In an investment forum I enjoy, I saw a comment that made me laugh.
One investor, responding to a lengthy discussion of asset mix, hedging, funding and risk in Agency mortgage REITs (amREITs) said that they would stick with easy-to-understand banks, and let the experts play in mortgage REIT land.
Why did I laugh?
Because every bank I know of has a mortgage REIT inside it. Not only that, banks run at far higher leverage ratios on their mortgage portfolios than any of the publicly traded mREITs or amREITs.
Let’s start with mortgages that aren’t guaranteed by government. Those loans are the old-fashioned portfolio loans like Bailey Brothers (Jimmy Stewart’s mythical S&L) made within a community. They are subject to “100% risk weight,” or 8% reserve capital requirements.
We should note that new BIS standards will raise this amount, but that’s the level it’s been at since the Basel II Accord was adopted in 2004.
Put another way, if the bank holds 8 cents of capital for each dollar of non-guaranteed mortgage loan, they are levered 11.5 to 1. That is obviously higher than the 3:1 or so that mREITs that buy non-Agency paper use. In Agency MBS, the numbers are even more “scary” at banks. Agency MBS are “20% risk weight” assets. That means 8% times 20%, or 1.6% capital reserves are required. Theoretically, a bank can be an amREIT running 61.5 to 1 leverage if they only hold that minimal 1.6%.
In practice, most banks have higher measures of risk for their Agency MBS, and typically hold 3% to 6% in capital to deal with the price and spread risk of that product. They report the excess above the required amount as part of their capital. We do, after all, see a lot of banks carrying capital north of 10%, which tends to make investors pretty comfortable.
Now let’s compare that with the publicly traded amREITs. They are running leverage of 7:1 up to around 8:1 at the end of their reporting periods (and I suspect a bit higher during the quarters). That’s the same as a bank carrying as much as 15% capital against a portfolio that requires only 1.6%.
Now a few words on the other side of the story. First of all, banks, especially S&L’s and community banks, fund themselves with “stickier” funding sources like deposits. Those can take up to several years to reset, and don’t carry with them the risk of nightly mark-to-markets. That’s not to say the banks skate free on market value. They have to report their capital based on market value for any asset held for sale or available for sale. They also don’t fund themselves exclusively by taking in deposits. The S&L’s are huge users of FHLB (Federal Home Loan Bank) advances and loans, especially for their mortgages. There is literally trillions of dollars of MBS and mortgage loans funded this way. The FHLB can and does make margin calls, so that funding has a lot of the risk profile that the amREITs have with their repo funding.
For both amREITs and banks, loss of value in their mortgage portfolios is a hit to capital. How it gets reported may vary, but the bottom line is the same.
So, when I see someone say that amREITs are too complicated, and banks are “simple,” I shake my head and wonder whether ignorance is truly bliss, since banks have a whole lot more going on than simply running a portfolio of liquid bonds (MBS).
When you think about it, the main reason banks are tight with credit for entrepeneurs and consumers is the fact that they can run a profitable “amREIT” with virtually no credit risk, and truly astounding ROE. We like our 12% to 18% dividends, and worry about the risk being taken to get that kind of return. If we broke out the Agency MBS and its funding from most banks, we’d be amazed to see returns well north of 30%, and the risk that attends that level of return.