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REITs Trigger Fed Warning as Kain Tops $100 Billion

Gary Kain spent 20 years at Freddie Mac managing as much as $800 billion of bonds before the U.S. took over the company. Since 2009, he’s used his knowledge of the home-loan market to help turn American Capital Agency Corp. (AGNC) into the fastest growing mortgage debt investor.

American Capital’s assets grew to $100.5 billion at the end of last year from less than $5 billion three years earlier, making the Bethesda, Maryland-based real estate investment trust the largest after Annaly Capital Management Inc. (NLY), in an industry that’s drawing attention from investors and the Federal Reserve for its double-digit yields and rapid expansion.

REITs bought more than $100 billion of government-backed mortgage securities in 2012, the most since at least the credit crisis, and will purchase another $60 billion in 2013, JPMorgan Chase & Co. estimated this month. Fed Governor Jeremy Stein pointed to the expansion of mortgage REITs, which have amassed almost $400 billion of the debt, during a speech last month on risky behavior in credit markets influenced by the central bank holding borrowing costs near zero for a fifth year and investors searching for high-yielding assets.

“Agency mortgage REITs deserve attention in particular because they have exploded in size,” said John Gilbert, chief investment officer at General Re-New England Asset Management, a unit of Warren Buffett’s Berkshire Hathaway Inc. (BRK/A) that oversees $64 billion. “We’ve been dealing with the unintended consequences of monetary policy for a long time. We have to be on the lookout for the downside.”

Photographer: Justin Sullivan/Getty Images

Homes stand at a housing development on March 6, 2013 in Mesa, Arizona. Close

Homes stand at a housing development on March 6, 2013 in Mesa, Arizona.

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Photographer: Justin Sullivan/Getty Images

Homes stand at a housing development on March 6, 2013 in Mesa, Arizona.

Best Returns

American Capital, along with growing the fastest, has also been one of the most successful of the mortgage REITs. Since Kain, 48, was named chief investment officer, it’s returned 261 percent, including reinvested dividends, almost double the returns of a 34-company index.

The firm was started by private-equity financier Malon Wilkus and went public in February 2008, just as the Fed was responding to the biggest financial crisis since the 1930s.

Wilkus, chief executive officer of investment firm American Capital Ltd. (ACAS), hired Kain to help “navigate the evolving mortgage landscape,” he said in a statement at the time. The original management team had left in January 2009, about four months after the government seized Fannie Mae and Freddie Mac, when loan losses pushed the two firms to the brink of bankruptcy.

Kain, now president of the REIT, joined the firm when it held a little more than $2 billion and the Fed was preparing to start buying government bonds to resuscitate the housing market.

Taking Advantage

He took advantage of the central bank’s buying and used cheap borrowing costs to increase leverage for the REIT’s purchases of government-backed mortgage securities. The bets paid off, with the company returning 53 percent in 2009 including reinvested dividends.

The Silver Spring, Maryland native had spent almost his entire career at Freddie Mac (FMCC), coming from Johns Hopkins University’s Applied Physics Lab. He worked there for 18 months after graduating with a degree in electrical engineering from the University of Pennsylvania.

He wrote computer models for mortgage cash flows in Freddie Mac’s financial research team before moving into trading. By 1995, he was responsible for managing trading decisions and hedging the company’s mortgage positions. When he left, he was senior vice president of investments and capital markets.

Hedging Rates

Kain oversaw an average of about $700 billion during his last few years with the company, primarily government-backed mortgages. Since these bonds don’t take credit risks, his main responsibility was hedging for changes in interest rates. The portfolio also included non-agency mortgage-backed securities, including the subprime debt that helped fuel the housing boom and contributed to the company’s losses that led to the government rescue.

“A major emphasis of the subprime AAA portfolio was around hitting affordable housing goals so it was not as pure of an investment mindset,” Kain said.

When the government seized the company and sought to shrink the portfolio and the company’s imprint on housing finance, Kain said he “knew life at Freddie Mac was going to be very different” and started considering other options.

“His background was a perfect fit for American Capital,” said Jason Arnold, an analyst at RBC Capital Markets in San Francisco. “There’s been a lot of problems at Fannie and Freddie so it’s not surprising that someone would want to go out and do something else rather than be under the umbrella of the U.S. government.”

Biggest Winners

REITs (BBREMTG) have been among the biggest winners from government policies to resuscitate housing and stimulate the economy. The Fed has made it easier and cheaper for the companies to borrow through the so-called repo market. The central bank’s buying has also pushed up the value of mortgage bonds that REITs invest in.

Dividend yields that average about 12 percent have also lured investors seeking alternatives to corporate and government debt paying shrinking coupons. American Capital is yielding more than 15 percent. The company increased 0.8 percent to $32.78 at 4 p.m. today in New York.

Kain has applied knowledge from his experience at Freddie Mac to buy mortgage bonds that have a lower risk of refinancing, helping the firm return 17 percent this year. Since the debt typically trades above 100 cents on the dollar, homeowners taking out new loans when interest rates fall can erase the value of the securities.

The resurgence of REITs has attracted the attention of Fed officials and regulators, including the Securities and Exchange Commission, which has said it’s examining whether the companies should be allowed to continue borrowing without restrictions.

Market Forces

The concerns are overstated as REITs are limited by the quality of assets or lender confidence in how they manage their businesses, according to Kain.

