We are in unchartered territory I know. When crises happen, people have different reactions and they don’t always act logically, this is especially true when it comes to their money.
There have been a number of casualties of Covid-19 in the market. One of these that has caught income investors attention recently is the performance of mortgage REITs or mREITs. A look at the iShares Mortgage Real Estate Capped ETF, which holds a number of mortgage REITs, gives an idea of how the sector has imploded in the past month.
Source: Market Watch
At one point, this ETF was down 73% from its recent high in February. Why are mortgage REITs in particular getting slammed and what is the logic behind it?
Agency vs. Non-Agency
Many people think that the bank holds your mortgage after they lend you the money. This is only true for about the first year in many cases. After that, the banks get your risk off their balance sheet and package your loan with thousands of other loans and sell it as a bond to investors. These are called MBS or mortgage backed securities.
Since the Great Depression, the government has underwritten a large portion this market. If your loan conforms to the basic terms set by Fannie Mae and Freddie Mac, two government sponsored entities, they will buy your mortgage from the bank, package it in with thousands of other mortgages and sell it to investors, all with an implicit government guarantee. This is where the basic terms of your mortgage come from, 15 or 30 years, amortizing and fixed or floating rate. All these terms are set by the government and it is quite unique to the US, many other countries do not have mortgages that go beyond 10 years.
This makes a distinction between agency MBS (those issues by Fannie Mae and Freddie Mac) and non-agency MBS. Why this matters will come into play shortly but first it’s also useful to have a basic understanding of how mortgage REITs work.
A Simple Model of How a Mortgage REIT Works
What mortgage REITs do is essentially borrow short term and lend long term and take advantage of the interest rate spread between the two. They do this by buying those MBS securities that may yield 2.0% and then they post those securities as collateral through a repurchase, or repo, agreement with a bank which charges an interest rate called the repo rate.
The bank also applies a discount to the collateral used for the loan which is called the haircut. For example, if a bond posted as collateral is worth $100, the mortgage REIT agrees to buy it back the following day for $100 and the bank will “purchase” the collateral at $99.50 today. This is in addition to the repo rate previously mentioned.
Mortgage REITs are known to post up to 85% of their assets as this collateral, on which they still receive the interest income. This allows them to get outsized returns on the small 2.0% yield mentioned previously.
To give an example of how this process works consider the following:
- A new mREIT issues equity of $10 million, it then uses the $10 million raised in cash to go out and buy $10 million worth of MBS.
- It uses the $10 million MBS as collateral to borrow $9.5 million, in this example there is a 5% haircut.
- It then uses that $9.5 million to buy more MBS and then uses that MBS as collateral for another loan of $9.025 million.
- In theory this process can be repeated until the mREIT has reached a maximum leverage of 1 divided by the haircut rate or in this case 1/.05 = 20 times or $200 million. Most mREITs do not have this high leverage and tend to stay somewhere in the 7x to 10x range.
The simplistic transaction is a bilateral repo. This transaction was visualized in a paper by the New York Fed below.
Source: New York Fed
This leverage is what allows the mREITs to provide eye popping yields on boring assets. If the spread is 1.5% on what is earned on the bonds versus what is paid in the repo market, we divide the spread by the proportion of equity to get the yield for the equity investors. If leveraged 7x this yield is 1.5/.142 = 10.56%.
Obviously this is a simple example and can get much more complicated in terms of how a mortgage REIT finds itself. Mortgage REITs may issue always types of debt both short and long term to leverage themselves and enter into derivative contracts to hedge the risk of changes in the interest rate curve. Curve management is critical for mortgage REITs because they tend to do better in a falling interest rate environment while income usually falls in a rising rate environment.
Why Agency Mortgages Are an Important Distinction
So we now know how these mortgage REITs offer those famous high yields in normal times, but what is going wrong in the market today and why have they dropped so much?
In normal times the small haircut allows mREITs to operate with that high level of leverage and continually post the MBS as collateral for their short term loans with a small haircut. When the value of those MBS starts to fall rapidly though, like in a credit market seize up, chaos ensues as the haircut demanded by the lender increases dramatically and the lenders asks for more collateral to be posted to cover the decline in value. This causes the mREIT to have to unwind some of its repos and post the MBS they get back as collateral for another lender. This could in theory work if one or two lenders asked for additional collateral at the same time but when they all do at once, it’s like a run on the bank and the mREIT will not have enough MBS to go around and will be forced to default, losing their assets to the lender.
What triggered this jump in haircuts? The fact that millions are out of work and may not be able to pay their mortgages has spooked the MBs market. There exists a lot if uncertainty as to whether investors will get paid in the coming months, especially if many go through with the moratorium on mortgage payments. In addition to the moratorium, if unemployment jumps to 30% like some at the St. Louis Fed have predicted, even with the mortgage holiday, we may see a wave of defaults across the US. This would cripple the value of mortgage securities, lenders are concilia of this risk and in turn demanding collateral based on depressed values showing up in recent transactions.
This is where the agency vs non-agency distinction becomes important. The Fed’s charter authorizes then to lend with government securities as collateral. This includes T-Bills and treasuries but most importantly here, also includes agency mortgage debt. The Fed has stepped in as a backstop for prices of the agency debt, extending repo lines to those lenders who can then offload them to the Fed at a reasonable haircut, this provides a floor to the market. The lender can then pass those rates onto the mREIT who is able to post agency MBS without the huge haircut that lenders were demanding before the Fed stepped in.
In fact, this is critical to the repo market in general. Treasuries provide the bulk of the collateral for repo lending in the market but agency MBS collateral is the second most important type.
Source: Richmond Fed
Two Names That Will Likely Survive
There are two large names in the mREIT space that tend to be professionally managed, play it safer and focus on agency debt, these are Annaly Capital Management (NLY) and American Capital Agency Corp. (AGNC). Although the below is a bit dated, the asset and funding composition of these two mREITs hasn’t changed dramatically.
Source: Richmond Fed
As you can see above, in the case of Annaly, about 95% of the MBS they held was agency debt. This means that the Fed has given forms like this a lifeline and that it is highly unlikely they will default on their lenders. It’s a similar story for AGNC where 85% of their MBS assets were agency debt.
Even if there is a moratorium on mortgage payments, this likely won’t be the end of the world. The latest interpretation of the relief package has homeowners who have been affected by the pandemic to opt for forbearance of their payments, similar to what is done in natural disasters. This would mean a borrower would be able to skip mortgage payments for six months but then would have those payments tacked onto the end of their previously scheduled end date. This allows the borrower to maintain their credit rating and not see their house go into foreclosure.
The worst potential downside for the mREITs holding agency debt is that they may have to suspend dividend payments for a quarter or two. This doesn’t mean there isn’t value in these stocks and it definitely means they won’t go to zero.
The ones that may be in serious trouble though, are those that hold much of their assets in non-agency mortgage debt and continue to see massive haircuts and margin calls from lenders. Invesco Mortgage Capital (IVR) has assets like these and has seen its value plummet as much as 85%. The company suspended all dividends last week as it failed to meet margin calls.
Conclusion
There are great deals to be had in this space currently. Annaly is yielding over 17% based on its most recent dividend while AGNC is yielding 16.4%. Keeping to the quality names and knowing what you are investing in may enable some savvy investors to take advantage of this mis pricing in the short term.
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