Credit and liquidity risk in mortgage REITs

This is the 3rd post on mortgage REIT basics. In my last post on mortgage REITs (mREITs) I discussed interest rate risk. Today, I’ll discuss the other two major risks in investing in mREITs, credit risk and liquidity risk. Both of these risks can lay dormant for long periods of time and then rise quickly to severely impact mREIT prices. As they say in investing, everything is fine until it isn’t. Lets look at credit and liquidity risk and what an investor can do to mitigate them.

Credit risk in mREITs is relatively easy to address. The bulk of investments by mREITs are in what are called Agency mortgages. Agency refers to the fact that the mortgage securities are 100% guaranteed by an agency of the federal government, usually Fannie Mae or Ginnie Mae. That means that for mREITs that invest in agency mortgages there is zero credit risk. Let me say that again. There is no credit risk when investing in agency mortgage REITs. For non-agency mortgage investments credit risk is back on the table and an investor needs to pay attention to the credit characteristics of the mREIT investments. This vast difference in credit risk between agency and non-agency portfolios is clearly evident in the economic numbers of mREITs. For example, lets compare NLY and CIM which invest primarily in agency and non-agency mortgages respectively. See table below.

NLY’s asset yield is lower than CIM’s. NLY’s cost of funds is lower, and their leverage is higher. This makes intuitive sense. Non-agency mortgages are riskier and thus command a higher yield. The banks who loan funds to the mREITs also factor credit risk into the interest rate they charge the mREITs. And because of the credit risk to the portfolio non-agency investments are done at lower leverage. The net effect of these factors is shown in the difference in gross ROE for NLY and CIM. The question for the investor then becomes is the credit risk taken by the non-agency mREIT worth the extra return? For me, all else being equal, a non-agency REIT should offer a higher yield to compensate for the extra risk and extra volatility in the share prices. Investors not wanting to deal with the nuances of credit risk can just contain their investments to agency REITs and avoid the issue all together. The importance of this was evident this week in the share price of CIM. Due to rising concerns of a housing double dip, lower equity by homeowners, and fear of higher defaults, credit fears seem to be raising their heads again in the non-agency mortgage market. CIM was down over 7% on Wednesday alone.

Liquidity risk is much harder to judge. mREITs are subject to liquidity risk because they operate at such high leverage. Their borrowings are of short duration and their assets are of long duration. This mismatch in duration can create major problems if the mREITs cannot rollover their borrowings. This creates liquidity risk, i.e. not having access to funds when you need them. An mREIT’s borrowings are predominantly made up of repos, repurchase agreements, from various counter parties, usually big banks. There is no guarantee that the counter parties will renew the loans once they come due. This is only a problem during times of crisis and was fully on display during 2008. Because of the government guarantee agency mREITs have less liquidity risk than non-agency REITs. The bigger mREITs will tend to have better access to funds than smaller cap REITs. Also, I think experience matters. Many of the REITs today have never been around for an interest rate cycle. AGNC, IVR, HTS, CYS, PMT, TWO are all post financial crisis creations. They have never been through a full mortgage cycle nor have they experienced a freeze up in the credit markets. This doesn’t mean this in and of itself is an issue. It’s just another thing to consider when choosing an mREIT. Personally, in terms of risk, I judge all mREITs versus the biggest, probably the best run, and longest running mREIT around, NLY. NLY has been around for two full mortgage cycles and survived the financial crisis relatively unscathed. During times of tight liquidity it will hold up the best. The other mREITs should be judged against it. So, in order to minimize liquidity risk an investor should stick with the large agency REITs and/or seek higher returns from non-agency or hybrid REITs.

In summary, credit risk and liquidity risk are important considerations for mREIT investors. Both of these risks are ever present in mREITs. Unfortunately, they only seem to pop up to the surface during times of distress or crisis. mREIT investors need to have a plan to deal with these risks such as avoiding non-agency REITs or demanding higher returns for the extra risk. To paraphrase Buffett, the tide will go out again some day, you want to do everything you can to make sure your mREIT is wearing bathing trunks when that happens.

P.S. One potential risk in mREITs I did not discuss is political risk, i.e. the risk that agency mortgages lose the full backing of the US government. While there has been a lot of talk and several proposals made for a new role for the mortgage agencies, all the proposals involve some type of federal guarantee. I don’t think the political environment will allow the government to exit the mortgage environment and thus I think this is a minimal risk.