Seeding a Financial Crisis

In 1999, the Clinton administration, with the support of a majority of Democrats and Republicans, repealed the Glass-Steagall Act effectively allowing the merger of commercial and investment banking.   "The Glass-Steagall Act is no longer relevant"  Bill Clinton publicly declared.  Nine years later, the collapse of the US housing market would trigger a global financial crisis. 

The Glass Steagall Act was enacted in 1933 and introduced a series of banking reforms that were designed to control speculation by banks and other financial institutions that controlled deposit and investment monies.  It was a consumer protection act with provisions to separate commercial and investment banking.  Banks held depositors money and the purpose of the act was to keep it separate from the riskier investment market.  If depositors wanted to invest, they could do so in investment markets but if not, they didn't have to worry about their money being at risk through their banking institution's actions.  It was a policy that worked until the Glass Steagall Act was repealed and replaced by the Financial Modernization Act.   With the support of the Clinton administration, the Financial Modernization Act effectively merged commercial and investing banking allowing banks to risk their depositors money.

Until the Clinton administration repealed the Glass Steagall Act, banks were restricted from doing some of the things they wanted to do.  They were unable to risk huge pools of depositor's money on investments and speculation.  After repealing the Glass Steagall Act and replacing it with Financial Modernization Act, commercial banks played a crucial role as buyers and sellers of mortgage-backed securities, credit-default swaps and other explosive financial derivatives.  The Chinese firewall between investment and commercial banking had been torn down and billions in depositor savings were being risked by commercial banks on new financial products.  Let's take a look at some of these products:

• 1) Subprime Mortgages:  Banks pushed lenders to take on these products because they offered higher yields than traditional mortgage.  Pools of higher yielding subprime mortgages were packaged into MBS and sold to investors lured by the higher yields.
• 2) Adjustable Rate Mortgages (ARM): Offered low teaser rates for limited time periods to entice home buyers.  After the time period elapsed, rates would reset at a much higher market value.
• 3) Mortgage Backed Securities (MBS): Banks issuing loans would pool these assets together securitizing and selling them to other investors.  Essentially, a mortgage backed security is a way for a bank to lend mortgages to its customers without having to worry about whether the customers have the assets to cover the loan. Instead, the bank acts as a broker between the home buyer and the investors willing to purchase securitized mortgages.  Pools of higher yielding subprime mortgages made MBS more appealing to yield hungry pension funds.
• 4) Collateralized Debt Obligations (CDO):  are a type of structured asset backed security (ABS) with multiple tranches that are issued by special purpose entities and collateralized by debt obligations including bonds and loans. Each tranche offers a varying degree of risk and return so as to meet investor demand. CDOs' value and payments are derived from a portfolio of fixed income underlying assets.  Banks created and sold CDO's to investors while betting against them with CDS.   
• 5) Credit Default Swaps (CDS):  Are essentially an insurance policy on an asset.  The holder of an asset buys a CDS to receive credit protection on their asset.  Sellers of the CDS guarantee the credit worthiness of the debt security.  For example, if an investor purchased a loan from the bank and the homeowner defaulted on payment, the investor would be protected from loss if they purchased a credit default swap against the asset.  Financial institutions selling CDS did not limit the selling of the swaps to the holder of the asset.  Anyone willing to purchase a credit default swap could bet against the solvency of an asset by purchasing a CDS earning the banks additional premiums. 
• 6) Derivatives: A security whose price is dependent upon or derived from one or more underlying assets. Derivatives are generally used to hedge against risk.  For example a Canadian investor could purchase a contract to buy US$ at a fixed exchange rate a year into the future.

In early 2006, US housing prices peaked.  By September 2008, the global financial system was tethering on the brink of collapse.  Mortgage Back Securities (MBS), Collateralized Debt Obligations (CDO), Credit Default Swaps (CDS), Derivatives, Adjustable Rate Mortgages (ARM), Subprime loans and low interest rates were amongst the tools and policies blamed for the collapse in the financial system.  Before the financial crisis, up to 80% of bank profits came from trading.  

Subprime mortgage (1) holders, unable to meet interest payments in an environment of rising rates defaulted on mass.  MBS (3) and CDO (4) created by pooling thousands of individual subprime mortgages (1) together before being sold off to investors were overwhelmed by the number of loan defaults losing investors, including banks, billions of dollars.  Savvy investors and banks holding CDS (5) as "insurance" profited from the collapse of MBS (3) and CDO (4).   In later years, wave after wave of ARM (2) reset at higher rates leading to additional defaults.  4 years later, deleveraging is still taking place. 

