Maybe There's Truth Inside This Fortune Cookie

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Includes: AGNC, CYS, NLY
by: Brad Thomas

Summary

Einstein once wrote, “A scientific theory should be as simple as possible, but no simpler.” We agree as it pertains to investment returns.

Forecasting future returns by over-simplifying a complex investment is neither safe nor smart.

We will review mortgage REITs and provide some food for thought (in the form of a fortune cookie).

A few weeks ago, we learned of a new phrase for an investment approach: "Keep It Safe, Smart!" But alas, as we read on, we determined that the premise was flawed and the Smart rapidly became, ummm, Silly.

Permit me to explain and provide my thoughts on the luxury of keeping it simple.

Mortgage REITs vs. Equity REITs: the debate that seems never ending.

Many believe we have picked a side and will forever be inflexible. This is, of course, untrue. What we have always emphasized is the complexity of many of the mortgage REITs and the potential for loss due to leveraged complexity.

This does not mean that we are somehow "against" mREITs, but rather that we believe they are not entirely suitable for many investors.

This is due to their complexity, the need for investors to follow multiple data series in order to understand what is driving them, and potential for inconsistencies between an investor's outlook and management's actions.

Recently, we read the following statement:

The main difference between eREITs to mREITs lies in their attitude towards long-term yields. While eREITs adore low long-term yields, as outlined above, mREITs actually don't mind and in most cases benefit from higher long-term yields.

The reason for that is simple: Higher long-term yields may result in wider spreads and that is what counts the most for mREITs. Just like eREITs praying for low long-term yields, mREITs wish for wider long-short spreads.

After reading, we scratched our heads and wondered aloud, what can we learn from a fortune cookie?

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Allow us to explain.

How Is This Keep It Smart, Safe?

If we take a simplistic view of a mortgage portfolio (long mortgages, financed by repo or "levered"), we observe the following dynamic:

  1. If longer-term rates go up, the portfolio is exposed to mark-to-market risk as the existing portfolio sells off in order to have MBS yields equal the new market yields.
  2. If short rates increase, the funding (REPO) rate increases and causes spread compression negatively impacts NIM and causes reductions in cash flows and pay-outs (dividends).
  3. If the yield curve has a parallel shift upwards, the NIM remains constant, but the portfolio is marked lower in order for the existing holdings to reprice to market yields.
  4. If long rates increase, prepayments would slow, causing adjustments in the accounting treatment and an extension of duration (which is bad when rates are increasing - see point 1).
  5. If MBS spreads (the basis) tighten (MBS trades closer to treasuries/swaps), the portfolio has an MTM gain (as the portfolio reprices to the new yield level).
  6. If MBS spreads (the basis) widen, the portfolio has an MTM loss (as the portfolio reprices to the new yield level).

Wow, seems like an awful lot of risk, no?

This is why mortgage REITs hedge! The scenarios above would potentially dissuade even cast iron stomach investors from being involved. Hedges, you see, offset a significant portion of these risks.

Before we jump into this, perhaps a few definitions will help:

A swap is an exchange of fixed interest rate payments for floating interest rate payments over some period of time. The "types":

  • "payer": right to enter into a pay fixed, receive floating swap
  • "receiver" right to enter into a receive fixed, pay floating swap

A swaption is an option to enter into a swap with a pre-specified fixed rate (I)

  • Receiver swaption: option to enter into a swap to receive the fixed rate i (and pay the floating),
  • Payer swaption: option to enter into a swap to pay the fixed rate i (and receive the floating)

You pay a premium for the swaption at time 0 and are not required to pay anything when entering the swap.

The use of interest rate swaps helps transform short-term funding to long-term fixed funding (swaps of the "payer" variety). The use of swaptions gives a mortgage REIT the ability to adjust hedges "on the fly" at levels previously set, essentially allowing them to "lock in the NIM." This can be especially advantageous if rates - and hence prepayments - are changing rapidly (think of it as a volatility hedge).

Now, let's take a look at a hedged levered MBS portfolio.

  1. If longer-term rates go up, the mortgages will decrease in value, but the hedges will increase in value, offsetting the loss to the degree hedged.
  2. If short rates increase, funding costs rise, but are offset by interest rate swaps that receive a floating rate and pay a fixed rate.
  3. If the yield curve has a parallel shift upwards, your NIM remains the same and you are nearly indifferent.
  4. If long rates increase, prepayments would slow, causing adjustments in the accounting treatment and an extension of duration, the swaptions allow a manager to react relatively quickly and mitigate the impact.

Golly, that's wonderful, no? Astute readers will recognize we have left out one key facet of risk that we addressed in the "unhedged" example. The mortgage basis.

If MBS spreads widen (increase faster than the benchmark rate - treasuries, swaps), the existing portfolio sells off in order to have MBS yields equal the new market yields. This risk is difficult; as efficient hedges are difficult to find - especially with larger mortgage REITs.

Let's have a look at the basis (which we have as Fannie current coupon mortgages less the 10-year swap rate):

The "basis" has been increasing, which can lead to mark-to-market losses and the erosion of book value.

