Published September/October 2013
Financial markets have had a case of the jitters any time officials at the Federal Reserve discuss a possible end to the quantitative easing program, and mortgage REITs have been particularly sensitive to the news since May. The sector’s total returns fell 15.3 percent in the second quarter of 2013 and were down nearly 5 percent for the year-to-date through late August.
Just as the broader equity markets rebounded from their initial sell-off, though, mortgage REITs are likely to benefit from trends in the mortgage markets that will present opportunities in the months and years ahead. With the future of Fannie Mae and Freddie Mac up in the air, and other traditional lenders like commercial banks unable or unwilling to increase their involvement in the home mortgage market right now, mortgage REITs are well positioned to bring new capital to support the housing market recovery.
“Many banks have lost the degree of appetite that they used to have to hold residential mortgages or MBS [mortgage-backed securities] in their bank portfolio,” says Lloyd McAdams, CEO of Anworth Mortgage Asset Corp. (NYSE: ANH). “The same is true of insurance companies. In the last 15 years, mortgage REITs have become quite prominent and acquired a lot of these mortgages. What is unique about mortgage REITs is that they have a long-term commitment to owning mortgages, and I think that does support the U.S. housing market.”
Mortgage REITs, which can raise capital in the public markets without any government guarantees and without relying on FDIC-insured bank deposits, have been an increasingly important source of funding for the residential sector. Mortgage REITs increased their holdings of agency mortgage-backed securities from $90 billion in 2008 to as much as $350 billion in early 2013, according to the Federal Reserve’s Flow of Funds Accounts. Their ability to provide much-needed capital and liquidity to the market has helped provide the financing needed to facilitate the emerging housing market recovery. Mortgage REITs now stand poised to play an even greater role as the government moves forward with plans for housing finance reform.
Mortgage REITs in the Post-GSE World
The Financial Stability Oversight Council (FSOC) recently stated that a top priority for a more stable mortgage market is to draw more private capital into the housing market to bear credit risk. The thinking is that doing so will help support the housing sector while also reducing the risks to U.S. taxpayers posed by the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac.
Given their ability to raise capital in public markets without direct government backing, the new direction in public policy should create an opportunity for mortgage REITs in the post-GSE mortgage market. Indeed, mortgage REITs have actively raised capital, including more than $8 billion through equity offerings in the first half of 2013, following $13.4 billion in 2012 and $16.5 billion in 2011.
Mortgage REITs have also played a role in securitizing mortgages beyond the government-guaranteed GSE bond arena. For instance, Redwood Trust (NYSE: RWT) came out with the first private-label residential mortgage-backed securities (RMBS) issuance following the housing market downturn. Others have emerged to take advantage of post-crisis opportunities, with 20 new mortgage REITs raising total capital of more than $50 billion since 2008, according to Annaly Capital Management, Inc. (NYSE: NLY), which invests in agency RMBS. McAdams of Anworth says he expects that there will continue to be credit support from some kind of government entity for the mortgage market, providing opportunities for his company as well.
SECTOR SPOTLIGHT STATS:
Sector: FTSE NAREIT Mortage REITs
Dividend Yield: 3.02%
One-Year Return: -7.34%
Three-Year Return: 8.41%
Five-Year Return: 10.91%
Dividend Yield: 13.04%
Avg. Daily Tracing Volume (shares): 2.0 million
Source: NAREIT. Data as of Aug 15, 2013
“You wouldn’t think that it would be in the best interest of public policy to prevent people from being able to get a mortgage,” he says. “So, I’m going to assume that the very same people who were provided financing through Fannie Mae and Freddie Mac will still be provided financing because of some other government entity.”
The rising prominence of mortgage REITs also brings with it greater scrutiny from regulators and investors.
In its 2013 annual report, FSOC pointed out the potential for “convexity event risk.” This could come about as interest rates start going up and REITs sell Treasury notes or bonds in an effort to hedge risk as mortgage prepayments decline and their RMBS portfolio durations rise.
