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WSJ: Securitized banking making a comeback with REITs

Borrowing on the repurchase market to invest in residential mortgage-backed securities, which was the main systemic risk that caused the crisis in banking in 2007-2008, is making a comeback with REITs, according to the Wall Street Journal April 13.

From the article:

A few years ago, real-estate investment trusts that bought and sold residential-mortgage securities were a dying breed. Today, they are one of the hottest REIT sectors in the industry.

Of nine new REITs that have applied to sell stock in initial public offerings so far this year, seven are REITs that will invest in mortgage-backed securities, according to Dealogic Inc. The value of the offerings totals $2.6 billion, the largest amount devoted to mortgage REITs since 2009, when a flurry of investment companies set up REITs to scoop up battered commercial mortgage-backed securities.

Often REITs use repurchase agreements to finance their operations, which is one example of how repos permeate finance today. At the end of 2010, one out of every five dollars of REIT debt was a repo loan, according to the Federal Reserve’s Flow of funds report.

The Journal article never mentions repurchase agreements, but it does talk about “short-term debt.”

Yield-hungry investors have gobbled up REIT stocks during the past two years because they offer higher dividend yields than other financial stocks and U.S. Treasurys. But dividend yields on residential-mortgage REITs have been especially large, averaging 14.6% as of Monday, compared with 3.5% for all REITs, according to Nareit.

Mortgage REITs have high dividend yields partly because the managers use high leverage, which can boost returns. The REITs use low-rate, short-term debt to finance their bond purchases.

And what is that low-rate, short-term debt? A big piece of it will be repos. From the Pimco REIT Inc. filing with the Securities and Exchange Commission April 5:

We will rely on our agency mortgage-backed securities (as well as non-Agency residential mortgage-backed securities) as collateral for our financings under the repurchase agreements that we intend to enter into upon the completion of this offering.

Other financing will come from credit facilities such as term loans and revolving lines of credit, short- and long-term warehouse facilities and securitizations, according to the circular.

Pimco’s offering warns investors that its REIT could be hurt by a run on repo, meaning that repo lenders could decide overnight not to renew their loans. When this happened to investment and commercial banks in 2007 and 2008, it triggered the federal bank bailout.

In the event we utilize these financing arrangements, they would involve the risk that the market value of our assets pledged or sold by us to the repurchase agreement counterparty, provider of the credit facility, lender of the warehouse facility or the securitization counterparty may decline in value, in which case the lender may require us to provide additional collateral or to repay all or a portion of the funds advanced. We may not have the funds available to repay our debt at that time, which would likely result in defaults unless we are able to raise the funds from alternative sources, which we may not be able to achieve on favorable terms or at all. Posting additional collateral would reduce our liquidity and limit our ability to leverage our assets. If we cannot meet these requirements, the lender could accelerate our indebtedness, increase the interest rate on advanced funds and terminate our ability to borrow funds from them, which could materially and adversely affect our financial condition and ability to implement our business plan.

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