Federal Reserve Board governor Jeremy Stein pointed to various risk factors in the market, specifically noting that mortgage real-estate investment trusts are an area where troubles could arise due to the Fed’s monetary policies.
Stein spoke at the Federal Reserve Bank of St. Louis covering the topic of overheating in the credit markets.
Financial innovation was one of the three factors Stein listed as contributing to credit overheating.
He noted that innovation could create new ways for "agents to write puts that are not captured by existing rules."
As a result, Stein warns policymakers to be on alert any time there is rapid growth in a new product that is not yet fully understood.
Thus, Stein pointed to mortgage REITs, noting their rapid growth over the past few years. Mortgage REITs grew from $152 billion in 2010 to $398 billion at the end of the third quarter of 2012.
Click on the graph to view total agency REIT assets.
"These agency REITs buy agency mortgage-backed securities (MBS), fund them largely in the short-term repo market in what is essentially a levered carry trade, and are required to pass through at least 90% of the net interest to their investors as dividends," Stein said in his prepared remarks.
Additionally, Stein stated that an interesting aspect of the REIT business model is that its economic sustainability is sensitive to conditions both in the MBS market as well as the repurchase agreement (repo) market.
"If MBS yields decline, or the repo rate rises, the ability of mortgage REITs to generate current income based on the spread between the two is correspondingly reduced," he said.
The Federal Reserve's more aggressive monetary policies continue today. During the last Federal Open Market Committee announcement, FOMC members concluded that the Fed will continue to purchase additional agency mortgage-backed securities at a pace of $40 billon per month.
Additionally, the Fed will continue to purchase longer-term Treasury securities at a pace of $45 billion a month.