Back in April, there had been, as I posted yesterday, a change in funding conditions for dollar markets. It was, by most accounts, imperceptible except for the strange secondary collateral and liquidity indications that began to appear with more frequency. Sitting in the intersection between liquidity, monetary policy and the real estate re-bubble, Wellington Denahan, CEO of Annaly Capital, the world’s largest REIT, compared reports of systemic danger posed by REIT’s to the shark frenzy of 2001. Those comments came, fatefully as it has turned out, on May 2.

Most investors have at least a passing familiarity with the REIT classification, aware of their connection to real estate markets. As a class of yield securities, REIT’s have performed pretty much in line with the bond selloff.

ABOOK Aug 2013 REITs v HYG

However, REIT’s are actually not a homogenous taxonomy outside of their legal similarity. They break down into three groups: equity REIT’s, mortgage REIT’s and hybrids of the two. Equity REIT’s are essentially property managers investing in real estate and buildings, trying to harvest both real estate price appreciation and income potential from rents and such. Mortgage REIT’s could not be more different.

A mortgage REIT, of which Annaly is one, is essentially a specialized bank. In terms of structure, it is exactly like the SIV’s of 2008 lore. A mortgage REIT takes in equity capital and then leverages several times on top of its equity slice – it is the epitome of the modern concept of banking through wholesale and shadow means. The entire business is predicated on the carry spread between short-term borrowing and long-term lending, minus any of the deposit “complications” that “hinder” banks in the post-traditional banking age.

These kinds of specialized finance companies will “buy” mortgages and, more likely, mortgage bonds from a GSE or private label (not so much after 2007), funding these positions with wholesale borrowing in eurodollars, fed funds and especially repos. That makes mortgage REIT’s susceptible to not only interest rate risk like equity REIT’s, but liquidity risk like shadow banks. Because they sit at this crossroads of money markets, they can tell us a lot about conditions in places we cannot directly observe (like repo and wholesale money markets that largely occur OTC).

ABOOK Aug 2013 REITs v REITs

Looking at mortgage REIT’s in comparison to equity REIT’s shows us a peak in the upward trend occurring long before it was apparent in either equity REIT’s or even the general bond market. Not coincidentally, if the ETF is at all close to an accurate depiction of mortgage REIT pricing, that upward trend arrested on March 18 – the very same timeframe that swaps and repo failures were suggesting for the first time widening liquidity complications.

From mid-March forward, the mortgage REIT segment traded largely sideways until the general selloff in May, in sharp contrast the 45 degree ascent in equity REIT’s, high yield debt and other fixed income and income securities. Where complacency was highly evident, it had already passed out of the mortgage REIT segment (just like derivative markets).

ABOOK Aug 2013 REITs v NLY

Annaly Capital has traded very much like the overall ETF and index for most of 2013. The chart above shows different ends of the mortgage REIT danger zone – the dramatic slide after QE 3 was announced in September 2012 shows the expected pressure on NLY’s earnings as QE suppressed mortgage yields.

As is usually the case, however, the liquidity risk is the larger of the problems facing shadow bank systems. Liquidity risk itself is not just based on the potential for problems in rolling over short-term liabilities, those short-term liabilities are often based on additional and related factors that combine to amplify negative feedback.

For example, in repo markets, as most are now aware post-2008, models of expected prices and valuations of complex mortgage securities are included in setting repo haircuts. Declining modeled repo values that lead to larger haircuts means shadow banks have to either post additional repo collateral or face a firesale situation.

The selloff in May 2013 triggered a great deal of mortgage REIT selling due to just these kinds of liquidity concerns. “Unexpectedly” rising interest rates reduced the value of mortgage bond collateral, but more than that modeled expectations for funding volatility likely made their way into these calculations as well. As funding markets incorporated this “unexpected” increase in both rate and liquidity volatility, shadow bank conduits were extremely exposed. That was largely hidden in the repo markets except for the indications I have mentioned, but it shows up pretty clearly in the trend of mortgage REIT stocks.

We need only go back to 2011 to see the same kinds of risks being foretold by trading in mortgage REIT’s.

ABOOK Aug 2013 REITs v REITs 2011

Where equity REIT’s were participating in the QE 2 rally to the fullest extent, mortgage REIT’s had, like in 2013, reached a plateau and sideways trade in anticipation of heightening liquidity risks.

Going back to the collapse of the housing bubble, mortgage REIT’s were also largely ahead of the curve, moving in advance of our awareness of every big liquidity drain.

ABOOK Aug 2013 REITs 2008

From the first indications of subprime distress to the first freeze in eurodollar funding, mortgage REIT’s were selling in anticipation. The liquidity squeeze that eventually brought down Bear Stearns was similarly foreshadowed. For the most part, mortgage REIT’s have been a relatively reliable liquidity barometer both before and after the panic period.

Given what we know about repo markets, collateral pressures and now the selloff in mortgage REIT’s, there is a very good likelihood that liquidity has been redistributed and scaled back dating to the change in swaps and expectations for policy that I highlighted yesterday. As dollar funding conditions changed slowly between March and May, it’s not really that surprising the head of the largest mortgage REIT would attempt to project confidence in her company’s massively leveraged position. Since those shark comments, NLY is down more than 25%, wiping out more than two year’s dividend payments in just a few months.

Just as we received the dollar warning from the June TIC data that exposed the global dollar crisis as it was unfolding for the BRIC’s, I think the mortgage REIT’s show the domestic side of that same leverage-unwinding. The results are, predictably, downright ugly. The question now becomes one of undoing the damage – can liquidity markets find a new stable operational constraint that is consistent with such policy uncertainty and funding volatility?

Given the price action in mortgage REIT’s, swaps and eurodollar futures, it looked like that might be the case in early to mid-July. Then another bout of collateral shortage seems to have ended that attempt, and the selloffs in various markets continued – notably mortgage REIT’s and destabilized currencies (particularly the rupee and rupiah).


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