The FSOC expressed concern that “this hedging activity, in turn, can cause interest rates to rise further, which may increase the duration hedging need for other MBS holders, inducing another round of duration sell-offs.”
However, the FSOC also said it believes that such an event is less likely today than in previous periods of rising interest rates. While the amount of mortgage REIT assets has grown, they have had a “relatively stable” amount of leverage following the financial crisis, even as their total assets have gone up.
Another potential source of risk for mortgage REITs comes from their funding strategies. The REITs that invest in agency RMBS primarily rely on repurchase agreements, or “repos,” whereby they pledge the bonds as collateral to lenders and raise money to invest further. The FSOC report points out that there is a rollover risk, since they borrow for short terms to invest in longer-term assets.
Other REITs that invest in loans, taking on credit risk, typically have access to warehouse facilities from large banks and broker-dealers.
“Mortgage REITs are dependent upon outside entities for their financing,” notes Jason Arnold, an equity research analyst with RBC Capital Markets. “So, if something were to happen—such as 2008, 2009 all over again, where credit becomes a big concern—then the credit-focused strategies would potentially be at risk of having their lines pulled or haircuts increased.”
Notably, credit-focused mortgage REITs that had high levels of leverage or exposure to riskier assets struggled during the credit crisis.
Mortgage REITs also face a financing mismatch in that the funding sources for mortgage REITs are linked to short-term rates, typically the fed funds rate. Their investments, however, are tied to longer-term rates, with mortgages pricing off the 10-year Treasury bond.
Arnold says he’s not unduly concerned about the earnings impact on mortgage REITs as their funding costs go up in a rising interest rate environment: “The fed funds rate is typically the one that drives earnings a lot more meaningfully, so you wouldn’t have as much current direct book value impact, because, presumably, if short-term rates are going up, the long end of the curve is potentially going up as well.”
Market Reaction to Tapering
Mortgage REIT investors have been rattled of late, anticipating the impact of a higher interest rate environment as the economy gradually recovers.
“As a result of the worries about interest-rate risk, mortgage REIT stocks have declined, in the same order of magnitude as a lot of other yield-oriented stocks,” Arnold says.
The concern is that as the Fed ends its purchases and mortgage interest rates go up, the value of RMBS held by mortgage REITs will go down, impairing their book values.
“As with every financial company, when you transition from a very low interest rate environment to a higher interest rate environment, there are negative impacts on the assets you already own,” says Annaly CEO Wellington Denahan.
That negative impact was reflected in the latest round of earnings reports. In July, mortgage REIT American Capital Agency Corp. (NASDAQ: AGNC) reported a loss of $936 million, equivalent to a loss of $2.37 per common share. That included a charge of $2.8 billion, or $6.98 per common share, primarily derived from “net unrealized losses” on investments that were marked-to-market. The company’s book value fell from $28.93 per share in the previous quarter to $25.51 per share, a decline of nearly 12 percent.
“The second quarter was characterized by extreme volatility in both interest rates and mortgage spreads,” said Gary Kain, the company’s president and chief investment officer.
Looking ahead, mortgage REITs are adapting to the changing interest rate environment. For example, in response to the turbulence of the second quarter, American Capital Agency reduced the size of its portfolio, adjusted its asset mix and altered its hedging strategy.
Such hedging strategies have become an increasingly popular way for mortgage REITs to deal with interest rate risk since the days of 1994, when the Fed’s interest rate hikes upset the sector. By taking into account the payouts an investor receives from a bond over its life, bond duration provides a refined measure of bond investors’ exposure to interest rate risk during the time that they hold the bond, with a shorter duration exposing the investor to less interest rate risk.
“The objective is to reduce the duration of the portfolio to lessen the portfolio’s exposure to interest rate risk,” McAdams explains.
Hedging strategies have grown in sophistication, too, according to Denahan.
“In 1994, the derivatives market, the interest-rate swap market, was a very small, unsophisticated market with very few players,” Denahan notes. “So, your ability to hedge was more limited back then. There has been a tremendous evolution (since then) of the options that you have available to hedge some of the volatility.”