Based on the hedged levered mortgage portfolio, we can see that a large amount of risk that results from running a "simplistic" levered MBS portfolio can be managed and reduced by hedges, while other risks, such as the basis risks, are unchanged.

All this hedging would make investing in mREITs easy, if life was static and nothing changed. Unfortunately, if that were so, there would be little risk premium afforded investors. The reality is that the following decisions must be made by the mREIT manager (without, of course, the benefit of hindsight - Forward to the past, we would guess):

  1. How much of your financing should you hedge? Rarely is 100% of the financing hedged.
  2. Where on the curve should you hedge? If your asset duration is some "x," there are many combinations of swap maturities/durations that can be used to hedge to a duration gap of zero.
  3. All duration gaps can be zero, but some are more zero than others. Non-parallel curve shifts will create different "duration zero" results.
  4. What hedges should you use? The choices could be Eurodollar strings, swaps, treasuries, IO/PO, MSRs etc.

The numerous choices managers must make result in complex, multi-faceted/dimensional risk decisions which are dynamic and constantly changing.

With this in mind, let's look at a couple of earnings calls from some mREITs.

American Capital Agency's (NASDAQ:AGNC) Q2 call:

As a result, our pay fixed swap portfolio balance at quarter end decreased to $35 billion down $3 billion from the prior quarter. Given the reduction in our swap portfolio, our aggregate hedge ratio declined to 79% in the second quarter down from 83% in the prior quarter and down from 96% at the end of the third quarter 2015.

I'll quickly review our hedging activity during the quarter. Given the rally in rates and our view that interest rates will likely remain range bound, we took steps to rebalance the size and maturity composition of our pay fixed swap portfolio. In total during the quarter, we terminated $5.6 billion of existing pay fixed swaps and entered into $2.6 billion of new pay fixed swaps.

Ok, the folks over at AGNC decided to hedge less of their financing and rebalanced their hedges to create a different maturity/duration profile (the rebalancing was also done at MTGE, which they manage).

CYS's (NYSE:CYS) Q2 call (worth the price of admission just to hear CEO Kevin Grant call out Fed policy, btw):

…the bond market rallied and 10-year U.S. Treasury hit new post-World War II lows, as low as 1.35% intraday. This triggered a pickup in mortgage refi applications and those prepayments will come through over the next 60 to 90 days. This will impact yields in late Q3 and Q4. With rates now back up above 1.5% on the 10-year Treasury, we should indeed expect the prepayment wave to be brief much like it was with the April spike.

..we took advantage of the lower rates and a flatter curve by replacing $2.2 billion of short swaps struck at 1.43% with $1.7 billion of longer-dated swaps struck at 1.21%.

I think we're in a pretty good neighborhood right now. I definitely would not go to zero. I wouldn't - absolutely would not go negative. I wouldn't be surprised to see the 10-year Treasury hit 1%. I know that's probably a shocker for a lot of people. I'm just saying I wouldn't be surprised, but I wouldn't bet on it anytime soon. And a significant backup is very unlikely.

CYS is expecting prepayment spikes, which typically means entering into swaptions to deal with the volatility. Then it replaced shorter duration swaps with longer duration swaps at lower rates (and needed less to hit its hedge ratio).

Our point in referencing these two mREITs' calls is that mREITs are more than just guessing the direction of rates and the slope of the curve.

Ultimately, if you are trying to determine the (future) performance of mortgage REITs based on the direction of rates and the slope of the curve, it is akin to having a plan to go back to the future that requires you to have one of these:

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And all you have is this:

Seriously, it is important to have a macro view in order to create an investment plan (or to adapt your portfolio to meet your outlook), and we believe that mortgage REITs (especially CRE mREITs) can play a role, but if you believe they are a simple beast, you may end up creating losses in your portfolio or your clients' portfolios.

To simply state that equity REITs are pricey and the curve should steepen which should lead to mortgage REITs outperforming is, unfortunately, making things too Simple to be Smart.

A decent primer on swaps/swaptions here.

If you are, however, a believer in the steep curve theory, here are a couple of charts that might help you along (in all honesty, we follow these just to keep an eye on things in the unhedged world).

We always enjoy the friendly debate with our friend, Fortune Teller, and we look forward to the comments to follow.

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Rubicon contributed to this article and he is long NLY common and various mREIT preferred shares.

Author's Note: Brad Thomas is a Wall Street writer and that means that he is not always right with his predictions or recommendations. That also applies to his grammar. Please excuse any typos, and I assure you that he will do his best to correct any errors if they are overlooked.

Finally, this article is free, and the sole purpose for writing it is to assist with research (Thomas is the editor of a newsletter, Forbes Real Estate Investor), while also providing a forum for second-level thinking. If you have not followed him, please take 5 seconds and click his name above (top of the page).

Disclaimer: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks mentioned or recommended.

Disclosure: I am/we are long O, DLR, VTR, HTA , STAG, GPT, ROIC, HCN, OHI, LXP, KIM, WPC, DOC, EXR, MYCC, TCO, SKT, UBA, STWD, CONE, BRX, CLDT, HST, APTS, FPI, CORR, NHI, CCP, CTRE, WPG, KRG, SNR, LADR, PEB, BXMT, IRM, CIO.

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.