- mREITS with large holdings of Agency guaranteed RMBS and CMBS securities occupy a unique position within the wider mREIT sector.
- While the Federal Reserve is an active participant in the Agency-eligible securitized mortgage market, Agency mREITs can outperform more diversified mREIT baskets.
- By most measures, the primary mortgage market outperformed in 2020. Demographic shifts and the "home office" premium should support the primary home purchase market into 2021.
- NLY, AGNC and TWO are all positioned to enjoy outsized benefits from Federal Reserve support of the money and securitized mortgage markets.
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Federal Reserve support of U.S. money and securitized mortgage markets coupled with the dramatic strengthening of the primary mortgage markets warrant a separation of mortgage Real Estate Investment Trusts (mREITs) with concentrated exposure to Agency guaranteed mortgage-backed securities (Agency mREITs) from the broader mREIT space. Relative value analysis of mREIT common and preferred shares is warranted in isolation of mREITs with diversified mortgages held on balance.
mREITs in general purchase and originate a wide swath of mortgage and commercial real estate securities and debt instruments: Agency single family MBS, non-Agency residential MBS, Agency CMBS, private label CMBS securitized by first and second liens, as well as direct commercial lending. Drawing on my experience and observations as a sell-side participant in the Agency eligible single- and multifamily- securitized mortgage markets over the past year, I will examine three macroeconomic factors that should lead to outperformance of Agency mREITs in 2021: Federal Reserve money market support, Federal Reserve quantitative easing and price support in the secondary mortgage market and the outperformance of the primary mortgage market.
The basis will be constructed for a generally bullish backdrop to be applied to a basket of names, upon which more detailed comparative single name analysis can be built. To reiterate, while not always stated explicitly, the investment thesis outlined in this article will be limited to those mREITs with significant holdings of Agency guaranteed RMBS and CMBS securities.
Three names fall under the criteria set forth above:
Agency MBS & CMBS
% Total Assets
AGNC Investment (AGNC)
Annaly Capital Management (NLY)
Two Harbors Investment (TWO)
Author, data from SEC Filings
Agency mREIT Participation in the 2020 Risk-On was Limited
From an epidemiologist’s point of view, the domestic COVID situation improved little in 2020, but paradoxically the US economic and financial landscape strengthened dramatically. Two engines have been critical in driving capital market outperformance. Notwithstanding tense political contention, The Federal government has now passed two iterations of the CARES Act, and the Federal Reserve has embarked on a stimulus mission buying all types of general collateral and in sum, injecting trillions of dollars of liquidity back into the Capital Markets and corporate balance sheets. Absent some industries that are uniquely COVID exposed (food service, airline, hotel & hospitality, physical consumer discretionary, etc.), equity and credit indices have recovered well beyond pre-pandemic levels:
Author, open source data
Looking at that same indexed price change for a broad basket of Agency mREITs shows the riches of the 2020 rally has not been distributed equally.
Author, open source data
Why then have Agency mREITs been left out of the 2020/2021 rally? To arrive at an answer to that question, it is critical to first understand how Agency mREITs structure their balance sheets to generate return, and how the viability of that structure was threatened in early 2020.
Agency mREITs and the “COVID Crash”
Agency mREITs generate most of their revenue from interest earned on commercial and residential securitized mortgage instruments (RMBS & CMBS) and the purchase of these pass-thru securities are financed in large via overnight and term repurchase agreements. This combination of the highly leveraged acquisition of held-for-sale, mark-to-market, rate sensitive assets is a precarious model in normal market conditions, and even more so in times of extreme volatility and market wide risk off sentiment.
Agency mREITs were uniquely positioned to bear the worst financial impact of early 2020 COVID market disruptions. Contagion originated on the Asset side of the mREIT balance sheet. The market price of Agency RMBS securities, discoverable via the To-Be-Announced (TBA) MBS forward market, collapsed in late-March 2020. On Wednesday, March 18th, the then production coupon near-month delivery 3% TBA touched intraday lows of 98.22, comparable to 103.31 a week prior and a 101.91 open on March 17th. Agency mREITs maintain hedging programs to insulate their balance sheets from adverse impacts of small changes to the mark-to-market price of MBS holdings but day over day price changes of 1-2 points are multiple standard deviations outside normal day over day price deltas and would have thrown quantitative risk models into complete disarray.
