
IVR

NYMT
NCT
NRF
PMT
RWT
RSO
STWD
TWO
ZFC

**Companies in the Agency mREIT index had an Agency –to-Asset Ratio greater than 80% as of Q4 2012.
non-Agency/Hybrid mREIT index subcomponents had an Agency –to-Asset Ratio less than 80% as of Q4 2012.

Table A4: List of mREITs and Their Relevant Financial Information
Some Facts

Swaps
Net
Short-Term
Swap
Interest
Leverage (1) Ratio (2)
Margin (3)

Name

External
Manager

Date
Established

Type

AG Mortgage Investment Trust
American Capital Agency Corp.
American Capital Mortgage Investment
Corp.
Annaly Capital Mgmt Inc.
Anworth Mortgage Asset Corp.

1
1

3/7/2011
1/7/2008

Hybrid
Agency

3/15/2011

Hybrid

2.31

6.8

1
1

11/25/1996
10/20/1997

Agency
Agency

1.14
1.03

6.5
7.5

2.54
1.87

5.3
6.8

51.8
62.9

Swaps
Notional
(Bil. USD)

Repurchase Agreements

Weighted
Weighted
Average Pay Average Recieve
Rate
Rate

Weighted
Average
Years to
Maturity

Repurchase
Agreements (Bil. USD)

4.42
4.4

4.19
74.48

2.17
46.85

1.172
1.46

0.309
0.29

2.94

1.33

0.32

5.5

6.25

45.6
39.4

46.91
3.16

2.21
1.98

0.24
3 month LIBOR

4.77
2.8

102.79
8.02

Weighted Avg
Weighted Avg.
Days Till
Repo Rate
Maturity
0.78
0.51

Portfolio Composition and Assets

Weighted Avg. Haircut

36.9
118

6.90%
<5%

30
32

0.57

4.7% Agency, 29.5% Non-Agency

0.63
0.47

191
34

Apollo Residential Mortgage

3/15/2011

Hybrid

2.7

5.1

41.1

1.5

1.2

3 month LIBOR

5.3

3.65

0.61

ARMOUR Residential REIT Inc.
Bimini Capital Mgmt Inc.
Capstead Mortgage Corp.
Chimera Investment Corp.*
CYS Investments

1
1

Hybrid
Agency
Agency ARM
Hybrid
Agency

1.45
0.87
1.09
4.69
1.14

8
42.6
8.5
0.9
6

47.4
0
0
35.6
53.6

8.7
0
0
0.95
7.49

1.2

0.21

5.3

2.08
1.27

0.29
3M Libor

2.7

18.37
0.15
12.78
2.67
13.98

0.49
0.49
0.47
0.45
0.48

34
14

1
0

2/5/2008
12/19/2003
9/5/1985
6/1/2007
1/3/2006

48
19.6

5%
4.86%
3-7% for Agency MBS, 10-50% for
non-Agency MBS
4.80%
5.10%
4.50%
5%
3-6%

Dynex Capital Inc.

12/18/1987

Hybrid

2.05

5.8

1.46

1.53

3M Libor

3.4

3.56

0.7

7.4% Agency, 19.5% non-Agency

3/28/2012
11/5/2007

Hybrid
Agency ARM

5.3
1.16

2.5
7.4

50
46.8

0.04
10.7

1.47

2.6

0.08
22.87

0.85
0.47

17
24.8

10%
4.34%
4.74% Agency, 17.86% non-Agency,
18.91% CMBS

Five Oaks Investment Corp.
Hatteras Financial Corp.
Invesco Mortgage Capital Inc.

6/5/2008

Hybrid

1.81

6.1

50.9

2.13

JAVELIN Mortgage Investment Corp.**

6/18/2012

Hybrid

0.66

7.7

28.9

0.33

1.5

MFA Financial Inc.

4/10/1998

Hybrid

2.7

2.6

28.8

2.52

2.31

6/24/2004

Hybrid

3.38

2.8

40.4

0.36

New York Mortgage Trust Inc.

1M LIBOR

7.7

6.37

133.45
9.29

123.96
9.24

73.27

4.49

3.29

26*
6*
23
23*

91.48
89.47
95.78
40.52
95.25

20.88
0.19
14.47
7.75
21.06

19.1
0.17
13.86
3.14
20.06

19*

81.54

4.28

3.49

4*
24

58.33
90.61

0.12
26.4

0.07
23.92

26*

67.69

18.91

12.8

6.40%

86.05

1.29

1.11

1.4

8.75

0.85

4.8% Agency, 30.49% non-Agency,
1.74% Treasuries

26*

53.48

13.52

7.23

0.74

0.89

0.54

11*

13.97

7.16

5.04

20.76

3.95

0.82

100

0.12

2.56

Don't Hold MBS

5.24

2.48

4.32

0.13
Negligable
amount
11.6
5.1

0.22

Multiple

4.23

0.9

16.1

0.15

0.93

0.81

36.5

8/17/2010

Agency

1.66

7.06

0.1

0.49

1
1

82.73
92.89
99.46

0.78

10/10/2002

Two Harbors Investment Corp.
Western Asset Mrtg Cap Corp

3.79
83.71

0.62

Starwood Property Trust Inc.

