It's not enough that retail investors have been squeezed with 2% CDs, 1% Treasury notes or 0.10% money market funds. Now, the do-gooders in Washington, DC, are reported to be gunning for the Mortgage REITs, a popular sector with retail investors that I have written favorably about before on Seeking Alpha. Mortgage REITs have undergone a tremendous explosion in size recently, nearly quadrupling their portfolios since 2009. This has placed them on the radar screen of Federal Reserve officials like Jeremy Stein, Washington regulators and the SEC.
Recent news stories have indicated that certain Mortgage REITs - specifically, Annaly Capital Management (NYSE:NLY) and American Capital Agency (NASDAQ:AGNC) - might be in the crosshairs of regulators under the guise that the total size of their investment portfolios (over $100 billion) makes them a systemic risk. While the reaction was muted compared to the 2011 announcement by the SEC that they would be looking at the MREIT exemption to the 1940 Investment Act, it nonetheless opens up the possibility that increased regulatory restrictions - or even just the fear of such restrictions showing up in news articles - could negatively impact the stock prices of the MREITs. Given that the MREIT sector has provided attractive yields, excellent risk-adjusted total returns, and added liquidity and funding to the mortgage market, any regulation or interference should be based on fact and not ignorant hysteria regarding "too big to fail" or other such popular trite clichés.
I believe that both the (pending) SEC decision on the 1940 Investment Company Act exemption as well as the attempts to corral the MREITs under the Financial Stability Oversight Committee (FSOC) are misguided. MREITs' total investment portfolio assets ostensibly qualify them as Systemically Important Financial Institutions (SIFI), just like banks or other lending institutions. However, not only are the MREITs among the least risky sectors of the financial world, they provide a valuable service - and one that will increase in coming years - in adding liquidity and funding to the mortgage market. This will become increasingly important as the GSEs - Fannie Mae (FMNA.OB) and Freddie Mac (OTCQB:FMCC) - are wound down and their portfolios downsized (currently targeted at a 10% reduction per annum). Without both the agency MREITs and their hybrid cousins to take up the slack, mortgage costs would increase and so would the cost of housing. This would likely stop any recovery from the housing bubble in its tracks.
Pop-Quiz Time: What is riskier, an investor owning 10 homes worth $10 million with loan-to-value (LTV) ratios approaching 95%, or an investor owning 50 homes worth $50 million with LTVs at 50%? In the former, you are leveraged 20:1 with equity at 5%. In the latter example, you are leveraged 1:1 with equity at 50%. MREITs are closer to the latter example because even as the MREITs have expanded their asset base tremendously in recent years their leverage has come down from 9-12x to the current range of 6-8x. The explosion in assets has been done by raising equity as the chart below shows:
At 7x average leverage over the last 5 years, the $40 billion raised from 2009-13 would account for $275 billion in agency MBS purchases. But 7x leverage is less than half what the average bank is leveraged with far more riskier assets.
In 2011, the SEC extended an invitation to the investing public to offer comments regarding a re-examination of the exemption given to MREITs under the 1940 Investment Company Act. Virtually all Washington elected officials who offered comments and input backed the continuation of the exemption. Since this same group had passed the Dodd-Frank bill a year earlier to regulate banks and the financial system, that should bode well for a favorable outcome from the SEC, especially in regard to the agency MREITs.
However, the hybrid MREITs may find that in the future they are closer to any regulatory leverage ceiling imposed on them by the SEC or FSOC. This could end up being a function of the percentage of non-GSE MBS that an MREIT holds as well as the specific type (IO, PO, CMO, pure credit sensitive MBS, etc.). So investors in American Capital Mortgage (NASDAQ:MTGE), Invesco Capital Mortgage (NYSE:IVR) and Two Harbors Investment (NYSE:TWO) will want to keep an eye on the SEC and FSOC. Hybrid MREITs invest in less-liquid assets that are likely to attract the scrutiny of both overseers more so than pure agency pass-through MBS. Remember, even small allocations to non-agency MBS or other less-liquid MBS can represent a large portion of equity capital, thus increasing risk.
