Assessing the Risks of Mortgage REITs

8/14/2019 Assessing the Risks of Mortgage REITs

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A class of investments known as mREITsrealestate investment trusts that invest primarily inmortgage-backed securities (MBS)has grownsubstantially during the period of low interestrates since the 200708 nancial crisis. Regulatorsand other observers increasingly have expressedconcern in recent months about risks to the

nancial system from the growth of mREITs. 1 Thisconcern is rooted in a number of characteristicsof mREITs, including high leverage, a high degreeof maturity mismatch (investments in long-termassets funded by short-term liabilities), and arelatively low degree of regulatory supervision.At the same time, however, policymakers may bereluctant to place too heavy a hand on mREITs,given the desirability of an active, liquid marketfor MBS. An examination of the role of mREITssuggests that although investors in mREITs doface signi cant risks on a number of fronts, theextent of the risks to the nancial system as awhole is uncertain. 2

Emergence of mREITsUnlike traditional REITs, or equity REITs, whichinvest in portfolios of real estate, mREITs makemortgage loans, buy existing mortgages from

November 2013, EB13-11Economic Brief

EB13-11 - Federal Reserve Bank of Richmond

Assessing the Risks of Mortgage REITsBy Sabrina R. Pellerin, David A. Price, Steven J. Sabol, and John R. Walter

Regulators have expressed concern about the growth of a category of realestate investment trusts (REITs) that today invest primarily in mortgage-backed securities (MBS). These companies, known as mortgage REITs, ormREITs, have increased both in number and in asset size since the nancialcrisis, bene ting from federal guarantees and other support for MBS andfrom favorable regulatory treatment that allows high levels of leverage.While mREIT investors face signi cant risks, the level of risk that mREITspresent to the nancial system as a whole is unclear.

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lenders on the secondary market, or buy MBS.Of these activities, the mREITs that exist todaypredominantly buy MBS (and fund themselvesmostly with short-term debt).

mREITs have enjoyed signi cant growth in recentyears, both in number and in asset size. Althoughsome mREITs emerged as early as the 1990s, themREIT sector has had its greatest period ofgrowthsince the nancial crisis. The peak years of mREITformation were 2009 and 2011. Of todays 42listed and unlisted mREITs, 19 debuted between2008 and 2012. Since 2006, before the crisis, totalassets of mREITs have grown by 210 percent to acurrent size of $443 billion. (See Figure 1 on thefollowing page.)

This growth likely has been driven by a numberof factors. To the extent mREITs invest in agencyMBS, their assets are effectively free of credit riskthanks to the implicit or explicit federal guaran-tee associated with those securities. Moreover,mREITs have bene ted since the nancial crisisfrom a large amount of federal support for MBS. The U.S. Treasury and the Fed took actions thatstabilized the MBS market and supported MBS


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mREITs multiply the difference between their short-term borrowing rates and long-term lending ratesthrough a process known as levering up. In thisprocess, the mREIT initially takes the cash it raisesfrom investors and purchases MBS. Then it uses thatMBS as collateral to borrow money to purchase moreMBSa process that it repeats multiple times. Thenumber of rounds is limited by the fact that the repolender will require a haircut on each loan; that is,the loan payout is perhaps 3 percent to 5 percent lessthan the value of the collateral, a gap that serves as abuffer for the lenders protection.

Beyond the constraint of the haircut, mREIT managersface other limitations on levering up: the repo lendermay impose covenants with regard to leverage, andmanagers have an incentive to re ect the risk prefer-ences of their investors. But in theoryassuming notransaction costs, no relevant covenants in the repoagreements, a suffi cient supply of repo nancing, anda preference for maximum risk (and thus for the most

unusual for mREITs. Indeed, they are essential to themechanism through which mREITs generate favor-able returns during certain economic conditions.

In essence, mREITs make money for their investors bytaking out short-term loans at low interest rates andholding long-term assetsMBSthat yield higherinterest rates. mREITs obtain their short-term nanc-ing from the repo market, which offers among thelowest interest rates in the funding markets. Inter-est rates charged by repo lenders are low not onlybecause repos are short-term, but also because theyare backed by desirable liquid collateral (here, MBS)and because the Bankruptcy Code gives repo bor-rowing preferential treatment in the event of defaultin that repo lenders can immediately seize theircollateral. This special treatment has existed for reposbacked by MBS since 2005. (Strictly speaking, a repo,or repurchase agreement, is an agreement for thesale of an asset and its subsequent repurchase, but itis economically equivalent to lending.)

