Friday’s Mortgage REIT Flash Crash

Last Friday (7/29/11) morning, the US equity market experienced a multi-stock flash crash in the mortgage REIT sector. Stocks in major mortgage REITs (NLY, HTS, CMO, IVR, ANH, AGNC) collapsed over 10% in just a few minutes. And then as quickly as they fell, they all rebounded in the next few minutes. Since the headlines coming out of DC have been fast and furious, this event received little notice in the media. We also realize that there was some major events in the mortgage REIT market that have taken place recently including the fact that S&P would not rate a Goldman/Citi CMBS deal  Read WSJ article here The one or two reporters that happened to notice the roller coaster ride in the mortgage REIT sector blamed it on bigger issues and not the fact that the US equity market structure is badly damaged. Here is how Bloomberg explained Friday mornings events Read Bloomberg article here

“Real estate investment trusts that buy mortgage debt tumbled, adding to their biggest weekly loss in more than a year, on concern the markets that finance them will be roiled if the U.S. government defaults on its debt…The companies fell as the cost of overnight repurchase agreement, or repo, financing for government-backed mortgage securities jumped 9 basis points to 20 basis points as of 12:21 p.m., the highest since Jan. 19…”It’s just an equity market event,” Kenneth A. Steele, chief financial officer at Winston-Salem, North Carolina-based Hatteras”

Whoa! Stop the presses. What did Kenneth Steele, the CFO from Hatteras, just say, “It’s just an equity market event.” Right you are Mr. Steele, it was just an equity market event and let’s take a closer look as to what happened.

The mortgage REIT sector ride on Friday morning reminded us alot of May 6th. In both cases, major events were taking place and the market mood was nervous. In the case of May 6th, the SEC/CFTC joint committee reported that a large order had entered the market in the e-minis and then a sequence of events led to the flash crash. Those events included HFT market makers shutting down their systems and internalizers not accepting orders and instead shifting them to the publicly displayed exchange market. With these two sources of “liquidity” out of the market, the market spiraled down as “hot potato” volume chased prices lower and lower. The mortgage REIT sector appeared to exhibit these same traits last Friday.

Due to its tight spreads and low volatility, the mortgage REIT sector is usually easy pickings for HFT rebate traders. These rebate traders usually are happy just collecting their exchange provided liquidity rebates and don’t even need to make a trading profit. They dominate the volume in these types of stocks. They also skew the average daily volume in these types of stocks and this could be extremely damaging to a real seller looking to exit a position. Nothing ruins a highly leveraged, rebate traders day more than a real order in a stock. They will run faster than cockroaches when a light is turned on once they sense a real order. This is exactly what appeared to happen on Friday in this sector. We are still investigating what type of order entered the market and how large it was but the damaging effects were felt across the sector.

Investors who felt safe placing stop limit orders 10% below the market were quickly stopped out on Friday (by the way, no circuit breakers were activated since none of these stocks are in the Phase 1 part of the current single stock circuit breaker system). Our markets today are no longer driven by rational thought processes. They have been hijacked by machines who just follow their programmers instructions. In this case, the machine was instructed to sell and left a mile-wide path of destruction. After looking at these events, do you really believe that a larger flash crash couldn’t happen again?