In an otherwise enlightening August 2 story about how repo-dependent Real Estate Investment Trusts fared during the debt ceiling crisis, Wall Street Journal reporter John Jannarone made the following statement:
Fortunately, the repo market is unlikely to freeze up entirely. It functioned through the financial crisis, and the Federal Reserve would probably work hard to avoid any interruption, given its importance to the banking system.
As RepoWatch readers know, the repurchase market functioned through the financial crisis only because of Herculean efforts by the Federal Reserve.
That said, Jannarone is certainly right that the Federal Reserve seems determined to keep the repurchase market functioning, no matter what. Likely, REITs and their repo lenders are counting on that free safety net, as RepoWatch has noted here and here.
Jannarone’s article was a rare look inside the repo world while Congress debated raising the debt ceiling.
REITS are publicly traded companies that sell stock, use the proceeds to buy real estate or real estate securities (mortgage-backed securities), and use the securities as collateral to borrow on the repurchase market, so they can buy more real estate or real estate securities.
Some REIT shares fell precipitiously July 29, as investors worried that the chaos in Washington might spook repo lenders and REITS might lose their repo funding, according to Jannarone. (Shares fell again on August 8 for the same reason, after Standard & Poor’s downgraded the U.S. credit rating, according to an August 13 Wall Street Journal story.)
Typically, REITs use repos, or repurchase agreements, getting leverage by pledging their government-mortgage securities as collateral. That amplifies returns, helping Annaly (Capital Management) pay a hefty 16 percent dividend yield.
Yet, dependence on repos carries a big, if rarely pondered, risk. As of March 31, Annaly had $80 billion in repos. That included $11 billion due in one day and $22 billion due in two to 29 days. In contrast, 99 percent of Annaly’s $94 billion in mortgage-backed securities had maturities of more than one year. If Annaly couldn’t replace maturing repos, it could be forced to liquidate assets.
Thanks to Jannarone for this valuable insight. It’s sobering to see a specific example of an industry that is so exposed to repo runs, three years after the crisis.
This time, though, the REITs’ repo lenders did not withdraw, at least not in large enough numbers to cause a panic in the REIT industry.
REITS are an example of why average Americans need to understand the repurchase market. Many small investors believe that REITS sell stock, use that money to buy high-performing real estate or mortgage-backed securities, and pay generous dividends to their shareholders. What’s often left out of the story is that REITS achieve those generous dividends by using the securities to borrow heavily on the repurchase market. In other words, REITs are much more in debt that many investors understand.
Further, by being vulnerable to the repo market, REITs are especially sensitive to a rise in interest rates. That’s because a rise in rates makes the value of the REITs’ real estate securities decline, and if the REIT is using those securities as collateral for a repo loan, the repo lender will demand more collateral or withdraw the loan.
REITs are a fine example of the extra layer of risk that the financial markets can lay on, by borrowing on the repurchase market to boost leverage, profits, and debt.