The vulnerability of unregulated US mortgage REITs: Ken Atchison
In addition to listed REITs which own property in the US there are also mortgage REITs which own mortgages and mortgage backed securities. Assets of mortgage REITs total US$500 billion. They have a market cap of US $60 billion compared with a market cap of US $550 billion for property REITs.
In the current interest rate environment mortgage REITs borrow short-term and invest in longer term mortgage backed securities. They are potentially highly sensitive to interest rate changes. Gearing employed has been beneficial as borrowing rates kept falling. Gearing has meant that returns have been strong.
The quantitative easing (QE) policy adopted by the Federal Reserve in the US has involved purchases of mortgage backed securities which has accentuated the strong return. When QE tapers and borrowing costs rise then the returns will decline. Federal Reserve Governor Stein, US Financial Stability Oversight Council and now the IMF have highlighted this vulnerability. Mortgage REITs are not the subject of regulatory oversight of capital adequacy.
When interest rates rise, the risk of falls in market value will increase. Greater gearing means greater risk. Average gearing is 8.5 times.
In Australia debenture issuers which share some attributes with mortgage REITs are regulated by ASIC. Following failure in the sector, ASIC have foreshadowed tighter controls, including a minimum capital ratio adequacy of 8%.
Failure of financial institutions in the global crisis arose from inadequate equity capital, being excessive gearing, systemic risk of sectors in the financial systems and inadequate liquidity.
Counter cyclical prudential regulations including capital adequacy are the preferred response supporting public pronouncements about mortgage REITs.
Ken Atchison is managing director of Atchison Consultants.
