FHFA's Final Rule On FHLB And mREIT Exposure

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Includes: CMO, LADR, MITT, NLY, OAKS, RWT, TWO
by: Rubicon Associates

Summary

FHFA has issued a final rule on FHLB membership.

Essentially, in the final rule mREITs will not be eligible for membership - removing a stable funding source.

Here is a list of mREIT exposures to the FHLB and the most affected.

The Federal Housing Finance Authority ("FHFA") issued their final rule on Federal Home Loan Bank ("FHLB") membership, which many mortgage REITs have been accessing through captive insurers. In the release they state:

The final rule does adopt the provision in the 2014 proposed rule that defines "insurance company" to exclude so-called "captive insurers." The final rule, therefore, will prevent non-eligible entities from gaining de facto FHLBank membership through a captive insurer. The primary business of a captive insurer is underwriting insurance for its parent company or for other affiliates, rather than for the public at large, and captives are generally easier and less expensive to charter, capitalize and operate. In defining "insurance company" to exclude captives, FHFA seeks to prevent entities that do not otherwise meet the statutory requirements from becoming FHLBank members by establishing and using captives as conduits to circumvent the membership eligibility requirements and gain access to low-cost FHLBank funding and other benefits of FHLBank membership. An increasing number of entities that are ineligible for FHLBank membership have been establishing captive subsidiaries as a means for their parent company to become a de facto FHLBank member, according to FHFA.

"FHFA has the authority and the duty to implement the statutory membership provisions of the Federal Home Loan Bank Act and by adopting the proposal to exclude captives from the definition of insurance company we are making sure that institutions can't frustrate the intent of Congress. Congress has amended the Federal Home Loan Bank Act in the past to allow additional entities to become members of a Federal Home Loan Bank and it can certainly do so again if it wants some of these entities to be eligible for membership," Director Watt said.

In summary, the effect on mREIT captives is:

Consistent with the proposed rule, under the final rule captive insurers that became members prior to publication of FHFA's proposed rule in 2014 will be allowed to remain members for up to 5 years after the effective date of the final rule. For these institutions, the final rule limits outstanding advances during the five-year transition period to 40 percent of the assets of the captive and prohibits new advances or renewals that mature beyond the five-year transition period. Existing advances that mature beyond this transition period will be permitted to remain in place.

Captive insurers that became members after publication of the proposed rule must terminate their memberships within one year following the effective date of the final rule. The final rule allows such captives until the end of that one-year period (or until the date of termination, if earlier) to repay their existing advances, but prohibits them from taking new advances or renewing existing advances that expire during that transition period.

The final rule can be found here.

Exposures:

Click to enlarge

Some REITs have been filing 8-ks on this development. I am not sure why others haven't, but it seems important enough to warrant it.

Five Oaks (NYSE:OAKS) issued a release this morning:

On January 12, 2016, the Federal Housing Finance Agency (FHFA) adopted a final rule (the "FHFA Final Rule") revising its regulations governing Federal Home Loan Bank (OTCPK:FHLB) membership. The FHFA Final Rule requires FHLB-Indianapolis, the bank that admitted Five Oaks Investment Corp.'s (the "Company") wholly owned "captive" insurance company, Five Oaks Insurance LLC ("FOI"), as a member on February 24, 2015, to wind down and settle its transactions with FOI, as well as to terminate the membership of FOI in FHLB-Indianapolis no later than one year after the effective date of the FHFA Final Rule.

FOI currently has $49,697,000 of advances from FHLB-Indianapolis, collateralized solely by Agency securities. Such amount represented 8.8% of the Company's total financings as of January 12, 2016. FOI's capital stock investment in FHLB-Indianapolis that will be paid to FOI upon the redemption of its membership interest is $2,403,000.

Redwood Trust (NYSE:RWT) issued the following:

Redwood Trust, Inc. today addressed the impact of the release by the Federal Housing Finance Agency (FHFA) of its final regulation relating to captive insurance company membership in the Federal Home Loan Bank System. Redwood Trust's wholly-owned captive insurance company subsidiary, RWT Financial, LLC, is currently a member of the Federal Home Loan Bank of Chicago (FHLB Chicago) and, as a member, is able to maintain borrowings (also referred to as advances) from the FHLB Chicago that are collateralized by residential mortgage loans and other eligible assets held by RWT Financial in its investment portfolio.

Because RWT Financial was admitted as a member of the FHLB Chicago prior to September 2014, it is eligible under the FHFA's final regulation to remain as a member of the FHLB Chicago for a five-year transition period following the effectiveness of the FHFA's final regulation. In addition, under the FHFA's final regulation, the FHLB Chicago is permitted to allow advances that were outstanding to RWT Financial prior to effectiveness of the FHFA's final regulation to remain outstanding until scheduled maturity, even if that scheduled maturity extends beyond the five-year transition period. The final regulation will become effective 30 days after official publication in the Federal Register.

RWT Financial currently has borrowing capacity from the FHLB Chicago of $2.0 billion. As of January 12, 2016, RWT Financial had outstanding advances from the FHLB Chicago of $2.0 billion. These outstanding advances have a weighted average remaining maturity of approximately 9.5 years.

Bottom Line: As I see it, the most negatively affected mREITs are:

  1. AG Mortgage Investment (NYSE:MITT)
  2. Capstead Mortgage (NYSE:CMO)
  3. Ladder Capital (NYSE:LADR), and
  4. Redwood Trust

Of these, obviously the first two are the most affected as they have decent size relative borrowings and a one year sunset.

Annaly Capital (NYSE:NLY) is the least at risk, as they have not made substantial use of the FHLB.

Two Harbors (NYSE:TWO) pioneered the FHLB borrowings, and with 27% of its borrowings from the home loan system, is also at risk. Personally, I think the folks at TWO have a good handle on liability management and continue to be forward thinking and pre-emptive.

None of this is insurmountable, but investors have to be aware - especially in this sector as borrowing drying up is what kills mREITs. Access to capital is paramount, and losing the FHLB (unless congress gets involved) at a time when banks are trying to optimize capital (which means less repo) is just another weight on the shoulders of mREIT investors.

Disclosure: I am/we are long NLY.

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.

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