Riskier non-agency debt compounds the problem. This is why Chimera Investment (NYSE:CIM) had such a large price meltdown from 2008-09 and is still underwater, whereas MFA Financial (NYSE:MFA) has generated positive returns over the same time horizon:
Agency MREITs can act very differently over time from hybrid MREITs, and within the hybrid sector there is just as much variation. Just as investors must discriminate between the 2 types of MREITs and within each sector, hopefully regulators will also be careful and discriminating rather than imposing a one-size-fits-all approach.
Gary Kain, the highly-regarded CIO of AGNC, ran a portfolio that was $700 billion at Freddie Mac with leverage approaching 50:1. Nobody worried then but now that Kain and AGNC are running $100 billion that is leveraged 8:1, we are supposed to panic? At Freddie Mac, a 2% drop in asset prices would theoretically wipe out the equity - such a move would have been equivalent to an instantaneous rise in mortgage rates of about 40-50 bp. (of course, it was credit that did in Freddie, not rising rates). Today, it would take a 12% drop in prices or a rapid 175-250 bp. rise in mortgages to wipe out an agency MREIT's equity. These figures are inexact - MBS have dynamic duration and convexity characteristics and MREITs have offsetting hedges, swaps and swaptions, etc. - but they show the extent of the size of the price declines necessary to cause a problem for the agency MREITs and lead to systemic risk.
The average agency MREIT is leveraged at about 8:1. These MREITs have close to 100% of their assets in U.S. Government Agency MBS. These securities are the 2nd most liquid, safest securities in the world. They are held by the Federal Reserve, global central banks, pension funds, mutual fund companies, and other large institutional investors. They trade close to $275 billion a day, a figure dwarfed only by the U.S. Treasury market which trades $550 billion a day.
Other U.S. markets are no where near as large, liquid or price transparent. The municipal bond market trades about $11 billion a day, non-agency MBS trade $5 billion in daily volume, and the entire corporate bond market trades no more than $20 billion a day. When the Chinese Central Bank or PIMCO or a state pension fund wants to move tens of billions into fixed-income investments, they are not going into illiquid corporate bonds which might trade a few billion a day, or even government bonds issued by EU countries, the BRICs, or emerging markets. There simply is not enough daily volume to make a big daily or weekly move. Even the British gilt market might trade $40 billion a day, too small for the elephants to move in-and-out of without disrupting it, and the German bund market trades about $20 billion daily.
Most mortgage-backed securities (MBS) are Level 1 assets: easily observable prices in a liquid market. Level 2 and Level 3 assets are more difficult to price, much more illiquid. While some of the hybrid MREITs have some Level 2 assets, they use very low leverage on these securities. Most are leveraged 3-5x in the aggregate between their agency and non-agency MBS. Traditional REITs such as the mall REITs have an average leverage ratio of 7x but many own dozens or hundreds of malls, outlet centers and other retail locations. How long would it take Simon Property Group (SPG) or another mall REIT to liquidate and go to their stated book value or sell themselves to a potential acquirer? Months, if not years. Not so for even the most aggressive of the hybrid MREITs. It's even better for agency MREITs, as we will see below.
Contrast this with banks, which have balance sheets stuffed to the gills with illiquid, hard-to-value Level 2 and Level 3 assets. Indeed, it was the evaporation of prices in 2008 that led to the suspension of the mark-to-market rule on the grounds that it was leading to a vicious circle in the financial sector. Most money center banks and even local thrifts are leveraged about 15:1 on a hodge-podge of Level 1, 2, and 3 assets. Now, which do you think the government regulators should be worrying about: the MREITs which own 100% super-liquid, AAA-rated collateral leveraged at 8:1 or less, or the banking sector which owns large swathes of illiquid, hard-to-value assets with suspect credit quality and leverages them up on average 15:1?
