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June 7, 2013 9:45 am
US borrowers who take out the country’s traditional 30-year fixed-rate mortgages win both ways.
If rates fall, they can refinance for lower monthly payments; if they rise, they can sit back and boast of their good fortune at having locked-in a great rate.
The risk of rising rates is shouldered by others – and risk is the operative word. The humble mortgage has a history of humbling the biggest names on Wall Street.
In the $1.3tn a year market for mortgage-backed securities, where loans are pooled together and traded, small changes in interest rates can mean the difference between big gains and big losses. And the sudden return of market turbulence is a foretaste of what could come if the Federal Reserve puts the brakes on monetary stimulus.
Moreover, while this market has previously been the preserve of sophisticated traders and money managers, this time it is small investors that could be in the line of fire – through a fast-growing class of stock market-listed investment companies called mortgage Reits (real estate investment trusts).
“The combination of high leverage and sensitivity to interest rates could lead to disappointing results rather than the high yield they promise,” says Kate Warne, investment strategist at Edward Jones, which has 12,000 financial advisers in the US and Canada and which routinely sends out research notes warning them to steer their clients away.
“We believe mortgage Reits are not appropriate for most individual investors,” Ms Warne adds. Yet, lured by huge dividends, retail investors keep clamouring.
Scott Ulm, co-chief executive officer of Vero Beach, Florida-based Armour Residential Reit, says: “I would not overestimate retail investors’ knowledge of how this business works.”
His company is a relatively typical, if smaller, mortgage Reit. It has borrowed about nine times as much as its underlying capital and used the leverage to assemble a portfolio of MBS that was most recently valued at $24.3bn.
It hedges away part of the risks of an interest rate move, but after these hedging costs, any difference between its short-term borrowing rates and the monthly income from its MBS can be distributed to shareholders.
A dividend yield of approximately 16 per cent had attracted plenty of institutional and retail buyers to Armour shares – until the MBS portfolio slipped by what KBW estimates is 6 per cent in value between the end of March and the end of May, sending Armour shares tumbling.
When US interest rates jumped in May, as Fed officials suggested the central bank’s monetary stimulus could be tapered off starting this summer, it hurt not just Reits but all investors’ MBS portfolios.
The reason: If interest rates rise, fewer people will refinance their mortgage, which means that existing MBS will not wind down as quickly as they might otherwise.
We believe mortgage Reits are not appropriate for most individual investors
- Kate Warne, investment strategist at Edward Jones
An MBS that takes longer to mature is riskier, and therefore worth less, and the change in value can be quite sharp – much more sharp than the increase in value that comes from a move downwards in interest rates. That asymmetry is known by practitioners as “negative convexity” and it has claimed many a smart Wall Street trader.
No less a person than Larry Fink, now arguably the most powerful man on Wall Street, as chief executive of the world’s largest fund manager, BlackRock, was fired from his job at First Boston after losing the bank $100m in 1986 after being caught out by interest rates.
A 1994 surge in interest rates caused a Wall Street bloodbath, when hedge fund Askin Capital Management went under and Goldman Sachs went into the red, and there have been mortgage debacles in 1998 and 2003, as well.
There are many booby traps. Because of the leverage involved, a rise in long-term rates and corresponding fall in the value of the portfolio can trigger margin calls and potential forced selling of assets. A spike in short-term borrowing costs can wipe out much of the profit margin on MBS income. And volatility in the markets can make hedging more expensive and less effective than planned.
Money has been pouring into mortgage Reits at a faster and faster pace since the financial crisis. The capital infusion and their tax advantages mean that these vehicles are now among the most aggressive buyers of MBS, though they still represent about 4 per cent of all US residential mortgage debt.
KBW estimates $6bn was wiped off the value of mortgage Reits that invest in government-backed MBS in May – 16 per cent – as the values of their MBS portfolios tumbled and investors got a glimpse of a potentially negative feedback loop.
Falling asset values forced many MBS holders to increase their rate hedges, and traders say the consequent pressure in the swaps market appears to have exacerbated the jump in market-wide interest rates, which caused further price declines in MBS.
Short-term interest rates remain low, however, and unaffected by the longer term rate turmoil in May, keeping costs down for Reits and other leveraged MBS holders.
After the May storms, Mr Ulm dares hope for June sunshine. “As bonds become cheaper, reinvestment becomes more profitable,” he says. “New money put to work will achieve a higher return and in mortgage Reits you have new money every month. That’s the nature of the business.”
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