The result of reckless lending has been high unemployment and a slugish economy for the last 5 years.  Record amounts of cash were injected into the system to prevent the collapse of companies deemed to big to fail.   No one was held accountable for the collapse of the financial system.  Rather than blaming the individual, you could say the financial collapse resulted from the actions of a collective of individuals encouraged to make poor decisions by a poorly designed system.  Perhaps the responsibility lies in the hands of those who repealed the Glass Steagall Act, but that is another story.   

QE3 & The Effect on Mortgage REITS

High yields have made Mortgage Real Estate Investment Trusts popular investments with yield hungry investors over the past few years.  Today we take a look at how Mortgage REITs work and how QE3 affects their ability to maintain high payouts to their holders.

Simply put, a Mortgage REIT borrows money cheaply at short term rates, and lends effectively at higher long term rates by buying mortgage backed securities (MBS).  MBS are essentially individual mortgages pooled together as a security and sold by banks to investors.  By pooling mortgages, the risk of losses to the investor from individual mortgage defaults is reduced.

A normal yield curve shows the relationship between interest rate yields and time to maturity.  Lenders, concerned about the long term risk of default, offer longer term loans at higher interest rates than short term loans.  Mortgage REITs borrowing money at the cheaper short term rate and buying higher yielding government backed MBS from banks pass through 90% of their taxable income to investors.   This money is made on the difference between the spread on the interest rates payed on the money the Mortgage REIT borrows and the interest rate earned on the MBS that they purchase.

By leveraging up, a Mortgage REIT can make up to 6 to 8 times the spread.  Mechanically, the REIT leverages by taking a new, purchased agency mortgage-backed securities (MBS) pool and entering into a repurchase agreement (repo) with a dealer, where the dealer gives the REIT cash. Then the REIT then purchases another agency MBS pool.  REITs repeat this process until they have achieved six to eight times leverage earning investors double digit yields.

After the financial crisis in 2008, the FED bought over 1 trillion in MBS to keep interest rates down.  With the FED buying MBS off the banks, bankers were able to offer borrowers lower rates on their mortgages.  The massive amount of buying by the FED drove up prices of MBS reducing yields.  With QE3, the FED plans to buy 40 billion in MBS every month.  This represents 56% of the MBS market.  Yields for MBS have fallen to record lows at 1.8% to 2% as prices soar.  The decrease in spread between higher yielding MBS and short term borrowing costs brought about by QE3 should theoretically, drive prices of Mortgage REITS down as payouts shrink.

Some of the risks of owning Mortgage REITs include:

1) Record High MBS prices: New purchases of MBS by Mortgage REITs have yields that are significantly lower than whats already on their books.

2) Extremely tight spreads. Spreads over a comparable maturity U.S. Treasury or swap are at historically low levels; thus, these bonds don’t have the ability to tighten in spread to offset a decline in price.

3) Expected increase in prepayments. Given the recent drop in mortgage rates, there has been a dramatic pickup in refinancing activity. The problem for the mortgage REITs is that an increasing amount of their earlier purchased MBS yielding 3% or higher will be returned at par (100), instead of where they may be currently trading (Higher than par given the current 1.8% to 2% yield).

4) Margin compression. The implication of reasons one through three is that mortgage REITs are facing and will face strong margin compression in the coming quarters. High-yielding bonds are running off and being replaced with lower-yielding securities, while the cost of their funding hasn’t changed. This is a perfect combination for future dividend cuts, which have already begun in some cases.

5) Dividend popularity. With dividend paying stocks now in vogue, mortgage REITs are trading under a halo; they are one of the few places to find a significant yield. As quickly as these stocks have come into favor, they can also fall out of favor. Stocks that were trading at a premium to book value could quickly find themselves trading at a discount.

Investors looking for yield in Mortgage REITs need to be cautious.  With the FED buying up 56% of MBS on the market, yields payed out by Mortgage REITS will come down.  As the spread between yields on MBS and short term borrowing costs decrease, payouts for Mortgage REITs should fall.  Falling share prices will lead to capital destruction for incognizant investors.