As the fair market value of Agency MBS securities eroded, Agency mREITs were forced to sell balance sheet holdings of marked-to-market Agency MBS to meet variation margin calls and over-supply pushed the mortgage basis, an industry indicator of excess spread demanded by investors in MBS securities, to multi-year wides. MBS holders continued to report unhedged mark to market losses, margin calls on drawn repurchase lines forced MBS holders to raise additional capital, resulting in further selling at distressed MBS prices. Two Harbors specifically notes large scale asset sales in the wake of the COVID dislocation. On or around March 25th, 2020 the company sold approximately 1/3rd of its Agency RMBS position to raise capital. Assuming Two Harbors’ trading desk was not the only one pushing massive positions into the market, without a strong bid to take down that kind of volume, oversupply induced price declines accelerated, capital pressures continued to build, and more selling programs were required.
Program selling to meet capital calls due to unhedged MBS price declines was a self-perpetuating feedback cycle. With short-term money market funding sources assumed to be less reliable, mREITs faced a short-term outlook under which they needed to significantly discount the prospect that their funding desks would have uninterrupted access to their number one source of financing. Without the ability to finance MBS purchases, almost overnight, a longstanding bid for MBS faltered and we observed additional price deterioration in spot MBS and TBA forward space.
MBS price action in mid-March 2020 was driven by two primary concerns: involuntary and voluntary prepayments. In March 2020, the Federal Reserve changed the lower-bound on the Federal Reserve Rate target range to 0. Treasury yields, LIBOR/Swap rates and the coupon on a par MBS pass-through security fell dramatically, and in turn, the prepayment option on a large portion of homeowners' mortgages was suddenly deep in the money. Home mortgage refinancing, or “voluntary prepayment”, is a drag on MBS valuation because investors pay a premium for the cash flows generated by mortgage instruments. When borrowers prepay their loans, they prepay at par value: investors are not compensated for the lost capitalized interest which they paid for upfront.
Of equal concern to assumed spikes in voluntary prepayments were involuntary prepayments. Post-COVID, investors priced in the assumption that a large population of American mortgage borrowers would lose their primary source of income and with it their ability to cover their mortgage obligations.
Taken in sum, March 2020 was a perfect storm for the Agency mREIT. Cherry picking one of many reportable metrics that highlight mREIT financial distress in Q1 2020, we can see dramatic degradation in net loss attributable to shareholders in Q1 year over year:
Net Gain (Loss) Per Share Attributable to Common Stockholders
Three Months Ended March 31
Annaly Capital Management
AGNC Investment Corporation
Two Harbors Investment Corporation1
1 Cut dividends per share by 100%
Author, SEC Filings
The Bull Case: Market Developments in Q2 & Q3 2020 Support Agency MBS
My case for the current industry wide undervaluation of Agency mREITs lies not in an assertion that the intrinsic value discount applied to mREITs in Q1-Q2 2020 was unjustified, but rather, that the market has failed to price the impact of events that have transpired in the weeks after March 31st and continued to transpire since then. I identify three mitigating factors in support of generalized sector level bullish sentiment and an optimistic 2021 forward growth outlook.
1Q 2020 Aggravating Factors
3Q -> 2021 Mitigating Factors
Repurchase Market Dislocation & Draw Concerns
Federal Reserve Repurchase Market Support
MBS Asset Price Deterioration & Margin Calls
MBS Purchase Programs & Quantitative Easing
Prepayment Concerns and Default Forecasts
Default/Forbearance Expectation Outperformance
Liability Support - Repurchase Market Stabilization
The availability of, and access to, overnight and term repurchase facilities was of immediate concern in Q1 2020 when traditional sources of money market funding were identified as potentially unavailable. Due to the immediate and substantial actions of the Federal Reserve, however, those fears were never realized.
Federal Reserve facilities, specifically the Primary Dealer Credit Facility (PDCF), served to smooth some market dislocations and stem the tide of distressed asset selling by helping participants bolster liquidity without further open market price erosion. On March 12th, 2020, the Federal Reserve announced the first in a series of Term and Overnight repurchase operations totaling over $1T at its outset, with the capacity for draws well in excess of that initial capacity. Into April 2020, it became clear that the initial emergency Fed facility was going to size appropriately to market need and remain standing until officials were confident that repurchase markets could manage demand without funding rate pressure.
Federal Reserve support in the overnight/term repo space began in late 2019, but the scale at which that support was upsized in response to COVID dislocations was dramatic. The following chart shows bids submitted to Federal Reserve repurchase auctions by collateral type.
What the chart above clearly indicates is that the repurchase markets were under serious pressure in March and April of 2020. However, the chart above also clearly indicates that the Federal Reserve facilities were accessed for a short amount of time! By late April, term and overnight repurchase participation had dipped below 2019 levels and since June 2020, use of the facility has been effectively zero. That observation alone indicates that liquidity channels healed at almost the same pace at which they fractured.
