October 30, 2012
Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives. This article originally appeared on the CFA Institute’s Inside Investing blog.
Levered mortgage-backed REITs are dangerous. Many of those who invest in the underlying REITs have little idea what is generating 10%+ yields, nor do they understand what scenarios could lead share prices to drop precipitously. These investors need to recall the lesson we all learned so vividly in 2008 – leverage may increase returns, but it does so by significantly magnifying risk.
Having recently passed the four-year anniversary of the Lehman Brothers collapse, it’s tempting to believe that our capital markets have learned from their mistakes. After all, big banks are more heavily scrutinized (see J.P. Morgan’s “London Whale” debacle), fancy new regulations are in place or in the works (see Dodd–Frank and Basel III), and skepticism has burrowed permanently into the investor psyche. You could be forgiven for thinking that, big, bad Wall Street might have caught us off guard before, but that it can’t any longer.
If only. Every now and then, Wall Street reminds us that it has reverted back to its scary ways from the bad old days. For example, UBS recently announced a new two-times leveraged mortgage REIT exchange-traded note (ETN).
Adding unnecessary leverage to assets that were not safe in the first place – sound familiar?
But if you’re asking, “What is a mortgage REIT, and why is this so bad?” you’re not alone. Let’s examine what’s happening in the mortgage REIT market generally before taking a closer look at the UBS offering in particular.
Brief background on mortgage REITs
REITs typically purchase 30-year agency mortgage pools (issued by Fannie Mae and Freddie Mac) and lever them up. the mechanism by which the REIT does this is taking a newly purchased agency mortgage-backed securities (MBS) pool; entering into a repurchase agreement (repo) with a dealer, where the dealer gives the REIT cash; then purchasing another agency MBS pool with the cash.
REITs repeat this process until they have achieved six- to eight-times leverage.
The appeal of this model is easy to understand, once you consider the shape of the yield curve. Repo rates are based on the short-term end of the curve (let’s assume a cost of 25–50 basis points, for example); agency MBS pools, in contrast, price off of the belly part of the yield curve (5 to 10 years), where rates are higher. In short, the model allows the funds to borrow cheaply, invest at a higher rate, and capture some of this difference in interest rates.
For the better part of the last few years, 30-year current-coupon MBS pools have yielded 2.5% to 3.5%. In addition to incurring the repo cost, REITs typically use derivatives to hedge the interest-rate risk of the fixed-rate mortgage pools. The resulting net spread – after the costs of hedging – has been around 2% for some of the larger agency-only REITs.
The REIT American Capital Agency (Ticker: AGNC), for instance, had a net interest spread of 2.14% in 3Q2011 and a spread of 1.60% in 2Q2012. Because those interest spreads are being levered six or eight times, the leveraged net interest spread ran between 12% and 18% on average.
Ah, so that’s how these REITs were able to pay out such large dividends!
How did we get here, and why Is this scary?
All of this is possible right now because the Fed’s quantitative easing (QE) programs have resulted in extremely distorted pricing of both duration and credit risks. Though it’s an interesting story in its own right, I will not go through an in-depth explanation of how QE has distorted fixed-income risk assets, but if you’re interested to learn more you can go back to an earlier post, The QE Aftermath: What it Means and How it’s (not) Different.
All you really need to know is that there’s an insatiable appetite for yield in the fixed-income markets – Investors far and wide are scrambling to pick up as much yield as possible before it’s all gone. Investment-grade corporate bonds, high-yield bonds, leveraged loans, non-agency MBS, and commercial mortgage-backed securities (CMBS) are just a few asset classes where prices have been charging higher and higher.
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