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Elevated levels of consumer debt has been one of the reasons why recovery has been so weak
The New York Federal Reserve puts out a quarterly report on household debt and credit, which looks at the total debt as well as the composition of debt. Aggregate household debt fell by $110 billion in the first quarter to $11.23 trillion, which is well below the peak of $12.68 trillion in the third quarter of 2008. About 309,000 customers had a bankruptcy notation added to their credit reports in the first quarter, a nearly 17% drop year-over-year.
Addressing the consumer debt issue has been one of the major driving forces behind quantitative easing and ultra-low interest rates. Since the Great Recession began, the Fed has engineered a drop in interest rates in hopes of lowering the burden on middle class households. In many ways, the Fed has succeeded. On one hand, mortgage rates have dropped precipitously. On the other hand, credit card interest rates have not.
The Fed has been hoping to create modest inflation. Modest inflation (around 2% to 3%) would allow debt to deflate relative to the economy without triggering large increases in interest rates. The Fed is not comfortable with inflation that is too low – when interest rates are up against the zero bound (in other words, they are at zero and cannot go lower), decreasing inflation means real (inflation-adjusted) interest rates are rising. In a weak economy, that is the last thing they want to do. Japan has been struggling with this state of affairs for two decades – deflation in combination with zero percent interest rates means rising real interest rates and very slow growth.
Implications for the mortgage REITs
Until consumption demand and jobs return, the Fed will keep interest rates as low as they can. They have already given a numeric target for unemployment (6.5%) before they will consider raising interest rates. While they have yet to give a target for ending asset purchases, chances are they will err on the side of keeping rates low too long as opposed to tightening too early.
The net effect on REITs, such as American Capital (AGNC), Annaly (NLY), MFA Financial, or Hatteras (HTS), will be low interest rates and higher prepayments. Low interest rates means that mortgage REITs will have to use more leverage than usual to generate acceptable returns. As long as there is stability in the financial markets, their borrowing rates will remain low. They will benefit from having steady or rising prices for the assets on their balance sheet. The downside will be prepayments and delinquencies. For agency REITs, prepayment risk is their biggest worry. Prepayment risk occurs when borrowers refinance their mortgage, which removes high yielding assets from the REITs portfolio and replaces them with lower-yielding assets; this lowers net returns.
© 2013 Market Realist, Inc.