Regulators have growing concerns about the mortgage vehicles amid concerns that a rapid rise in interest rates could trigger a sell-off

October 27, 2013 6:07 pm

Fed probes banks’ exposure to mortgage vehicles

By Tracy Alloway, Arash Massoudi and Michael Mackenzie in New York

Regulators at the New York Fed have been probing banks’ exposure to a type of mortgage investment vehicle that has proliferated since the financial crisis amid concerns that a rapid rise in interest rates could trigger a sell-off. The private discussions, described by one person as a “deep dive” into the topic, underscore regulators’ growing concerns about the rapid expansion of mortgage real estate investment trusts. MReits finance their purchases of long-term mortgages with short-term borrowings, known as repo, secured from dealer banks.The worry is that MReits could be vulnerable to a sharp increase in interest rates which would force the vehicles to quickly reduce their holdings of mortgage-backed securities (MBS) and set off a wider fire sale. That could potentially lead to further problems in the vast $4.5tn repo market, where big banks also secure large amounts of their funding by pawning their MBS and other securities.

“In the spring they came into a lot of the banks and kind of did a deep dive in that topic,” said one person familiar with the discussions. The person added that the Fed was seeking to better understand dealer banks’ exposures to MReits but did not explicitly ask them to curb their financing of the mortgage vehicles.

The vehicles increased their MBS holdings from about $160bn at the end of 2009 to $460bn at the end of March this year, according to a recent report by Fitch Ratings.

But shortly after the inquiries from the Fed, MReitscurbed both their purchases of securities and their repo usage, as talk of higher interest rates and the possibility of the central bank “tapering” its bond purchases caused a wider market sell-off.

A spokesman for the Federal Reserve Bank of New York declined to comment.

MReits have been on regulators’ radar at least since February when Jeremy Stein, Fed governor, spoke about the possibility of overheating in credit markets. In the speech, Mr Stein described MReits’ reliance on short-term repo borrowing to finance their longer-term MBS purchases as “essentially a levered carry trade.”

Earlier this month, the International Monetary Fund also identified MReits as a growing component of the unregulated shadow banking system.

“There is definitely interest in how to figure out the systemic relevance of mortgage Reits in the repo market and ascertain how, in a period of stress, withdrawal from the market might impact it – almost like money funds in September 2008,” said another person familiar with the discussions between banks and the Fed.

The Fed has heightened its focus on the repo market since the financial crisis, when ultraconservative money market funds cut back on their repo lending to big banks, spreading systemic risk.

Earlier this month the New York Fed held an all-day conference exploring the danger posed by asset fire sales erupting from the repo market. The Fed has also cajoled the industry to reform practices in the market since 2008.

MReits argue that they have helped boost demand for home loans and lower the cost of residential borrowing at a time when the US government is still struggling to reform the mortgage market.

“It speaks to the duality of repo,” said Martin Hansen, senior director at Fitch Ratings. “For mortgage Reits, they’re able to fund themselves relatively cheaply. The issue is always what might happen in a stressed scenario.”