The Financial Stability Oversight Council has a new systemic risk concern on its radar: the potential for a sudden, disorderly sell-off of mortgage-backed securities by leveraged mortgage real estate investment trusts.

In its annual report, the FSOC highlighted its worries in a discussion of how rising interest rates might create a negative feedback loop centered around mortgage REITs that are funded by short-term repurchase agreements, or repos.

The worry stems, in part, from the rapid growth in the amount of agency MBS held by mortgage REITs, which have risen from $89.5 billion in 2008 to $352 billion at the end of 2012, according to Federal Reserve data.

Asset increases at some REITs have been dramatic. American Capital Agency in Bethesda, Md., grew its holdings from less than $5 billion in 2009 to $100.5 billion at the end of 2012 in an expansion led by President and Chief Investment Officer Gary Kain, who formerly managed Freddie Mac's $700 billion portfolio.

But what really worries the FSOC has to do with the negative convexity of MBS, the market phenomenon that occurs when the pace of the decline in mortgage asset values accelerates with each uptick in interest rates. Higher rates extend the duration risk for outstanding MBS, as they reduce the likelihood that existing, lower-rate mortgages will be prepaid. If repo funding costs rise at the same time as asset values fall, the FSOC warns in its April 25 report, mortgage REITs would be among the most exposed to losses, perhaps leading them to dump MBS into the market.

And the trouble might not stop there. REITs typically use a combination of shorter-term Treasury hedges that together reflect the duration risk of their MBS assets when interest rates are low and mortgages are expected to repay fairly early. When rising rates extend the duration of their assets, REITs sell short-term Treasuries and start buying longer-term paper, like 10-year Treasury debt, to match their new extended duration risk.

The FSOC suggests that the vulnerability of mortgage REITs could prompt them to set off a "convexity event" following a sharp rise in rates.

In such a scenario, the yield curve would steepen because of a sudden shift made by the REITs in the duration of their Treasury hedges. This in turn could push up the yield on 10-year Treasuries and on 30-year fixed-rate mortgages, which tend to track 10-year Treasuries. In this way, an increase in the benchmark interest rate would drive longer-term rates even higher than intended.

Fed Gov. Jeremy Stein expressed concern about the mortgage REIT business model in February, noting its sensitivity to both the MBS and repo markets. "If MBS yields decline, or the repo rate rises, the ability of mortgage REITs to generate current income based on the spread between the two is correspondingly reduced," he noted. William Dudley at the New York Fed also has identified mortgage REITs as a worry. In a March speech to the Economic Club of New York, he addressed the expectation that regulators will have to be ready "to take steps to mitigate the vulnerability of the economy to a sharp rise in interest rates."

The FSOC, despite its stated concerns, did not take the extra step of including agency REITs in its list of emerging systemic threats. But do the risks even merit a mention in the council's annual report?

As the report acknowledges, mortgage REITs hold only 5 percent of MBS paper. Other players have much larger stakes.

"Banks and credit unions own about 25 percent of outstanding MBS, up from about 16 percent in 2008," says Jason Arnold, director and research analyst at RBC Capital Markets in San Francisco. He argues that if mortgage REITs pose a potential danger for the MBS market, then the same could be said about banks.

U.S. depository institutions ended 2012 with $1.67 trillion in agency securities, up from $1.24 trillion in 2008, according to the Fed. At the same time, Fannie Mae and Freddie Mac dramatically decreased their holdings, from $910 billion in 2008 to $315 billion at the end of 2012.

At the Fed, MBS holdings soared from $19.7 billion in 2008 to just over $1 trillion at the end of 2012, the result of the central bank's quantitative easing measures.

With the Fed now owning 13 percent of outstanding agency MBS, "this is almost like the pot calling the kettle black," Arnold says. If the MBS market has systemic implications, then the Fed, he says, "has some systemic exposure as well."

But Arnold and other analysts suspect the FSOC is overstating the risks of the REIT model. "The argument about the negative convexity of agency MBS REITs is correct," says one veteran mortgage analyst who spoke on the condition of anonymity. But "this feature of MBS has been well understood for many years," and therefore would not be a surprise to the markets, he argues.

Moreover, leverage among mortgage REITs has not returned to the high levels that existed prior to the financial crisis as repo lenders continue to impose the margin requirements they put in place during the crisis. And REITs on the whole have a thicker equity cushion than before, although certainly individual REITs will have a higher vulnerability to a convexity event, especially those that have taken on too much leverage. (In early May, Bill Carcache, a research analyst at Nomura, downgraded his rating on both American Capital Agency and CYS Investments to neutral, citing a volatile first quarter in which asset values dropped and typical hedges were "relatively ineffective.")

Ironically, a slight increase in interest rates—to 2.25 percent or 2.5 percent, for example—could generally be positive for spread income at REITs, so long as the decline in the value of their portfolios was mild enough not to completely offset the benefit of stronger Treasury yields.

But if 10-year rates go to 3.5 percent or 4 percent, "it gets more painful" for REITs and other MBS holders as portfolio values start to fall significantly, Arnold says. At 5 percent or 6 percent, "it would be extremely painful."

Most mortgage market observers agree that sharply higher interest rates pose a risk for mortgage REITs. "If interest rates skyrocket, like they did in the late 1970s and early 1980s, it would very difficult to manage their portfolios," Arnold says.

"The same situation," he adds, "would be true for banks."

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