There's a funding problem brewing in the housing finance market, and it's sending mortgage rates up at a much faster clip than benchmark Treasuries.
The big picture: Large buyers of mortgage bonds — i.e. the Fed and the big banks — have dropped out of the game. The lower demand has pressured the value (or price) of mortgage bonds, sending yields soaring.
- Caught in the center of this storm are publicly traded mortgage REITs that are facing margin calls, and prospective U.S. homebuyers who are staring down the prospect of mortgage rates near 7%.
Why it matters: It's an example of how the volatility caused by rapidly rising rates is starting to cause cracks in the country’s intricately interwoven financial system.
Let's dig into mortgage REITs. These investment funds borrow heavily to buy mortgage bonds, since using borrowed money juices returns. But the decline in the value of their portfolios has led to margin calls from their lenders (those in the repo market, for example), says Eric Hagen, mortgage and specialty finance analyst at BTIG.
- Margin calls create more selling and price pressure, which leads to more margin calls — and so on. This type of thing can turn into a vicious cycle.
- Investors are increasingly worried that margin calls could deplete the mortgage REITs' cash piles. These concerns sent some of their stocks down 30% or so in just the last month.
- The yield curve isn't helping. Some mortgage REITs borrow using short-term funding and then invest in longer-term assets. With many parts of the curve inverted, or close to it, it’s not as lucrative anymore, Hagen notes.
Go deeper: When mortgage bonds are available in the secondary markets at discounted prices — i.e. higher yields — then investors are apt to buy those, instead of buying in the primary market where new deals are bundled.
- To entice buyers to scoop up these new deals, rates need to go up — a lot. Hence, 30-year-mortgages are hitting wild 20-year highs.
Where it stands: The volatility in the market over the last month was enough to prompt a bunch of mortgage REITs to crank out statements on their liquidity (cash positions), and provide some preliminary Q3 balance sheet figures — an out-of-the-ordinary move.
- A few examples are Annaly Capital Management, AGNC Investment Corp, AG Mortgage Investment Trust and MFA Financial.
- These disclosures seem to have quelled immediate concerns as some of the stocks have bounced back a tad.
What to watch: If the economy goes south, then you can add a new wrinkle to the dysfunction — the possibility of rising foreclosure rates.
