Mortgage REITs (mREITs) continued to face downward pressure as last week closed, following the SEC’s Wednesday announcements that it was seeking comments on issues germane to the mREIT business. In particular, the SEC is concerned with derivatives and asset backed issues. Do keep in mind, though, the SEC has only stated they are seeking comments on these matters, and that these announcements are wholly non-determinative, brief and vague.
In particular, one SEC release (2011-176) questions the future treatment of asset-backed issuers as well as real estate investment trusts (REITs) and other mortgage-related pools under the Investment Company Act of 1940. Rule 3a-7 of the Act excludes certain issuers of asset-backed securities from having to comply with the requirements of the Investment Company Act. The SEC also singled out Section 3(c)(5)(C) of the Act, which specifically exempts businesses involved in “purchasing or otherwise acquiring mortgages and other liens on and interest in real estate.”
Immediately before that release, the SEC also released an announcement (2011-175) it was seeking comments on the use of derivatives by mutual funds and other investment companies regulated under the Investment Company Act. While this does not directly involve mREITs, it could if they were to lose their REIT status based upon that other release issue that specifically references Section 3(c)(5)(C).
Release 175 refers back to a prior SEC derivatives announcement from last year (2010-45), which involves several concerns over derivatives and leverage, including leverage, concentration and diversification provisions of the Investment Company Act, as well as funds that rely substantially upon derivatives to provide leveraged returns. These concerns were primarily raised regarding the emergence of ETFs that are leveraged to double or triple an index, sector, industry, currency, commodity and any other product for which options and/or futures markets exist.
While these derivates and leverage concerns were not particularly raised towards mREITs, one can see how individuals would connect the dots. If mREITs were to lose their exemption and not qualify for another, while a simultaneous cap was placed on the leverage used by such non-exempt entities, then several mREITs would probably have to deleverage. This would require multiple significant regulation changes.
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, a business which exempts them under Section 3(c)(5)(C). 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 and/or hybrid mREITs are Chimera Investment Management (NYSE:CIM), MFA Financial (NYSE:MFA) and Invesco Mortgage Capital (NYSE:IVR). Index funds for mREITs include the FTSE NAREIT Mortgage REITs Index ETF (NYSEARCA:REM) and the Market Vectors Mortgage REIT Income ETF (NYSEARCA:MORT).
Several of these companies have reasonably high leverage when compared to those double and triple ETFs being questioned. For example, AGNC’s leverage was 8.7 times equity as of the end of the second quarter, with Annaly at 6.65x and Hatteras at 6.27x equity leverage. The non-agency mREITs usually have lower leverage, with MFA at about 2.96x and Chimera at about 1.89x leverage.
As the hybrid and non-agency mREITs have lower leverage, they should have less added risk here. The real leverage within this asset class is in the agency business, so this current regulatory risk is more concerning to them. Nonetheless, the SEC has traditionally deemed agency whole pool paper as a particular asset class that should be exempt from fund regulations, and much of this immediate panic is likely excessive. Their leverage, though, could expose them to interest rate risk if interest rates ever do spike up.
As to their qualification as a REIT, this is a very different issue and a very different subject matter. REITs must distribute at least 90% of their taxable income in order to eliminate the need to pay income tax at the corporate level, but these mREIT dividends are taxed as ordinary income, and not at the lower corporate dividend rate.
Modification from the REIT model would change them but not necessarily destroy it or even worsen it. These businesses could conceivably run better under an alternative corporate structure by more easily reinvesting returns towards growing a book of investments without consistently seeking funding through serial secondary offerings. Additionally, while the yields would reduce, they would qualify for a lower tax rate that would at least slightly offset that reduction, and the shares could also appreciate.
Nonetheless, given the little that the SEC has stated and the traditional reverence given to the agency backed securities, it appears likely that the SEC would more expressly exempt agency whole pools under any changes to the current regulations. Additionally, any pending regulations regarding leverage will also more likely be restricted to ETFs.
Disclosure: I am long NLY, CIM.