mREITs Have Moving Parts

I’ve gotten a number of calls and e-mails, comments and inquiries about the amREITs, especially since they hit a major air pocket this morning.  I’ll keep my comments general without mentioning opinions of specific REITs.

I had planned to back away from commenting about these companies while negotiating for a possible position with a firm that deals with them. The stock prices got hammered so hard this morning that some may think there is a serious problem.

I think it might help to explain the function of the reverse repurchase agreement (repo) in an amREIT, since that’s the only thing that has really changed so far. Then I’ll take a shot at predicting what may happen during and after this fabricated crisis over the debt ceiling increase.

Before I get into the specifics on the only moving part (repo) that is currently moving, I should probably point back to a few of the elementary posts from the last two years that explain the mechanics of an Agency mortgage REIT.

You’ll see some links after the break.

Below are posts that explain the ABC’s of amREITs, and my impressions of the strategies of a flock of players in the space.  These posts all date to the fall of 2010, when the amREITs were being “discovered” by the financial press and the big Wall Street Houses.  Your eyes are not playing tricks on you if you click on the links.  I did make up new, alternate titles for those posts from last year.

mREIT Basics

A Tale of Two amREITs

Banks Are amREITs, Too

mREITs Getting Bigger

Company Impressions

Back to this morning’s bloodbath.

In addition to the new entries to the field (Angelo Gordon’s MITT, for example), nearly all the older mREITs have raised new equity capital this year.  Taken together, the group probably holds closer to $200 billion of MBS than the $100 billion or so they had this time last year. Putting that in perspective, it’s still a $5.2 trillion market, and when Pimco likes (or dislikes) MBS, they can move more bonds than all the amREITs put together.  The Fed even put Pimco and Blackrock to shame when they stepped up for about a trillion dollars of MBS during QE1.

Just to keep the recent history in mind, when the Fed was active, we literally had hundreds of billions of “fails” floating around in the system, because they weren’t lending out their assets the way most big institutions do.  They tricked everybody by taking delivery and then just holding them.  The Bass Brothers of 1980 or Fisk and Gould of 1869 would have been proud.

But we were talking about today’s Richter 6.5 tremors.

The effect of this debt ceiling debate has been like one of those slow river floods in the north central plains caused by winter melt.  The river keeps rising by an inch or two each day, and people behind the levees start filling sandbags and watch the levees for damp spots.  Today you would have thought the levee burst, given the furious nature of the selling in the first few minutes of the market.

Lately, there have been several articles about repo rates and “haircuts” — the margin requirement for repo borrowing — that scared more than a few holders of the mortgage REITs.

Like the people in the towns protected by levees, holders of levered MBS bond funds (and that’s basically what an amREIT is) are right to be concerned.  Today, perhaps spurred by the realization that market disruption and default is apparently a valid political option, liquidation begot liquidation.

No doubt a number of naturally cautious income investors saw their shares sold in stop-loss sales that truly sucked.  I can just imagine how a holder of NLY bought recently for $18.50 or so as a safe yield play finds out that their $17 stop loss order resulted in a sale at 9:32 AM for $14.50.  Worse yet, it looks like the stock will end the day closer to $17 than to $14.  You might as well call it a “lock loss” order….

I did say I’d mention how the repo rate is moving, and how that affects the earning power of these companies.  I’ll also address the fear that the companies might be forced to sell their portfolios into a hostile market by margin calls.

With the worst possibility addressed first, the fact is that nobody in the amREIT group is anywhere near getting life-threatening margin calls.  They’ve kept their leverage in the 8×1 region, which translates into about 11% equity.  For now, the repo lenders who take Agency MBS as collateral are only asking for equity “haircuts” of 3% to 5%.  So, no worries.  The amREITs have plenty of cushion.

The amREITs also have plenty of liquidity from the repo lenders.  Frankly, since so much of the $5 trillion in MBS the amREITs do not own is held by banks, my guess is that the Fed would step in and provide repo if the mega-banks and dealers couldn’t.  That  already happened in the 2008 crisis, so they don’t even have to make up a new alphabet soup name for it.

So that leaves a major spike in medium term rates (five to ten year) as a concern, since MBS will price relative to those Treasuries. That scenario would cause a major decline in the value of the MBS, which is another way to get debilitating margin calls.  So far, MBS are slightly up in price for the day.

Needless to say, if the default scenario plays out to the point of actual default or repudiation of Treasury debt, the spike in interest rates could happen, but I would think it would take even more drastic irresponsibility than I can imagine to get to that point.  In the analogy of the flood, that would be like looking the already flooding river, and blowing the upstream dams just before a major storm system hits.

The one part that is moving against us (as amREIT holders) is the rate charged for short-term repo borrowing.  That’s up to about 20 basis points (overnight rate) from a low around 5 basis points a month or two ago.  Putting that into perspective, that repo rate was around 15 basis points at the end of 2009.

In general, repo rates track one month or three month LIBOR, so the most frequent hedge used by amREITs “locks in” LIBOR for the next couple of years for some or most of their financing needs.

Right now, the relationship between the LIBOR hedges and the actual financing rates (what we call the “basis”) has gotten out of whack by ten or fifteen basis points compared to its typical range.  So that means the amREITs may have lost 15 basis points or so from their net interest margin.  Not really a big deal, since their earnings are based on a couple of hundred basis points of net interest margin these days.

Still, that may decrease income this quarter, and sets up a potential for the price of the stocks to get whipsawed down, and then back up.  If Street analysts haven’t modeled in the basis between funding costs and hedges, they may overestimate earnings for Q3, which might lead to a few “disappointing earnings” announcements.

If human nature doesn’t change, chances are that any analyst who gets surprised to the downside by Q3 earnings might adjust their expectations for Q4 downward just enough for Q4 to turn into an upside earnings “surprise”.

I leave it to you, kind reader, to figure out what might happen to the stock prices if the earnings disappoint this quarter and surprise to the upside next quarter.  Bear in mind that we’re really talking about effects that will cause MAYBE 5% to 10% variance in earnings.

All bets are off, of course, if the political class manages to create an actual default or a liquidity crisis.  For directional guidance, those two bad events are bad for amREITs. There is also the potential for creating a nasty recession starting right here and right now.  That would most likely be good for amREIT holders, since it would auger well for continued low interest rates for a couple more years.

That third possibility, the lower-low double dip recession spurred by creating millions more unemployed middle class workers, would the TERRIBLE for non-Agency mREITs, but good for the guys holding Agency MBS, presuming Uncle Sam keeps paying.

hh

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One Response to mREITs Have Moving Parts

  1. Wayne says:

    Thank you Howard for taking to time to put this blog together.

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