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The end of the carry trade — Part 5

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Impact on mortgage REITS

The Treasury Department Financial Stability Oversight Council report mentioned the mortgage REIT sector specifically as at risk for a convexity event. A convexity event comes into play when interest rates move sharply. Because borrowers can prepay their mortgage without penalty, mortgage-backed securities are difficult to hedge in volatile interest rate environments. Agency REITs in particular use a lot of leverage, as the gross returns on agency mortgage backed securities are typically small because these securities are either explicitly (in the case of Ginnie Mae) or implicitly (in the case of Fannie Mae and Freddie Mac) guaranteed by the government. Some of the bigger REITs were operating at eight times leverage, which means the margin for error is very small. It doesn’t take much of a movement to wipe out the interest earned and start showing losses.

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The mortgage REITs have been absolutely pummeled as rates have increased. The mortgage REIT ETF (MORT) is down 19.5% since the bond market sell-off began. American Capital (AGNC) is down almost a third. Annaly (NLY) is down 22%. Right now, the To-Be-Announced (TBA) market is facing liquidity struggles as REITs sell MBS to de-leverage. This is wreaking havoc on mortgage rates, as mortgage originators find themselves competing with mortgage REITs to sell TBAs. The TBA market is the basis for new mortgage pricing. Originators will lock a loan with their customer and then simultaneously sell that loan forward in the TBA market, thereby hedging their risk if interest rates increase. Originators are finding themselves with difficulty executing large trades in the TBA market.

Right now, we’re in the first inning of a long process. Interest rate cycles last a long, long time—often measured in generations. Bill Gross of PIMCO said that April 30, 2013, will go down in history as the end of the long bond bull market that began in 1982, when Paul Volcker vanquished 1970s inflation with the wrenching 1981–1982 recession. How the end of the carry trade will play out is anyone’s guess. Will it end violently, like it did in 1994, when it took out a big mortgage-backed hedge fund, a bunch of prop desks, and a county? Or will it stay under control, as the Fed hopes it will?  Even if quantitative easing’s end is delayed by an economic slowdown, it’s doubtful that the Fed can put the toothpaste back in the tube and drive long-term rates back down to where they were six weeks ago.

The carry trade is now over.

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