News that a unit of private-equity giant Carlyle Group failed to meet margin calls on a $21.7 billion portfolio of mortgage-backed securities sent shares of a host of real estate investment trusts plummeting last week. Firms like Anworth Mortgage Asset, MFA Mortgage Investments, Annaly Capital Management, and Capstead Mortgage all dropped at least 18 percent in a day.
These latest victims of badly dysfunctional credit markets may not be household names, but their weakness has important implications. That's because the firms hold agency securities—the sort backed by government-sponsored entities like Fannie Mae and Freddie Mac. These are normally viewed as an incredibly sound asset class, so weakness there could be the start of the next leg down for credit markets and the economy.
Bose George, an analyst at Keefe, Bruyette & Woods, who downgraded Anworth and MFA Mortgage last week, predicts more trouble to come.
Mortgage REIT shares have been weaker lately. But March 6 was awful. What happened?
What happened is really part of a broad deleveraging. Most mortgage investors invest with borrowed money. What happened over the last many years is the amount you borrowed kept increasing. As we go into the credit crisis, the amount you can borrow just keeps diminishing. You're ending up with a squeeze from both sides. On the one hand, banks are letting you borrow less. That creates a situation where you have to sell into the market. That drives the price of the [mortgage] securities down, which in turn drives down the value of the portfolios and creates a cycle where selling perpetuates itself. In the last few days, it hit a new level of intensity. For a while it was just subprime, and then it moved into Alt-A [mortgages]. What's so worrying about the spread into higher-quality mortgages?
These companies' investments are all in securities guaranteed by Fannie Mae and Freddie Mac. They're generally seen as if not actually being backed by the government, then at least pretty close. The market has traditionally treated them as not being too dissimilar to treasuries. All of a sudden, those securities are losing value. Banks are reluctant to lend against them or are forcing REITs to put in more collateral when they borrow. It's a systemic deleveraging where people have to put in more and more of their own money. As that happens, there are going to have to be assets sold. Will there be catastrophic events at these companies where they have to sell assets at fire-sale prices?
For the [mortgage-backed securities] REITs, it hasn't reached that level yet. They've got plenty of capital to meet margin calls at the moment. At the moment, they don't have to sell anything. But this market is falling apart very quickly. Why did Carlyle's announcement spark the sell-off?
Carlyle was a very significant factor because their portfolio was all agency securities. But Carlyle was highly leveraged—about 30 to 1. That means they put in about 3 percent and borrow the remaining 97 percent from the market. The agency MBS REITs that were hit yesterday were about 10 to 1. Did you expect to see problems spreading to safe havens like agencies?
I'm pretty shocked. Everyone treats these as securities with unique status. Banks, regulators, and the Fed treat them differently. The fact that they've been selling off is really an indication that the system is just hemorrhaging capital. There's no capital to hold any assets. As people lose capital, they sell their way up the system. And the only thing left after this is treasuries. Why do credit and mortgage troubles matter to broader markets and the economy?
The [interest] rate to the average borrower has gone up 125-150 basis points [1¼ to 1½ percentage points] in the last six weeks. Meanwhile, the Fed is cutting rates hard to help the consumer, but the rate to the consumer has gone up 150 basis points while the Fed has cut about that much in the other direction. Monetary policy is clearly being undermined by things falling apart in the market. This part of the economy is the bigger focus of the Fed at the moment. If things don't work here, the broader repercussions for the wider economy are very significant.