Renewed government-sponsored enterprise reform efforts and recent increases in long-term rates coupled with volatility in agency mortgage-backed securities valuations have put an increasing focus on the need to illuminate risks in the “shadow banking” system and the mortgage repo funding market in particular, according to a recent Fitch Ratings report that aims to do just that.
“In benign market environments, this particular shadow banking process channels credit from short-term wholesale funding markets to mortgage borrowers, intermediated along the way by dealer banks and mortgage real estate investment trusts that purchase agency mortgage-backed securities,” Fitch notes in its report. “The potential risk is that disruptions in repo funding…could reduce the credit available to mREITs and other leveraged investors.”
In addition, “In a deleveraging scenario, MBS investors reliant on repo borrowing may need to liquidate some of their holdings, potentially creating negative knock-on effects for MBS valuations and mortgage markets more generally.”
The Fitch Ratings report notes that a recent Federal Reserve Bank of New York study “indicates one-day MBS liquidation of $4 billion could negatively affect prices.”
When it comes to real estate investment trusts that invest in mortgage-backed securities, on average “90% of their liabilities are repo funding,” Martin Hansen, a senior director in the macro credit research group at Fitch Ratings, said in an interview.
This has been highlighted as a “possible risk” in the Financial Stability Oversight Council’s annual report released in April and a speech by Federal Reserve Gov. Jeremy Stein earlier in the year, noted Hansen, who co-authored a Fitch report on the topic to “put some context” around the concern.
The report, which another co-author, Robert Grossman—a managing director in Fitch’s macro credit research group—described in an interview as a “focus on the process or architecture” of repo funding, shows that in the first quarter, the total mREIT sector was $460 million in size, $343 billion of which consisted of investments mainly in fixed rate agency mortgage-backed securities.
“Although mREIT holdings of roughly $340 billion in fixed-rate agency MBS are a relatively small portion of the total $6.7 trillion agency MBS market, a marginal amount of forced selling might nevertheless reduce MBS valuations,” the report notes.
The report adds, “MBS price declines, if rapid and sizeable, could negatively affect other institutional holders, including U.S. commercial banks,” as these as of the end of March held more than $1.3 trillion in agency MBS.
The mortgage real estate investment trust risk is somewhat concentrated based on first-quarter figures, Fitch analysts found, noting that the top five mREITs represent $280 billion of the $343 billion in the fixed-rate agency mortgage-backed securities segment.
It is these players that Fitch focused on in its report.
Another component of the risk lies in the dealer banks that provide funding to mortgage real estate investment trusts and “deploy leverage in their MBS repo intermediation activities,” the report notes, citing figures that show as of the end of May primary dealers on an aggregate basis conducted about $693 billion in agency mortgage-backed securities repo borrowing, exceeding agency MBS repo lending by approximately $185 billion or 36%.
“This leverage increases the risk that negative developments in dealer banks’ repo funding would be transmitted to their leveraged investor clients,” the Fitch report finds.