If the Financial Times report is to be believed, and there is no indication contrary, then FRBNY took warnings earlier this year to heart and began investigating. FT links a February speech by Fed Governor Jeremy Stein about “overheating credit markets” to what looks like an ongoing probe of bank exposure to mortgage REITs.

“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.”

I think it is fair to say that some of that may have actually occurred this summer, and may have had a hand in dollar tightening that so scared the FOMC out of tapering in September. There is no doubt that other factors were working as well, but illiquidity in repo markets was rather sharp in the middle of the year. There is more than enough reason to suspect mortgage REIT’s were at the center of that, particularly given the worries that still persist about them.

I don’t think there is anything particularly unusual about the apparent secrecy here, that is something that is institutionalized at the Federal Reserve – do not spook markets especially when there isn’t conclusive evidence that markets need to be concerned. The target of the inquiry also makes sense given the links between mortgage REITs to the shadow system. However, what they should be looking at is whether QE has caused any distortions that either makes repo markets less liquid, or even whether QE has contributed to the 2011-12 mortgage REIT surge.

Dollar funding markets, especially repos, are a tangled mess to begin with. And as much as Fed officials constantly voice concerns about them and lingering shadow conduits, I think they need to begin to connect the dots. Monetary distortions, particularly those that do not end on their own, create these obvious expressions of leverage. It’s not mortgage REIT’s that are the problem, per se, they are just the proximate appearance of distorted risk and monetary imbalance. A true investigation, or “deep dive”, should begin much closer to the source. To blame mortgage REIT’s is to say that all asset bubbles are the fault of markets being “exuberant” of their own accord. That has never been true.


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