4.86
100.45

1.14

Total Agency
Holdings (Bil.
USD)

15.72

Orchid Island Capital Inc.

Resource Capital Corp.

77.98
83.33

Total Assets
(Bil. USD)

9.3

Newcastle Investment Corp.

PennyMac Mortgage Investment

Counterparties (list Agency Secs as
specific
a % of Total
counterparties*)
Assets

5/18/2009

Multiple

2.21

1.05

0.16

0.64

3/8/2005

Multiple

4.85

0.2

127.3

0.14

0.11

2.28

5/26/2009

CMBS & CRE

7.58

0.4

21.9

0.254

1.39

LIBOR

5/21/2009
6/3/2009

Hybrid
Agency

2.64
3.68

3.7
9.2

99.6
58.7

12.57
2.81

0.85
1.2

0.426

1.16
2.85
7.2

12.62
4.79

5% Agency RMBS (excluding Agency
IOs), 25% Agency IOs, 35% CLOs,
total weighted average “haircut” of
6.9%
5% FNMA/FHLMC, 34% non-Agency
RMBS, 50% CDO VI
5.60%

3.60%

0.72
82
8.40%
21*
69.01
16.81
0.48
19
5.71%
14
95.15
5.36
.49 Agency,
3 - 5% Agency, 20 - 40% nonZAIS Financial Corp
1
5/24/2011
Hybrid
3.92
1.8
25
0.03
1.51
0.31
5.3
0.12
2.15 Non3
35
0.2
0.07
Agency.
Agency
Summary Statistics
2.64
6.3
50
160.034
1.68
0.29
4.48
320.34
0.67
47.38
5.4% (Agency), 29%(non-Agency)
17.05
81.97
432.07
354.15
1. Short-term leverage is defined as the amount of repurchase agreement liabilities as a ratio of equity. Leverage ratios below 6 are in blue. 2. Swap Ratios above 50% are in blue with the red text and below 50 is in pink with light blue text. *As of 10/10/2013 Chimera has only submitted a 10-Q for 2012 Q1 and those are the figures reported. **Year end
measures are used instead of Q4 2012 if no Q4 2012 estimate is provided. 3. NIM are from the SNL Financial (Financial Highlights) Source: Respective 2012 10K/10Qs, Richmond Fed

Table A5: List of mREITs (Companies that are used for the data in various figures)

1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28

AG Mortgage Investment Trust, Inc.
American Capital Agency Corp.
American Capital Mortgage Investment Corp.
American Home Mortgage Investment Corp.
American Residential Investment Trust, Inc.
Annaly Capital Management, Inc.
Annaly Commercial Real Estate Group, Inc.
Anworth Mortgage Asset Corporation
Apex Mortgage Capital, Inc.
Apollo Commercial Real Estate Finance, Inc.
Apollo Residential Mortgage, Inc.
Arbor Realty Trust, Inc.
ARMOUR Residential REIT, Inc.
Bimini Capital Management, Inc.
BRT Realty Trust
Capstead Mortgage Corporation
Chimera Investment Corporation
Clarion Commercial Holdings, Inc.
Cobalt Holdings Group LLC
CRIIMI MAE Inc.
Crystal River Capital, Inc.
CYS Investments, Inc.
Dynex Capital, Inc.
ECC Capital Corporation
Ellington Residential Mortgage REIT
EOS Preferred Corporation
FBR Asset Investment Corporation
Five Oaks Investment Corp.

29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55

Franklin Finance Corporation
Hatteras Financial Corp.
HomeBanc Corp.
Impac Commercial Holdings, Inc.
Imperial Credit Commercial Mortgage Investment Cp.
IndyMac Mortgage Holdings, Inc.
Invesco Mortgage Capital Inc.
JAVELIN Mortgage Investment Corp.
JER Investors Trust Inc.
Laser Mortgage Management, Inc.
MFA Financial, Inc.
MortgageIT Holdings, Inc.
New Century Financial Corporation
New Residential Investment Corp.
New York Mortgage Trust, Inc.
Newcastle Investment Corp.
Orchid Island Capital, Inc.
PennyMac Mortgage Investment Trust
Redwood Trust, Inc.
Resource Capital Corp.
Saxon Capital, Inc.
TMST, Inc.
Two Harbors Investment Corp.
Webster Preferred Capital Corporation
Western Asset Mortgage Capital Corporation
Wilshire Real Estate Investment Inc.
ZAIS Financial Corp.

Full text of Working Papers (Federal Reserve Bank of Richmond) : mREITs and Their Risks, Working Paper 13-19R

FRASER