Yesterday was sure an interesting day for the mortgage REIT (mREIT) market. Early in the morning trade investors seemed to be fleeing mREITs. At one point the biggest mREIT, NLY, traded down 18% from its opening price then came back to close down about 3% for the day. This was a highly unusual move to say the least. Lets take a look what happened and see if we can make sense of it.
First, lets take a look at the market’s reaction. The chart below shows the NLY intraday chart. Other mREITs showed similar performances.
So, what happened? Basically, one of those ‘other’ risks I’ve posted on before, liquidity risk in this case, came front and center this week for mREITs. As I stated in that post;
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.
What began to happen this week and came to a head on Friday morning was that investors became afraid of another 2008 type liquidity freeze up in the repo market. Investors are concerned that a downgrade of the US credit rating from AAA will trigger problems in the repo market which will freeze liquidity for mREITs. The two issues being talked about are a rise in repo interest rates and more importantly a rise in the ‘haircuts’ that counter parties, big banks, usually require for mREIT repos. Haircuts are down payments that banks require from mREIT for repos. Usually they run about 4% for agency repos. Bloomerg had a nice article yesterday summarizing all of this that is worth reading.
So, are investor’s concerns justified? I don’t think so. So far there has been no freeze up in repo markets. Both Invesco Mortgage (IVR) and American Agency (AGNC) reported Q2 earnings this week and both CEOs addressed these issues specifically on the conference call. Both said they have only seen a 1 or 2 basis point increase in repo rates, nothing out of the ordinary, and no increase in the haircuts required by the banks. More importantly there is not even a hint of a freeze up, i.e. the willingness of the banks to even engage in repos. This is the critical point. The risk is not a rise in repo rates or haricuts but the functioning of the repo market. AGNC’s CEO made the point that mREITs have operated just fine at with higher haircut requirements and higher repo rates in the past. I encourage investors to listen to both conference calls. So, as long as the repo market functions the mREITs will be fine. So what is the risk the repo market freezes up? I don’t think its very high, this is not 2008, but it is probably non zero. Personally, I would wait to see how this whole debt thing plays out and/or wait for lower mREIT prices before committing new money to mREITs. It almost impossible to invest with such low probability high impact risks. Also, this week pay attention to earnings from more mREITs, especially NLY. CEO, Mike Farrell, will give a lot of insight into this current mess and its impact on mREITs on the earnings call.
What is ironic is that the current economic slowdown, confirmed on Friday in the latest GDP release, is more positive for mREITs going forward. Interest rates will be staying low longer than previously thought. The earnings out of IVR and AGNC confirm that business is great and if anything is getting better, at least on the agency side. The non-agency side has the extra factor of credit risk that has been hurting them as of late. A slowing economy will keep it tough for non-agency REITs but they also are doing well. Business is still good and if anything getting better and mREIT prices are coming down. Sounds like the making of a good setup. IVR and AGNC are both trading just slightly above their recently announced Q2 book values and are both off 19% and 10% off their highs respectively. As the other mREITs announce Q2 earnings and book values I think we’ll see more of the same.
In short, regarding investing in mREITs right now, I’ll quote Falstaff in Henry IV, “The better part of valor is discretion; in the which better part I have saved my life”.
Full Disclaimer - Nothing on this site should ever be considered advice, research or the invitation to buy or sell securities. These are my personal opinions only.