One More Systemic Risk to Worry About

(Originally published here.)

Borrowing lots of money overnight to buy long-term assets is a great way to blow up the world economy. That’s why everyone from Federal Reserve Governor Jeremy Stein, to theInternational Monetary Fund, to Financial Times columnist Gillian Tett is worried about the systemic danger posed by mortgage real estate investment trusts, which collectively own about $500 billion in assets, according to the IMF. The good news is that this risk can be reduced with the help of a little financial engineering.

These kinds of REITs buy mortgage bonds to leverage the difference between their short-term borrowing costs and the yield on the bonds. Low interest rates and the Fed’s asset purchases have made this strategy very attractive, at least until the most recent vintage of mortgage bonds guaranteed by Fannie Mae and Freddie Mac lost about 10 percent of their value between May and September.

The IMF worries that things could get a lot worse if interest rates rise more. Declining bond prices would make lenders skittish. Finding it harder to borrow, mortgage REITs would be forced to sell their holdings into a falling market. In an extreme case we might end up with a broader panic in the short-term money markets and sharply higher interest rates for households and businesses.

Yet it might be hard for mortgage REITs to use swaps that protect against rising interest rates. First, the spread between mortgage-bond yields and the swap rates offered by banks isn’t constant. Second, mortgage-bond prices are more sensitive to rising interest rates than falling interest rates. This comes from the fact that people pay attention to mortgage rates when deciding whether to refinance. (Check this post on the convexity vortex for a deeper explanation.) Swaps don’t have this property.

Two Harbors Investment Corp., a mortgage REIT with about $16.1 billion in assets, may have found an innovative solution to this problem. Earlier this week, the firm agreed to buy mortgage-servicing rights on new loans originated by PHH Mortgage Corp. According to Bloomberg News, Two Harbors has been accumulating mortgage servicing rights since thesecond quarter of this year.

How does this have anything to do with the systemic risk that may be posed by mortgage REITs? It turns out that mortgage-servicing rights are a great asset to own if you want to hedge your exposure to rising mortgage rates. Mortgage servicers collect small fixed feesthroughout the life of each loan they service, so the value of a right is just the sum of those payments discounted by some appropriate interest rate. But higher interest rates don’t hurt mortgage-servicing rights as they do bonds.

An example should make this clear. Suppose you own mortgage-servicing rights on loans that were originated at an interest rate of 6 percent. If rates stay around 6 percent you will earn a steady income stream and own an asset that doesn’t change much in value. There is always the risk, though, that many of those borrowers would refinance into new loans if mortgage rates fell far enough. Years of payments you had been expecting would disappear and your rights would lose value.

If, however, mortgage rates rose to, say, 9 percent, your servicing rights would become more valuable. No one would refinance and it’s even possible that the higher cost of borrowing would make homeowners less likely to move. Prepayment rates would plunge and you could expect to get your income stream for many more years. The result is that your rights would soar in value just as your mortgage-bond portfolio lost value — exactly what you want a hedge to do.

The risk mortgage REITs pose to the broader financial system might be reduced if more of them followed Two Harbors’ lead and bought servicing rights from mortgage originators. That would make these so-called shadow banks even more like plain old banks that balance interest-rate risk with fee income. No wonder Bloomberg View’s editors think the regulatory distinction needs a rethink.

(Matthew C. Klein is a writer for Bloomberg View. Follow him on Twitter.)


About Matthew C. Klein

I write about the economy and financial markets for Bloomberg View. Before that I wrote for The Economist on a fellowship provided by the Marjorie Deane Financial Journalism Foundation. I have worked at the world's largest hedge fund and read every FOMC transcript since May, 1987.
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