Mortgage real-estate investment trusts, which have operated in relative obscurity for decades, have emerged center stage in the debate over the Federal Reserve's strategy to stimulate the economy.
Some policy makers, including Fed governor Jeremy Stein, have pointed to the explosive growth of mortgage REITs as an example of risks emerging in the economy as a result of the Fed holding down interest rates.
The assets of mortgage REITs ballooned to $426 billion in the third quarter of 2012 from $111.5 billion at the end of 2009, according to SNL Financial.
The concern has raised questions about the recent performance of mortgage REITs, their current health and whether they pose any possible risk for the broader economy.
Here are some answers:
Q: What are mortgage REITs?
Mortgage REITs are niche financial stocks that have been around since the REIT industry was established in 1960. These REITs don't buy office buildings or malls but invest in real-estate debt. Some used to make loans but now primarily buy commercial and residential mortgage-backed securities. Many of the 33 existing mortgage REITs currently focus on buying mortgage securities guaranteed by Freddie Mac FMCC 3.40 % and Fannie Mae, FNMA 4.58 % which are government-backed financial firms.
Q: How do mortgage REITs make money?
They borrow money using short-term debt and use the funds to buy longer-term mortgage securities, earning the spread between the rates. They also use leverage to boost their returns.
Q: Why is the Fed's stimulus policy creating a mortgage-REIT boom?
The Fed is keeping short-term interest rates low to stimulate the economy. This is greatly reducing mortgage REIT borrowing costs, enabling them to make more money off their bond portfolio. REITs that purchase Freddie and Fannie debt currently pay dividends of about 12%, compared with 3.4% for equity REITs and 1.8% for U.S. Treasury bonds. Low rates are driving investors into instruments such as REITs that promise high returns. Overall, mortgage REITs have raised $30 billion in equity during the past two years to buy cheap mortgage debt.
Q: Should I call my broker?
Be careful. The Fed's economic-stimulus plan has been a double-edged sword for mortgage REITs. While short-term rates have lowered funding costs for the REITs, the Fed's $80 billion monthly purchases of mortgage securities—part of its quantitative-easing program—has pushed mortgage bond prices higher and yields lower. As a result, some REITs have been less profitable and have seen declines in dividends and stock prices over the past six months.
Q: What is the larger danger?
Fed officials are concerned about their funding model. During the 2008 crisis, financial institutions that depended on short-term debt were prone to investor panics. They also face risk if interest rates rise, a likely outcome when the Fed slows down quantitative easing. That would increase the short-term borrowing costs of mortgage REITs and cut the value of the mortgage bonds that they hold, possibly resulting in losses.
Q: Does this pose a risk for the broader economy?
Probably not. Mortgage REITs pose no systemic economic threat because the sector is still a small player in financial markets despite its rapid growth. Mortgage REITs represent less than 10% of the nearly $7 trillion securitized residential and commercial mortgage market. But there are numerous other investment vehicles that also have seen rapid growth because of the Fed's interest-rate policies, such as the junk-bond market. If all of these vehicles suffer big losses at the same time, there is more systemic risk.
Q: What do mortgage REITs say about the Fed's concerns?
Mortgage REIT executives say they are protected against these future pitfalls. They say they aren't as highly leveraged as they were before the financial crisis. REIT executives also say they are significantly hedged against a rise in interest rates by using interest rate swaps. Mortgage REITs focused on Fannie and Freddie debt point out that they survived other spikes in short-term rates. Unlike the market for some mortgage debt, such as bonds backed by subprime loans, they point out that the market for government-secured debt has never collapsed.
Q: Why are analysts still skeptical?
Analysts say that hedging tools may not be able to offset a steep drop in bond prices that may occur if the Fed halts its bond-buying program. Although companies can reinvest at lower bond prices, that will depend on having enough capital left over from covering potential losses on bond prices.
Q: Have mortgage REITs attracted other regulatory scrutiny?
In 2011, the Securities and Exchange Commission launched a review of mortgage REITs to determine if these companies should remain unregulated companies or be subjected, like mutual funds, to the Investment Act of 1940. Companies that invest the majority of their assets in real estate have always been exempted from the Investment Act. It appeared the SEC was looking at whether a distinction should be made between REITs that manage and operate real estate versus those that invest in real-estate securities. But the SEC hasn't pursued the matter.
—Jon Hilsenrath contributed to this article.