True, the health of the repurchase market in its entirety cannot be diagnosed via the participation of only one liquidity provider (albeit an exceptionally large one). However, the data points above force the consideration that at present the same liability pressures facing Agency mREITs in March are absent, or at least much less debilitating. Pricing Agency mREITs at the same discount that was applied to shares at a time when a principal liquidity channel was deemed inaccessible seems at best stubborn, at worst fundamentally misguided.
Quantitative Easing and MBS Price Support
Price deterioration in the Agency MBS space was extreme and wide-spread in Q1 2020. As we have previously explored, Agency mREITs fund asset purchases almost entirely via repurchase lines, and as such they are uniquely exposed to the knock-on effects of mark to market price disruptions and associated margin calls from repo facility providers. In their 1Q 2020 10-Q, Two Harbors Investment Corp. paints a particularly gruesome picture of the balance sheet dilemma:
On March 25th, 2020 we sold substantially all of our non-Agency securities in order to eliminate the risks posed by continued outsized margin calls and ongoing funding concerns associated with the significant spread widening on these assets. We also sold approximately one-third of our Agency RMBS in order to reduce risk and raise cash to establish a strong defensive liquidity position to weather potential ongoing economic and market instability.
Here, again, enter the Federal Reserve. On March 15th, the Federal Open Market Committee (OTCPK:FOMC) indicated the immediate commencement of open market operations (OMO) that increased Federal Reserve holdings of Treasury and Agency MBS over the following weeks by at least $500B and $200B respectively. The creation of what was essentially a “standing bid” for Agency MBS was well received by the market and MBS prices firmed almost immediately. Between the first OMO announcement and early June, the Federal Reserve continued purchasing MBS securities at a regular rate and periodically increased operation sizes in the continued interest of the “smooth functioning of markets for Treasury securities and Agency MBS”. On June 10th, the Federal Reserve indicated their commitment to indefinite asset purchases of appropriate size to ensure price stability in the Treasury and securitized mortgage space.
With the Federal Reserve steadfast in its willingness to jump into MBS markets as a buyer of last resort, price disruptions of the magnitude observed in Q1 2020 should be generally be deemed temporary until the Federal Reserve structurally adjusts its stance on securitized asset price support. Taking the existence of Federal Reserve MBS open market operations in periods of price dislocation as a given, it seems hard to argue that the immediate discount applied to Agency mREIT shares in March should persist in the medium- to long-term. The margin call distress that drove mREIT shares down in March was appropriate pricing out of real dollars from the asset side of the mREIT balance sheet, and an appropriate discount applied to the Agency mREIT leveraged MBS purchase model. On the surface however, I fail to see a similar pricing in of the indefinite presence of the Federal Reserve as a juggernaut MBS buyer.
Default/Forbearance Forecasts and MBS Coupon Advance Burden Underwhelm
Repo facility availability and MBS price dynamics aside, Investors pulling capital from Agency mREITs in Q1 2020 were justified given the lack of consensus conviction on the health of the housing market looking through 2020 and into 2021. Positioning to avoid any exposure to the housing market was defensible at the time. However, as has been the case with many fears that began to take form in the depth of the Coronavirus pandemic, the worst-case scenarios for the US housing market simply have not come to fruition.
First and foremost, widespread mortgage delinquency was taken off the table almost immediately as the FHFA announced in April 2020 the creation of the Borrower Protection Program (BPP). Under the terms of the BPP, borrowers with loans guaranteed by the GSEs (FHA, VA, USDA, Fannie Mae, and Freddie Mac) could temporarily reduce or defer their mortgage payments without any status migration of their re-payment profile (changing payment status from current to late or delinquent).
Coupons on mortgage securitizations are guaranteed so remittances to holders of MBS still need to be made regardless of whether or not the loans collateralizing those securities are current. If a loan has not been placed into default status, Mortgage Servicers who service loans on a scheduled/360 remittance basis are required to continue to remit coupon payments to MBS investors, again, whether the underlying loan is current or not. For loans that are not serviced on a scheduled/360 basis, one of the GSEs is equivalently responsible for remitting coupon payments to investors.
If a large percentage of borrowers elected forbearance on their loans, there certainly could have been unsustainable pressure placed on the GSEs or Mortgage Servicers to keep up with MBS coupon payments. That mass forbearance migration simply never materialized, and the balance sheet strain of securitization advances placed on Mortgage Servicers or the Agencies was never structurally destabilizing.
