Mortgage REIT Regulatory Risks Continue To Surface

by: Zvi Bar
After a difficult summer for the mortgage REIT (mREIT) industry, it appears that these entities are entering a high-risk autumn. These entities survived the debt ceiling crisis and a mini flash crash within mREITs, only to finally receive a blessing from the Federal Reserve, which announced that interest rates should stay low for the next two years. After all that, these mREITs emerged from this volatile August to be confronted with rumors of their potentially imminent demise.
mREITs buy mortgage paper as an investment, or in order to hold for yield or re-securitize and sell to another mREIT or other entity. Agency mortgages are backed by federal agencies, while non-agency debt has no such backing. Three well-known agency mREITs are Annaly Capital Management (NYSE:NLY), American Capital Agency (NASDAQ:AGNC) and Hatteras Financial (NYSE:HTS). Three well-known non-agency mREITs are Chimera Investment Management (NYSE:CIM), MFA Financial (NYSE:MFA) and Invesco Mortgage Capital (NYSE:IVR), though these companies also can and do buy large positions in agency paper. Index funds for mREITs include the FTSE NAREIT Mortgage REITs Index ETF (NYSEARCA:REM) and the Market Vectors Mortgage REIT Income ETF (NYSEARCA:MORT).
Recently, speculation has begin to spread as to whether these mREITs deserve the preferential tax treatment of a REIT while merely holding securitized loans at high leverage. Several have now begun to speculate that these mREITs may suffer the loss of either their REIT status or possibly their ability to utilize significant leverage. Several mREIT leverage rates are now well above five times equity.
REITs must distribute at least 90% of their taxable income in order to eliminate the need to pay income tax at the corporate level. Under the current tax laws, REIT dividends are taxed as ordinary income, and not at the lower corporate dividend rate. This present speculation appears to presume that these leveraged note holders may be forced to choose whether they prefer that leverage or their REIT status.
Mortgage REITs would not be able to maintain such high dividends if they were forced to convert to a corporate structure, but those lower dividends would also then get taxed at the currently lower dividend tax rate, as opposed to the income tax rate. This differentiation may change over time, especially if recent plans to increase dividend taxes are implemented.
Similarly, if most mREITs were required to not lever themselves above, for example, twice their equity, their yields would also come down considerably. Most mortgage REITs produce high yield returns by leveraging a spread. The spread is the profit margin the REIT can achieve between the rate on the money they borrow and the rate paid by the mortgage paper they hold. For example, if a company can borrow at 3% and buy paper that yields 5%, the spread is 2%. The level of leverage used by the mREIT then multiplies that spread payout. Less leverage mean the spread is multiplied less, and the dividend would stay lower.
This leverage risk is one that the market as generally not considered, though a clear issue. Several of the lowest leveraged non-agency or hybrid mREITs, such as CIM and MFA, hold some of the highest risk paper, but some of the lowest leverage risk. This fact was generally unappreciated and they now carry more clear and understandable risks than do agency mREITs, which are so heavily leveraged while holding only one asset: government backed MBSs. As often happens at points of pressure, it is possible that the higher risk non-agency mREITs could soon be deemed the lower risk option, or at least the more survivable operating model. All of this depends on future regulation.
Though agency mREITs are viewed by many as a relatively safe investment, it is also one that has a highly leveraged and non-diversified focus. Moreover, this focus could start to generate fear of coming regulatory risk hitting these businesses from multiple angles. For example, it is possibly that not only could they face scrutiny over leverage rates and tax pass-through status, but also agency backed MBSs could face expiration.
Other recent rumors have speculated that the U.S. government may end up eventually choosing to buy up much of the outstanding agency backed paper and discontinue the process of backing future paper. If this were to occur, it could mean the death of the asset class entirely. This is known as reinvestment risk. While existing agency mREITs would receive cash for those securities, if the ability to buy additional similar paper were removed then they would probably have to close shop or dramatically change.
Disclosure: I am long NLY, CIM.