The Securities and Exchange Commission (SEC) last week issued a concept release that reexamines the ability of REITs to use an exclusion under the Investment Company Act of 1940.

The original purpose of  Section 3(c)5(C) in 1940 was to offer an exemption for mortgage banking businesses that were not investment companies, an exemption that REITs currently enjoy.

The SEC, which said that it will be reexamining this exclusion and which cited the significant changes in the mortgage industry since 1940, opened the comment window for 60 days from the first announcement on Aug. 31.

Although the concept release "introduces the specter of REITs losing exemption from Investment Act regulations. However, it is important to keep in mind that a concept release is a first step in the rule-making process and is intended to solicit market participant viewpoints," equity analysts from Jefferies said.

The analysts expect the outcome to be determined by the government agency's trying to balance the trade-off between its stated goals of congressional intent and helping capital formation.

Given the considerable damage on the U.S. mortgage market and economy, Jefferies analysts expect "at the end of this process REITs will still have Investment Act exemption."

In the SEC's request for comment, a lot of focus is given to the potential costs that the rule changes will have and the SEC has indicated that one of its options will be to take no further action on the matter.

However, Bank of America Merrill Lynch analysts said that REITs will be unlikely to sell agency MBS until there is more clarity in the  changes.  

They said that  the impact on the mortgage market can actually come if the steady demand from REITs in the order of $ 10 billion per month in 2011 tapers down.

"This would happen if REIT stock prices are pulled down close to or below book value, thereby reducing the incentive  to raise additional capital," they wrote in a Sept. 7 report.

Longer-term, BofA Merrill analysts supported Jefferies' view when they said it does not seem that the SEC is looking to make any drastic change in the rules that govern agency REIT operations.

"With GSEs out of the picture, REITs have increasingly become a key source of demand for agency MBS. As a result, the possibility of curtailing this demand presents a clear risk to the downside for MBS; the upside is that nothing changes as the application of the relevant rules is clarified," they stated.

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