“Fannie Mae and Freddie Mac were not regulated by the markets,” Kain said. “That was a key complaint which turned out to be very fair. There weren’t any market forces that were controlling the government sponsored enterprises. They could borrow money irrespective of their risk posture because of the implied guarantee” of the government, he said.

Kain’s team at American Capital, which includes longtime Freddie Mac colleagues Peter Federico and Christopher Kuehl, managed more in assets as of Dec. 31 than regional banks such as Keycorp (KEY) and M&T Bank Corp. (MTB) Kain is also chief investment officer of American Capital Mortgage Investment Corp. (MTGE), a separate REIT with $7.7 billion in assets that buys securities not backed by the government. The two companies have a staff of about 50 people, according to Wilkus.

No Business

“There are a lot of risks that need managing when you get that big,” said Jason Stewart, an analyst at Washington-based Compass Point Research & Trading LLC. “Kain and his team have managed a block of assets much larger than they are doing today. There are others that have no business having a balance sheet that big.”

Armour Residential REIT Inc. (ARR), which offered 65 million shares to raise capital this quarter, is “an example of a company pushing the limit of what their infrastructure can support,” Stewart said.

Armour, which has returned 15 percent in the past year, had $20.9 billion in assets and 14 employees as of Dec. 31, according to a company filing. The firm has recently doubled the size of its office facilities to accommodate additional staff, according to Chief Financial Officer James Mountain.

The firm is “growing on pace with others in the industry and we are raising capital, expanding our facilities and increasing staff in step with that,” Mountain said.

Selling Shares

Mortgage REITs’ stock sales accelerated this year after grinding to a halt at the end of 2012 when their stock prices fell because of renewed Fed efforts to push down home-loan rates.

American Capital sold $1.6 billion of shares last month, allowing it to purchase as much as $15 billion of government- backed home-loan securities, through the use of borrowed money, according to Credit Suisse Group AG. Mortgage REITs have grown enough to make them eligible to be included in the Standard & Poor’s 500 Index, S&P said in a statement last month.

This addition could create more demand for the shares from mutual funds and exchange-traded funds, Morgan Stanley analysts led by Vipul Jain wrote in a March 1 report.

While mortgage REITs are showing attractive dividend yields -- they have to pay out 90 percent of most types of earnings in dividends, which allows the firms to avoid taxes on the income - - and drawing investor interest, the firms have “some of the characteristics of things one should worry about,” General Re- New England’s Gilbert said. “Is it a full-fledged bubble yet? Perhaps not. Could it go further? Certainly.”

Risk Taking

Fed Governor Stein, who voted in favor of continued asset purchases at the central bank’s January meeting, referenced mortgage REITs in a Feb. 7 speech discussing how some credit markets are showing signs of potentially excessive risk-taking.

The firms had “grown rapidly” by using low-cost, short- term financing to fund purchases of longer-term debt, he said.

Federal Reserve Bank of New York President William C. Dudley said in a speech to the Economic Club of New York this week that agency mortgage REITs “deserve ongoing attention,” from regulators, who “must continue to take steps to mitigate the vulnerability of the economy to a sharp rise in long-term rates” and look “outside the banking system because some risks reside elsewhere.” Dudley also cited the risk of large outflows from bond mutual funds.

Primary Regulators

Low rates pose risks that investors in every market must be prudent about managing, Wellington Denahan, chief executive officer of Annaly, which has about $133 billion in assets, said in an e-mail. The mortgage REIT sector in particular does so through the use of swaps, she said, referring to derivatives that can protect against changes in interest rates.

Unlike banks and insurers, mortgage REITs have no primary regulators. They aren’t subject to the Investment Company Act, which limits leverage.

American Capital uses 7 to 8 times leverage -- borrowing that much compared to its capital, according to RBC’s Arnold. “They are not sticking their neck way out,” he said.

When Kain was at Freddie Mac he ran a much larger portfolio that was levered around 50 to 1, said Merrill Ross, an analyst with Baltimore-based Wunderlich Securities Inc. That gave him experience with different methods of risk management than the ordinary public company or even hedge fund would be exposed to, she said.

“Most investors are less used to leverage; we were used to more,” Kain said. “That’s a key reason why we’ve been successful and why we’ve been using very different hedging techniques than our peers over the years.”

‘Huge Market’

American Capital’s growth also still dwarfs the overall market and the prior holdings of Fannie Mae and Freddie Mac, which had $1.8 trillion in assets on their balance sheets at their peak, according to Kain.

“This is a huge market and we’re not concerned about our size,” he said. “The REITs are a long, long way from what’s in the banking system or what was in the government sponsored enterprises.”

Kain may face bigger challenges at American Capital when the central bank reduces its monthly bond purchases. The Fed’s intervention in credit markets in the past year coupled with policies put in place by President Barack Obama have expanded opportunities for homeowners to refinance while sending borrowing costs to record lows. That’s forced mortgage REITs to make new investments at some of the lowest ever yields, increasing the risk of losing value when rates do rise.

“The ultimate judgment will be when this market sells off,” said Daniel Furtado, an analyst at Jefferies Group LLC in San Francisco. “When the Fed exits and people start to sell and when mortgage securities lose value.”

To contact the reporter on this story: Heather Perlberg in New York at hperlberg@bloomberg.net

To contact the editor responsible for this story: Rob Urban at robprag@bloomberg.net

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