Per their most recent extension of the Agency forbearance program, the FHFA has estimated the GSEs will incur an additional $1.7B in forbearance related expense in 2021, on top $6B in expenses already incurred. COVID related cash expenses and increased loan loss allowances have, and will continue to, negatively affect GSE net income but Fannie Mae was able to navigate the forbearance guaranteed payments effectively and will generate positive earnings growth into 4Q 2020.
Furthermore, The number of borrowers that entered forbearance and actually stopped their mortgage payments never reached the number estimated by the more conservative forecasts and has decreased continually since April 2020. Far more borrowers than expected entered forbearance but then continued to make their mortgage payments as scheduled. While there was a minor increase week over week noted in the last report, for 25 weeks prior the share of mortgage loans in forbearance has been declining. The initial prevalence and subsequent persistence of remote working arrangements have placed a premium on domestic space and pushed new home sales to multi-year highs, both in volume and price. The US Department of Housing and Urban Development released new residential home sales statistics on February 24th, 2021 and while January 2021 new home sales were below the August peak, relative to the same period in 2020, new home sales in January 2021 increased by 19% year over year.
By almost every metric, the primary mortgage market is the strongest it has been in years and the secondary mortgage market’s ability to manage forbearance migration, COVID related defaults and outstanding MBS remittances has far exceeded the most optimistic forecasts constructed in early 2020. Absent material and unforeseen degradation of the economic landscape in 2021, the primary mortgage is fundamentally healthy, and the secondary mortgage market should outperform in lockstep.
Federal Reserve MBS Support is a Blessing and a Curse
Accommodative monetary policy for extended periods of time does come at a price in the form of elevated prepayments and increased market sensitivity to eventual hawkish tightening. As MBS prices are supported by Federal Reserve OMO, the interest rate on the benchmark MBS security can remain artificially low and primary mortgage rates passed to borrowers will remain low as well. Low mortgage rates incentivize refinancing, which as noted, is a drag on MBS performance.
In addition, market participants inevitably become accustomed to the existence of the Federal Reserve as guaranteed bid for at least some percentage of securitized mortgage supply. When the Fed does begin to tighten monetary policy, the dollar price of MBS will oscillate to a new equilibrium as other participants move in to replace the Fed OMO standing bid, but that process will take time and won’t be seamless. So called “taper tantrums” have occurred with relative frequency in the past and there is no reason to suggest that as the current quantitative easing cycle is wound down, a similar reaction won’t occur again.
Elevated Prepayments and a messy QE exit are risks work noting but don't fatally damage the sector bull case. We have recently observed an upward trend in benchmark interest rates that should help to alleviate some pressure on the asset side of the Agency mREIT balance sheet and the end to the current quantitative easing cycle is specifically a long-term risk. The Federal Reserve has repeatedly reiterated their intention to continue quantitative easing programs and generally accommodative monetary policy until they determine broad asset market support is no longer necessary to achieve their inflation/employment mandate and even then, unwinding Fed participation will proceed gradually. The US is still far from target employment and inflation the Federal Open Market Committee continues to reiterate that at present, balance sheet normalization programs aren’t actively being discussed.
Healthy Sector Macroeconomics Warrant Single Name Analysis
Any strong investment thesis is built as a mosaic of company fundamentals, relative share price analysis and a strong macroeconomic sector story. Given the macroeconomic factors and structural securitized mortgage market dynamics examined above, I find evidence for a generally strong outlook for a basket of Agency mREIT names, AGNC, NLY and TWO specifically. This analysis is presented to lend support to a broad macroeconomic sector foundation upon which single name fundamental analysis might be constructed. There is some market signaling that can be drawn from the strong bid mREIT shares have enjoyed over the past month or so. On the back of positive COVID-19 vaccine headlines, some of the largest mREITs in the Agency eligible mortgage space have rallied more than sectors that had previously outperformed in early- to mid-2020.
Author, open source data
A fundamental shift in the Agency securitized mortgage market has taken place over the past 11 months. Moving through 2021, I expect more market participants to recognize the persistence of bullish structural trends and, if single name common or preferred share relative valuations warrant it, drive capital back into Agency MBS mREIT names. At present, AGNC, NLY and TWO all tout weighty dividend yields. Absent capital movement back into Agency mREITs, at the very least, I consider those dividends to be safe.
Federal Reserve Open market operations will be the norm in 2021 and by nature of their business model, Agency mREITs are positioned to benefit directly.
This article was written by
Analyst’s Disclosure: I am/we are long AGNC, 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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