Another Misuse of Leverage: mREITs
Just the hint that the Federal Reserve might taper its bond-buying program has already resulted in major damage, especially for retail investors. Mortgage real estate investment trusts (mREIT), which produced double digit gains for investors in 2011 and 2012, started to come under pressure this summer and are selling off again. This story is an old one. With interest rates low, investors were clamoring for yield. Wall Street and money managers were all too happy to manufacture funds to meet the appetite. By the time big dollars flowed into these products, the big gains were nowhere to be found, and problems began to surface. Set out below is the chart of Annaly Capital Management (NYSE: NLY), the largest mREIT. It’s easy to see that recent months have been very unkind to investors.
Instead of putting real estate assets into an REIT, managers purchased mortgage securities as well as debt issued by federal mortgage agencies. Since interest rates were low, the yield on these securities was also low, so the managers had to apply a significant amount of leverage in order to magnify the yield into an attractive return. While many of these mortgage portfolios had relatively short maturity profiles (more accurately measured by duration), the REITs borrowed using very short-term instruments. Short-term borrowing was, of course, incredibly cheap, so it was easy to produce and amplify the positive spread between the yield on the mortgage securities and the cost of borrowing. With the Federal Reserve buying mortgage securities, mREIT investors enjoyed strong double-digit returns as the markets recovered in 2009. Moreover, the REIT structure had major tax advantages over mutual funds, since all income and taxes is passed through to investors. In other words, there is no double taxation. As always, the money managers made out well because investors didn’t mind paying high fees for a product generating out-sized returns.
Mortgage-related securities are particularly tricky to manage. In addition to the obvious problem of interest rate risk, mortgage portfolios face prepayment risk. While mortgages have a final date on which they will mature and be paid off, the borrowers have an option to prepay the mortgages. Thus, most mortgages are likely to be paid off long before the final maturity. However, when interest rates begin to rise, mortgage refinancings tend to slow, and prepayments on existing mortgages tend to dry up as well. The result is that the average maturity on the mortgages starts to extend, further driving down the value of mortgage assets. While these risks can be hedged, the process is far from perfect, and many mortgage portfolios are vulnerable if interest rates rise. As interest rates rise, the leverage in the mREITS and rising borrowing costs magnify the losses. Since mREITs must pay out 90% of all income to investors, there’s less cash to service debt on the leverage.
According to the Richmond Fed, the mREIT market has grown from next-to-nothing to $443 billion since 2006. The product is now big enough to catch the attention of the Federal Stability Oversight Panel and the International Monetary Fund. Both the FSOP and the IMF are concerned that rising interest rates could cause major stress on the broader financial system as mortgage assets decline in price and the mREITs short-term borrowings becomes vulnerable. The Richmond Fed concluded in its recent research brief that mREITs probably don’t pose a systemic risk to the financial system but could unsettle markets.
What is amazing to me is how quickly money managers and Wall Street have been able to replicate the same mistakes that they made during the credit bubble. While mREITs haven’t taken on much credit risk, they have engaged in the same two practices that created the financial crisis. They’ve borrowed heavily to magnify returns, and their short-term borrowings have been not properly matched to their assets. While mREITs operate on a much smaller scale, their borrowing practices are straight out of the playbook of Lehman and Bear Stearns. We haven’t learned a thing.