Leverage has a mixed history. On one hand, leverage -- the use of borrowed capital to magnify returns -- has helped enrich individuals and companies. On the other hand, one need only recall the 1929 Wall Street crash to see how leverage, in the form of margin, can lead to ruin.
A company that needs to raise capital can take the leverage or equity path. If inflation is high or money is cheap, then leverage may be the solution, since high inflation favors the borrower, and cheap money put to work can earn more than it costs. On the other hand, if times are uncertain and money is expensive, then the sale of equity may be preferable, since it adds nothing to debt. The downside of selling equity is that it can dilute assets, which has the effect of lowering share price.
Mortgage REITs use both leverage and equity to augment earnings and to replenish and grow assets. The difference, or spread, between the interest an mREIT pays to borrow funds (usually as repurchase agreements or "repos") and the interest it earns on the mortgage-backed securities (MBS) it buys with those borrowed funds is around 2%. This in itself is not a big yield. So mREITs leverage, or borrow in multiples of stockholder equity, in order to multiply the spread by the leverage factor. Thus, if the leverage factor is 8 on a 2% net spread, then the effective spread is 16%. 90% of the resulting earnings (plus base asset yield less expenses like management fees and hedging costs) are distributed to shareholders.
Unlike other entities, mREITs can only retain 10% of earnings, so the mREIT uses equity, in the form of secondary share issues, to fund its asset replenishment and growth.
investors considering mREITs are often put off by what they consider the high leverage mREITs use to generate their double-digit yields, which are far superior to the payouts of other investment sectors. Because of the history of catastrophes brought on by leveraging, it's a well-founded fear, and certainly "this time it's different" is a familiar refrain to the jaded ear of the experienced investor. So I leave it to an mREIT, American Capital Agency Corp. (AGNC), addressing the Securities and Exchange Commission, to speak to the issue of leverage:
As of June 30, 2011, the Company's debt ratio was 88.23 -- just under an 8-to-1 debt-to-equity ratio. By contrast, as of June 30, 2011, the average debt ratio for all institutions insured by the Federal Deposit Insurance Corporation (the "FDIC") was 88.70 - just under a 10-to-1 debt-to-equity ratio. Moreover, as of June 30, 2011, some of the largest insured deposit institutions had higher debt ratios than the Company, including Wells Fargo Bank, N.A., with a debt ratio of 88.79; Citibank, N.A., with a debt ratio of 89.49; U.S. Bank, N.A., with a debt ratio of 89.77; and J.P. Morgan Chase Bank, N.A., with a debt ratio of 93.00. Even in interest rate environments where there was considerably less interest rate risk than in the current environment, our leverage was slightly below the average leverage levels employed by banks and other financial companies, which we believe have riskier businesses than ours. In addition, our leverage is also limited by the fact that our lenders are subject to governmental restrictions on the amount they can lend to individual borrowers.1
Annaly Capital Management (NLY) is more succinct:
The majority of Agency MBS investors are leveraged. Banks, insurance companies, foreign financial institutions and many private investors use varying degrees of leverage, while the GSEs themselves and the Federal Reserve are infinitely levered.2
As the recent JP Morgan trading fiasco attests, today's banks indeed have "riskier businesses" than mREITs. Just one aspect illustrates: hedging. Because of the repeal of the Glass-Steagall Act, banks have been free to "play the market." Hedges, such as options and swaps, which traditionally were used to reduce risks, have become speculative instruments in themselves, with the result that they become a larger share of risk than the assets they would otherwise cover. Mortgage REITs use hedges for their intended purposes only, to reduce risk rather than add to it. mREITs can thus be seen as closer to traditional Glass-Steagall era banks than today's banks, thus bolstering AGNC's assertion that mREITs' mortgage investments are less risky than banks' and warrant the use of leverage integral to the mREIT business model.
Generally speaking, mREITs will adjust leverage, as they adjust their portfolios, to meet changing environments. AGNC gives one example of how an mREIT adjusts its leverage:
[W]hile we closed the quarter at 8.4 times leverage, which was on the higher end of where we've operated over the last two or three years, we said we have brought that down, because valuations and mortgages...in April had been very strong, and we felt that the risk return was much more two-sided. So we've brought that down some.
But one thing that we stressed was...we were very reluctant to be at low leverage, going into...a scenario where there was a reasonable probability of a QE3. Why? Because when you're underweight or when you have low leverage, that means that you're kind of saying, I'm going to buy later.
Yes, you could potentially maintain that for a long period of time, but you're still -- especially if you have faster securities -- going to be doing a lot of reinvesting. And you're going to be competing with a multiple hundred-billion dollar program from the Fed. The...last thing we want to do is wait till the Fed starts buying, to then...increase our purchases of mortgages.
We'd rather, if anything, reduce our purchases going forward if the Fed drives mortgage prices to...extreme levels. So for that reason, we weren't comfortable in running with...low leverage in that kind of environment.3
If the increasing popularity of mREITs is an indicator, then one might say, about the two forces that govern the market, that greed has overcome fear. But even within the mREIT space, one can accommodate his personal greed/fear ratio. Different mREITs employ different levels of leverage. For example, AGNC employs a leverage factor of 8.4 at last report. On the other hand, NLY employs a leverage factor of 5.8 at last report. Normally, leverage is reflected in mREIT yields, thus, all other factors being equal, the lower the mREIT yield, the lower the leverage, by which one might infer a more conservative leverage strategy. Nevertheless, higher leverage not only increases yield, but can also be, as AGNC maintains above, a prudent strategy.
That said, it must be acknowledged that mREITs addressing themselves to regulators suggests the risk of regulatory intervention on how much leverage mREITs are allowed. In fact, regulatory intervention may be the single biggest risk in the mREIT space. On the other hand, it should be comforting that with regulators looking over their shoulders, the mREITs will be on a mission to prove that their leveraged business is legitimate and sound.
Summary: Leverage is integral to today's mREIT business model and is not applied at higher levels in the mREIT sector than in other financial sectors.
1 AGNC letter to SEC, 11 June 2011
2 NLY "Input on reform of the Housing Finance System," 21 June 2010
3 AGNC presentation at Morgan Stanley, 12 June 2012
Disclosure: I am long AGNC.