In early September, the Securities and Exchange Commission sent shockwaves through the mortgage REIT market seeking comment
regarding the treatment of asset-backed issuers and mortgage REITs. The SEC document
(pdf) provides background on the history of mortgage REIT regulations, raises questions on the industry’s legal and tax status and importantly for investors the use of leverage.
Mortgage REITs are defined as companies that are engaged in the business of acquiring mortgages and mortgage-related instruments that rely on the exclusion from the definition of investment company in Section 3(c)(5)(C
) of the Investment Company Act of 1940.
Based on the investor protection, the SEC regulates investment companies’ use of leverage, asset valuation and reporting, and corporate governance. Mortgage REITs enjoy a broad exemption under the Investment Company Act. This exemption has allowed mortgage REITs (particularly agency mortgage REITs) to “lever up.”
The mortgage REITs business model is relatively simple: borrow short and lend long, while making money on the spread. Mortgage REITs utilize leverage to amplify returns.
Under regulations, an investment company is limited in its use of leverage (assets divided by equity) of less than 2.0x. As depicted in the table below, agency mortgage REITs currently employ significantly higher leverage.
The SEC is questioning whether agency focused mortgage REITs, which primarily invest in “agency” mortgage backed securities that are akin to a bond fund, should be regulated similarly as other bond funds. Translation
: lower leverage.
A forced deleveraging from 7.0x leverage to 1.5x leverage would put pressure on the mortgage backed securities market. As shown in the table below, investment companies carry significantly lower leverage.
That said, even non-agency focused mREITs like Chimera Investment Corp. (CIM
) would be affected by this, despite having relatively lower leverage. The Marginal Buyer
The recent growth in mREIT issuance has turned the asset class into an important mortgage backed securities investors. While traditional investors such as banks and foreign investors have cut back, mREITs and their access to leverage have become the new marginal buyer of MBS. As shown in the graph below, the rate of change has been parabolic since 2009. Since early 2010, REITs have net purchased $130B MBS. At the same time, government entities (the Fed, Treasury, and GSEs) have been net shedding their MBS holdings by around $95B, $75B, and $45B, respectively. Conclusion
While we have been long-term holders of mREITs, we are not blind to the fact that there are risks associated with these investments. That said, investors get paid to take risks and it's imperative that they understand each risk completely and have a strategy in place to exit the trade if need be. We view this risk with the SEC as a 6-12 month risk, as it will likely take up to a year to fully implement if passed. In the meantime, we are holding our positions and we will do our best to keep readers informed.
I am long AGNC