Last night, Bloomberg broke the news that Federal Reserve Chairman Ben Bernanke sought to downplay concerns over monetary policies creating asset bubbles at a meeting with primary dealers (the biggest banks on Wall Street who trade directly with the Fed) earlier this month.That’s to be expected – Bernanke obviously isn’t running around trying to do the opposite.
What were the primary dealers worried about, though?
Bloomberg’s Rich Miller reports the two biggest concerns expressed to Bernanke at the meeting:
The Fed chairman brushed off the risks of asset bubbles in response to a presentation on the subject from the group, one person said.
Among the concerns raised, according to this person, were rising farmland prices and the growth of mortgage real estate investment trusts. Falling yields on speculative-grade bonds also were mentioned as a potential concern, two people said.
Farmland prices are a pretty common concern. The map below illustrates why that’s the case.
Photo: Kansas City Fed
Mortgage real-estate investment trusts (REITs) have been getting slammed since the Fed started intervening heavily in mortgage bond markets last year. They have rallied in 2013, though.
Federal Reserve Governor Jeremy Stein recently highlighted these REITs in a speech posing the question of whether or not credit markets were overheating.
Stein explained the business model, which shows why mortgage REITs are problematic:
Continuing on with the theme of maturity transformation, the next brief stop on the tour is the agency mortgage real estate investment trust (REIT) sector. 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 per cent of the net interest to their investors as dividends. As shown in exhibit 7, they have grown rapidly in the past few years, from $152 billion at yearend 2010 to $398 billion at the end of the third quarter of 2012.
One interesting aspect of this business model is that its economic viability is sensitive to conditions in both the MBS market and the 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.
In other words, REITs are getting squeezed because the interest rates they pay on the money they use to fund their investments are rising, while at the same time the coupon payments they receive from the bonds they invest in are falling.
Stein also expressed concern over speculative grade – or high-yield – corporate debt in his speech, which was also the final concern expressed by the banks, according to the report.
Perhaps the biggest concern in that market right now is the lack of liquidity and the prospect of forced selling by large mutual funds in the event of a rise in rates. To read more on the liquidity problems and what could happen, click here >
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