Figure 2: Holders of Agency MBS and Agency Debt in 2008 and 2013

1 Other includes Non nancial Corporations, Households, Credit Unions, and the U.S. Government.2 Nonbanks include security brokers and dealers, ABS issuers, holding companies, and money market mutual funds.Note: As of the second quarter of 2013, total agency MBS and agency debt equals $7.6 trillion, according to Z.1 data.Of this total, $5.8 trillion is agency MBS, according to Securities Industry and Financial Markets Association data.Source: Board of Governors of the Federal Reserve System, Financial Accounts of the United States, Table L.210,Second Quarter 2013 (See footnote 1 of Table L.210 for further details on the types of debt included in this gure.)

Federal Reserve16.7%Federal Reserve

0%

DepositoryInstitution

22.9%

DepositoryInstitutions

15.6%

Insurers 6.1%

Insurers 6.7%

Pension Funds

5.4%

Pension Funds5.1%

Mutual Funds

13.5%

Mutual Funds7.6%

GSEs 3.8%

GSEs

9.6%

Nonbanks 2 6.5%

Nonbanks 2 13.9%

Mortgage REITs1.2%

Mortgage REITs4.2%

Other1 3.2%Other

1

12.1%

State & LocalGovernments6.2%

State & LocalGovernments

6.6%

Foreign Sector11.4%

Foreign Sector21.7%

First Quarter 2008 Second Quarter 2013


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mREITs also incur regulatory and government-policyrisks, such as a loss of federal support for MBS, thewithdrawal of federal guarantees of agency MBS, oran end to the administrative exemption of mREITsfrom the Investment Company Act of 1940. Clearly,abrupt policy changes in these areas would be highly

destabilizing to mREITs. If such changes were to takeplace, however, policymakers might tend to phasethem in gradually.

Assessing Systemic EffectsWhile mREITs are susceptible to various risks, it is lessclear whether these risks are systemic. To what extent,if at all, would mREIT failures threaten the stability ofthe nancial system?

The primary rationale in the literature for hypothesiz-

ing that mREITs present systemic risk, not just private-ly internalized risk, is that spillover effects of mREITdeleveraging could drive down MBS valuations. 8 That, in turn, could have several systemic effects. Itwould affect the balance sheets of commercial banksand other MBS investors, cause repo lenders to pullback funding or raise rates where MBS collateral isinvolved, and drive up mortgage interest rates.

The question, however, is how repo lenderswhowould take possession of the mREITs collateral

would respond to mREITs rapid deleveraging. If theycontinued to hold the MBS collateral, the failure ofeven the entire mREIT sector likely would have littleeffect on MBS prices. On the other hand, if they wereto quickly liquidate the collateral, it is possible thatmajor failures of mREITs would have a material effecton MBS prices (with a further possibility of macro-economic effects by way of mortgage markets).

Intuitively, the relatively modest amount of MBS hold-ings by mREITs might seem to make it improbable

that mREITs pose systemic risk. On the other hand, inMay of 2007, shortly before the nancial crisis, sub-prime rst mortgages accounted for only about 14percent of all rst mortgages, and near-prime loansaccounted for only an additional 8 percent to 10percentyet subprime and near-prime mortgageswere a major factor in triggering the crisis. 9 To be sure,

leveraged portfolio)an mREIT facing a 5 percenthaircut could lever up the original equity by twenty-fold (1/0.05).

Risks Faced By mREITsAlthough mREITs are effectively free of credit risk, the

mREIT model does present investors with a numberof other risks, which are heightened by the use of le-verage. Perhaps the most obvious is interest rate risk.If interest rates were to increase rapidly, the prices ofoutstanding MBS would fall. This would reduce thevalue of mREITs MBS assets, both those MBS that areused as collateral for repo loans (encumbered MBS)and those that are not (unencumbered MBS). The sig-ni cance of the former arises from a feature of repocontracts, namely, that if the value of the collateralfalls more than a speci ed amount, the lender can

issue a margin call requiring the borrower to put upadditional collateral to get back to the haircut per-centage. If MBS values decline enough that margincalls exceed an mREITs unencumbered assets, themREIT likely would default.

mREITs are also vulnerable to rising interest rates dueto their reliance on rollovers of short-term fundingbecause maturing repos would have to be rolled overinto higher-interest repos. In addition, if repo lendersbecame concerned about the value of MBS as col-

lateral, for whatever reason, the result likely would beboth an increase in interest rates on repo nancingand increased haircuts. Thus, a negative shock, or theperception of one, leaves mREITs exposed to the riskthat their cost of funding could rise to levels thatcould fairly quickly make them insolvent, or at whichtheir creditors might simply refuse to lend.

