REITs Deepening Bond Losses as Leverage Forces SalesJody Shenn and Heather Perlberg
Annaly Capital Management Inc.’s Wellington Denahan, head of the largest mortgage real-estate investment trust, told investors less than three months ago that reports REITs could threaten U.S. financial stability were as misleading as the media frenzy over shark attacks in 2001.
Since the May 2 comments, shares of the companies, which use borrowed money to make $400 billion in credit market bets, dropped about 20 percent and the value of their assets has plunged after the Federal Reserve triggered a flight from bond funds by signaling plans to slow its debt-buying program.
REITs may have needed to sell about $30 billion of government-backed mortgage securities in just one week last month to maintain the amount of borrowing relative to their net worth, according to JPMorgan Chase & Co. Those types of sales deepened losses in the mortgage-bond market, which had the worst quarter since 1994, accelerated the exit from fixed-income funds and fueled a jump in home-loan rates to a two-year high.
REITs “have been one of, if not the biggest contributors” to the underperformance and volatility in mortgage bonds, said Bryan Whalen, co-head of mortgage bonds at Los Angeles-based TCW Group Inc., which oversees about $131 billion of assets.
Mortgage rates jumped to 4.46 percent at the end of June, up from a near-record low of 3.35 percent in early May, after the central bank indicated it will taper its monthly debt buying, including $40 billion of government-backed housing debt. Investors pulled about $60 billion from U.S. bond funds in June, the biggest monthly redemptions in records going back to 1961, according to estimates from the Investment Company Institute.
Firms including Annaly, American Capital Agency Corp., the second biggest of the companies, and Armour Residential REIT Inc., sell shares to the public so the capital can’t be redeemed. They also rely on leverage, typically using about six to eight times the amount of borrowed money compared with their capital.
That means they benefited from cheap financing as the Fed kept short-term interest rates near zero for more than four years. REITs more than tripled holdings of government-backed home-loan bonds since 2009 and their increased buying power helped push down mortgage rates.
Securities guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae have lost 2.5 percent since March 31, including 1.9 percent last quarter, trailing similar-duration U.S. government debt by 1 percentage point, according to Bank of America Merrill Lynch index data. REITs are plunging in part because the relatively worse performance of the mortgage bonds eroded the value of hedges against rising rates.
“The industry relies on leverage, and leverage cuts both ways,” said Ken Hackel, the head of securitized product strategy at Stamford, Connecticut-based bond broker CRT Capital Group LLC. “In good times it generates above-market returns. But when times get tougher, it creates challenges tied to the need to unwind it.”
The REITs, which focus on property-linked assets and avoid taxes by paying out 90 percent of their earnings, lured investors with returns of 19 percent last year and dividends in excess of 13 percent, almost twice the average yield on company junk bonds.
Annaly’s Denahan presented her shark analogy after Fed Governor Jeremy Stein referenced mortgage REITs in a February speech on how credit markets were showing signs of potentially excessive risk-taking. Media reports suggested that the Financial Stability Oversight Council, or FSOC, could call for new oversight for the firms in an annual report due in April.
Three shark attacks in July 2001 ignited a media frenzy resulting in a Time magazine cover story titled “Summer of the Shark,” Denahan said on a conference call with analysts to discuss Annaly’s first-quarter earnings.
“The lesson of the summer of 2001, the summer of sharks, is that fears rose with the level of media attention, even though there had been no actual change in the risks of shark attacks,” she said. “Mortgage REITs are going through their own summer of the sharks.” In reality, “I do not believe that the mortgage REIT sector poses a threat to the financial stability of the United States,” she said.
Denahan declined to discuss her comments of the performance of the REITs, Annaly spokesman Jay Diamond said this week.
Annaly, with $126 billion of assets as of March 31, grew from $69 billion at the end of 2009 and returned 43 percent, including reinvested dividends during the period. It fell 2 percent to $11.53 at the close in New York, extending its drop to 13 percent this year and 23 percent since the conference call.
