Debt Ceiling's Overlooked Flash Crash

Debt Ceiling's Overlooked Flash Crash

By JOHN JANNARONE
Markets were remarkably unmoved by Washington's political theater over the debt ceiling. The fall in stocks was limited. Any bounce from this weekend's deal was quickly overshadowed Monday by more bad news on the U.S. economy.

But, in an obscure corner of the stock market, investors did get a reminder of the risks still lurking in the system—in particular, Wall Street's popular practice of depending heavily on short-term funding to finance long-term investments.

At the height of the debt-ceiling uncertainty on Friday, a handful of mortgage real-estate investment trusts suffered a mini flash crash. Shares of Annaly Capital Management plummeted 19% in a few minutes in the morning, and American Capital Agency fell 22% before recovering the lost ground. The two REITs invest in government-backed mortgage securities using huge amounts of short-term debt.

.The quick selloff was said to be induced by stop-loss orders that many investors place on these shares, which trigger a sale if the share price moves a certain amount. The big fear for the companies has always been a spike in interest rates. That could create a double whammy, hitting the value of the REITs' long-dated mortgage securities, while also raising the cost of financing their short-term debt pile.

But the root of Friday's panic actually came from a different source. Investors suddenly worried that REITs would lose access to the debt market they rely on for funding. Typically, REITs use repos, or repurchase agreements, getting leverage by pledging their government-mortgage securities as collateral. That amplifies returns, helping Annaly pay a hefty 16% dividend yield.

WSJ's John Jannarone describes the brief panic that wafted through the REIT sector last week over fears of higher interest rates that may have resulted from a U.S. default. AP Photo.
.Yet, dependence on repos carries a big, if rarely pondered, risk. As of March 31, Annaly had $80 billion in repos. That included $11 billion due in one day and $22 billion due in two to 29 days. In contrast, 99% of Annaly's $94 billion in mortgage-backed securities had maturities of more than one year. If Annaly couldn't replace maturing repos, it could be forced to liquidate assets.

Fortunately, the repo market is unlikely to freeze up entirely. It functioned through the financial crisis, and the Federal Reserve would probably work hard to avoid any interruption, given its importance to the banking system.

And some tightening in the repo market is probably manageable. Steve DeLaney of JMP Securities says REITs can borrow against 95% to 97% of a government-backed mortgage security's value in the repo market. That percentage fell during the crisis, but only to about 93%.

But the fact remains that Annaly is beholden to the repo market, as well as being heavily exposed to any shift in interest rates. As plenty of highly leveraged borrowers learned in the crisis, hefty short-term funding can change from a profit engine to a huge liability overnight.

Write to John Jannarone at john.jannarone@wsj.com