Here's another question the regulators should be forced to answer. MREITs and banks have published book values, the liquidation value of all their assets. How long would it take a financial entity to self-liquidate and go 100% to cash? Even the largest of the agency MREITs, NLY and AGNC, could probably liquidate to book value within a week or two at the most. And in 1 day they could easily de-lever a tremendous amount just by selling $10-$30 billion in MBS without crushing the market for bids. Now, how long would it take JPMorgan (NYSE:JPM) or Bank of America (NYSE:BAC) to liquidate their Level 1, 2, and 3 assets, their equity and real estate holdings, thousands of bank branches and ATMs, and dozens of loans and support divisions and locations? Probably a few years, unless they wanted to crater the market for their assets in a firesale. Again, why worry about the MREITs with safer, more liquid assets, leveraged at half the level of the money center banks?
On a price-book basis, both the agency and hybrid MREITs are not at previously elevated levels. Whereas P/B levels of 120-150% were the norm 5-7 years ago, both sectors are close to 100% today. If each is trading around book value with mostly Level 1 assets (some Level 2 for the hybrids), why the obsession to regulate or worry about the MREITs?
The SEC is absolutely right to look at leverage (though I wish they would focus more on the pure banks) since the safest collateral combined with illiquidity and/or high leverage can be a death sentence. Carlyle Capital was an agency MREIT that did collapse in March 2008 but only because they were running leverage close to 30:1 while purchasing illiquid CMOs and other non-pass-through (but AAA-rated) MBS. At 30:1, a 3% decline in price effectively wipes you out and the inexperienced team quickly put together by Carlyle (they had been operating less than a year) was clearly not up to the task of navigating even the early pre-Lehman part of the 2008 Credit Crisis. Thornburg Mortgage, a popular investment with many retail investors, also collapsed in 2008. Thornburg invested largely in traditionally-safe Jumbo mortgages and MBS - usually low-LTV, high-FICO mortgages - but was running leverage at 18:1 when they stumbled. Jumbo mortgages do contain some credit risk and with only a 6% price drop wiping out Thornburg's equity capital it did not take much of a buyers strike for Jumbo MBS to bring the company down.
Instead of wasting time examining the agency and hybrid MREITs, the SEC and FSOC should simply look at general guidelines to prevent a gluttonous approach to leverage (probably 12-15x for the agency MREITs and 6-8x for the hybrids) if they do anything at all. Better to focus on the higher-leveraged, stuffed-to-the-gills money center and regional banks. Their balance sheets still have God-forsaken loans and in many cases have not recognized the losses on those assets, preferring to delay and obscure the day of reckoning.
Since inception in 1997, Annaly Capital Management has delivered annual total returns of approximately 16.5% a year, versus 3.1% for the S&P 500. American Capital Agency has returned 33.7% since May 2008 against a 9.8% total return for the S&P 500. Agency and hybrid MREITs are not without risks, but these kinds of high-dividend, low-volatility income vehicles are not easily replicated for retail and small investors. With traditional avenues of savings providing practically no return, the last thing the American investing public needs is for the SEC and FSOC to start screwing around with the one sector of the financial industry that is fully transparent, has reduced leverage and raised capital, and deals in one of the largest and most liquid fixed-income sectors in the world.
As one of the savviest investors I know who has dealt with MBS and MREITs for over 3 decades said regarding the 2011 SEC investigation: "The current pain inflicted on this space by…regulatory uncertainty borders on insane given how well the (MREITs) have done and their history through crisis periods, as well as the need for these companies to help keep mortgage rates low for middle-class buyers at a time the country is desperate to help the housing markets."
If you agree, continue to support the Seeking Alpha writers who write about Mortgage REITs as important contributors to retail investors' portfolios. Also, continue to track SEC developments and be prepared to comment as an investor on any future proposals. My Retiree Income Portfolio at PortfolioChannel.com has a heavy allocation to both agency and hybrid MREITs and I offer extensive commentary and analysis on the sector. Finally, consider visiting ValueForum.com where extensive buy-side and sell-side commentary on the plusses and minuses of investing in MREITs takes place daily.
Don't let small talk about "too big to fail" nonsense impact the little guys (and gals)!
Disclosure: I am long AGNC, MTGE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Individual accounts managed by the author online or for family members may have a position in the listed securities mentioned.