The FSOC didn’t say Annaly or its rivals needed special oversight, nor did it make any recommendations for specific regulatory changes in its report released in April. CRT’s Hackel said there have also been no signs of lenders to the mortgage REITs making sudden changes in terms and rates, a risk cited by the FSOC that could create a loop of more forced sales.
The repurchase agreement, or repo markets, used by REITs to borrow have been steady, according to Kenneth Steele, chief financial officer at Winston-Salem, North Carolina-based Hatteras Financial Corp. and Byron Boston, chief investment officer of Glen Allen, Virginia-based Dynex Capital Inc.
“Even in the last few weeks, we’ve had longer-term repo offered to us,” said Steele, whose REIT invests mainly in adjustable-rate agency mortgage bonds, unlike most of its peers.
Haircuts, or the difference between collateral values and loan amounts, weren’t changing last week even amid some of the highest bond-market volatility in recent months, said Boston, who was traveling in China.
“I keep checking,” said Boston, whose REIT owns more commercial-mortgage bonds than some peers.
Still, REITs’ sales of mortgage bonds to meet margin calls and maintain leverage have “absolutely been a factor” in the slump in mortgage-bond prices, Hackel said.
Credit Suisse Group AG analysts led by Mahesh Swaminathan wrote in a July 8 note to clients that higher interest rates could trigger further REIT sales, creating a “key risk” to their recommended bet that mortgage bonds would outperform.
REITs and other investors that use leverage helped push up bond yields as they sold debt or added bearish bets on Treasuries as hedges, Scott Minerd, chief investment officer of Guggenheim Partners LLC, said in a July 9 note to clients.
“Rising rates will continue to reduce housing affordability, which is especially troublesome because housing is the primary locomotive of U.S. economic growth,” he said.
U.S. government-backed mortgage securities account for 29 percent of the Barclays U.S. Aggregate Bond Index, a common benchmark for mutual funds, meaning the debt’s performance can be influential in determining the returns seen by investors, according to data from the bank.
American Capital and Armour Residential REIT Inc., which target Fannie Mae, Freddie Mac and Ginnie Mae securities have been some of the worst performers. Both slumped more than 30 percent since Denahan’s remarks, with American Capital dropping a further 2 percent today.
American Capital President Gary Kain and James Mountain, Armour’s Chief Financial Officer declined to comment on the companies’ losses.
“The space has not been getting love,” said Jason Arnold, an analyst at RBC Capital Markets in San Francisco. “It seems like one way or the other they’ve had fears weigh on valuations. Last fall it was that rates were so low that new investment spreads were not as attractive and investors were worried about earnings and dividends. Now rates have moved up and instead they are worrying about book value.”
Investors have been overcompensating in selling REIT stocks while preparing for bond prices to fall further, according to Steven Delaney, an analyst in Atlanta at JMP Securities LLC. That’s increased the discounts to net values of REIT holdings, or book values, at which the shares trade.
On July 5, companies that invest in only government-backed bonds were trading at 88 percent of current book values on average, he said. Whether to buy the shares depends mainly on the direction of mortgage-bond prices, which may be set for new sharp moves with Fed Chairman Ben S. Bernanke speaking today in Boston, he said.
“It’s kind of a coin flip,” he said. “I’m hoping Bernanke is going to try to calm the market a little bit, but I don’t want to invest on that hope.”
Analysts are split over whether the worst is over for the mortgage REITs.
Daniel Altscher, an analyst at FBR Capital Markets & Co. said the group “got undeservedly whacked and from a trading perspective looks attractive in the short term.”
Merrill Ross, an analyst with Baltimore-based Wunderlich Securities Inc. said this week she didn’t see relative value in REIT stocks for the first time in five years.
“There is heightened risk that the only way to raise liquidity might be to disgorge bonds at firesale prices,” Ross said in a report this week. “Investors need to be mindful of the potential downside scenarios.”