In the event of rising interest rates, the stress placedon mREITs would be further increased by their struc-ture. To maintain their favorable tax treatment, mREITs

(like REITs in general) must, among other require-ments, distribute at least 90 percent of each yearsincome to their owners. Otherwise, they would besubject to federal corporate income taxation. As aresult, mREITs have, at best, modest buffers againststress apart from whatever equity that they keepoutside the levering-up process.


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4 Securities and Exchange Commission, Companies Engagedin the Business of Acquiring Mortgages and Mortgage-RelatedInstruments, 76 Fed. Reg. 55300, (September 7, 2011).

5 See Copeland, Adam, Darrell Duffi e, Antoine Martin, and SusanMcLaughlin, Key Mechanics of the U.S. Tri-Party Repo Market,Federal Reserve Bank of New York Economic Policy Review ,November 2012, vol. 18, no. 3, p. 17.

6 Board of Governors of the Federal Reserve System, Financial

Accounts of the United States, Table L.210, and SecuritiesIndustry and Financial Markets Association, U.S. Agency MBSOutstanding. While mREITs grew signi cantly after the nan-cial crisis, they shrank somewhat during the rst half of 2013,likely due to increasing interest rates and expectations of such increases.

7 Annaly Capital Management Inc. Form 10-Q for the quarterending June 30, 2013, p. 46, and American Capital AgencyCorp. Form 10-Q for the quarter ending June 30, 2013, p. 38.

8 Financial Stability Oversight Council, 2013 Annual Report , p. 90,and Global Financial Stability Report: Transition Challenges toStability , Washington, D.C.: International Monetary Fund,October 2013, p. 10.

9

Bernanke, Ben S., The Subprime Mortgage Market, Speech atthe Federal Reserve Bank of Chicagos 43rd Annual Conferenceon Bank Structure and Competition, Chicago, May 17, 2007.

This article may be photocopied or reprinted in itsentirety. Please credit the authors, source, and theFederal Reserve Bank of Richmond, and include theitalicized statement below.

Views expressed in this article are those of the authorsand not necessarily those of the Federal Reserve Bankof Richmond or the Federal Reserve System.

those shares are markedly higher than the 5.6 percentshare of agency MBS held by mREITs. But a lesson ofthe crisis, arguably, is that the possibility of systemicrisk from an asset class cannot be dismissed on thebasis of its scale alone. The contingencies involved,however, make it challenging to assess the potentialsystemic effects of large-scale mREIT failures.

Conclusion The mREIT sector has mushroomed since the nancialcrisis, thanks to a yield curve that favors the mREITbusiness model and a low interest rate environmentthat fosters reaching for yield on the part of inves-tors despite the associated risks. While mREITs clearlypresent risks to investors, it is not yet clear wheremREITs fall relative to other nancial institutions interms of their systemic risk. The nancial crisis, how-ever, highlighted the potential hazards that leverageand maturity transformation may present to overall

nancial stability, particularly where less-regulatedinstitutions are involved.

Sabrina R. Pellerin is a bank structure manager,David A. Price is a senior editor, Steven J. Sabolis a research associate, and John R. Walter is asenior economist and research advisor in theResearch Department at the Federal ReserveBank of Richmond.

Endnotes1 See, for example, Financial Stability Oversight Council, 2013

Annual Report , pp. 7, 8790, and Global Financial Stability Report: Transition Challenges to Stability , Washington, D.C.:International Monetary Fund, October 2013, pp. 1014.

2 The issues addressed in this Economic Brief , as well as otherissues related to mREITs, are discussed in greater detail in aforthcoming Federal Reserve Bank of Richmond workingpaper by Sabrina R. Pellerin, Steven J. Sabol, andJohn R. Walter.

3 15 U.S.C. 80a-3(c)(5)(C).

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Assessing the Risks of Mortgage REITs

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