Shadow Bank REITs Draw Regulator Scrutiny Over FinancingHeather Perlberg and Jody Shenn
Mortgage investors are borrowing from government-chartered Federal Home Loan Banks, raising concerns from their regulator that the trend creates unacceptable risks.
Three real estate investment trusts -- Annaly Capital Management Inc., Invesco Mortgage Capital Inc. and Two Harbors Investment Corp. -- set up insurance units that allowed them to gain access to an FHLB in the past seven months. Commercial real-estate lender Ladder Capital Corp. joined the network of 12 regional cooperatives in 2012. Two Harbors and Ladder had borrowed a total of about $1.5 billion through March.
Lightly regulated investment firms and lenders that lack customer deposits are flocking to the FHLBs for dependable funding, often with better terms than traditional banks or debt markets. Their memberships are drawing scrutiny from the home loan bank overseer, the Federal Housing Finance Agency, because they may affect the safety of a system that operates with perceived taxpayer backing. FHFA Director Melvin Watt said last month he saw “possible issues” with the insurers’ access.
“Just because it’s legal doesn’t mean it’s not risky,” said Karen Shaw Petrou, managing partner of Washington-based research firm Federal Financial Analytics Inc. The companies “are technically eligible borrowers because of carefully constructed windows. These are not traditional banks. They’re very different.”
Mortgage REITs, which aren’t required to pay taxes if they pay out most of their earnings in dividends, invest in everything from government-backed securities to residential loans too large for federal programs and commercial property debt. The 44 members of a Bloomberg index of publicly traded mortgage REITs, some of which are run by money management firms, own almost $500 billion of assets. Ladder Capital, which isn’t a REIT or bank, makes commercial mortgages to package into bonds.
The firms are part of the shadow banking system because they lack the regulatory oversight and emergency funding tools of traditional banks. They’re joining FHLBs through so-called captive insurers, which are units that mostly serve needs of the parent companies.
“We want to and plan to address the issue of captives,” said Peter E. Garuccio, an FHFA spokesman. “We are looking at our toolkit of what we should do in terms of the next steps.”
The two home loan banks lending to these companies said that the risks are limited by practices that have kept FHLBs from ever suffering losses on their loans. Expanding funding options for the firms may also be a boon for property buyers and real-estate markets that the system is meant to bolster.
The FHLB of Indianapolis, Indiana, is accepting REIT insurance units as members and granting them loans under criteria that are “well-established for all member classes,” which have included insurers since Congress created the system, Jeff Sanders, a spokesman, said in an e-mail. “In addition to carefully underwriting every member, the bank controls and closely values and monitors each member’s collateral position.”
The FHLB in Des Moines, Iowa, requires collateral on every loan, so the borrowing is “fully secured,” Dan Clute, its chief business officer, said in a March telephone interview. The Two Harbors subsidiary, its first REIT-related member, was put through “the same exact process” any other prospective member would face, he said.
The lending network was set up in 1932 after a string of bank failures caused by runs on deposits. In return for buying stock in the institutions and pledging collateral such as mortgages, highly rated bonds or other assets, the members receive access to low-cost, wholesale funding.
The cooperatives’ lending is fueled by joint sales of bonds, now totaling $786 billion. Because of the perception the government would step in to prevent a default, they sell the debt at yields similar to Treasuries, with the notes carrying a top rating from Moody’s Investors Service and the second-best from Standard & Poor’s, the same as its U.S. ranking.
The FHFA, which Watt took over in January, monitors member activity at each bank.
“Captive insurance borrowing and membership in the FHLBank system raises a number of possible issues related to safety and soundness and access to the system,” Watt said in a speech at a conference for FHLB directors in May. “You will certainly be hearing more about this as we move forward.”
While mortgage REITs’ insurance units are overseen by state regulators, the financial health of their parent companies aren’t the responsibility of any U.S. agencies.
Two Harbors, which is managed by hedge fund Pine River Capital Management LP, linked up with the Des Moines FHLB last year. The Minnetonka, Minnesota-based REIT plans to use its membership to finance assets including mortgages that don’t qualify for government-backed guarantees before packaging those loans into bonds, according to Two Harbors Chief Investment Officer Bill Roth. The loans could also serve as a substitute for securitizations or help Two Harbors retain AAA classes if investor demand isn’t strong enough, he said.
“We believe what we’re doing is very consistent with their mission,” Roth said last month in a telephone interview.
Annaly, the largest mortgage REIT with $82 billion of assets, last quarter had an insurance subsidiary join the Des Moines bank. The New York-based REIT will use the loans “as one of the many complementary funding alternatives available” to the company, President Kevin Keyes said in an e-mail. “The FHLBs are very strict with respect to their credit process and criteria for access to advances.”
Invesco Mortgage Capital’s unit joined an FHLB last quarter and started borrowing against its AA rated commercial-mortgage securities, Chief Executive Officer Richard King said on a conference call last month. The Atlanta-based firm in the future may use the membership for residential and commercial mortgages, he said.
Ladder Capital uses its FHLB funding from Indianapolis to buy mostly AAA rated bonds, CEO Brian Harris said last month in a conference call. The New York-based firm is in the process of applying to increase the $1.4 billion in available financing from the FHLB, Chief Financial Officer Marc Fox said on the call.
Hatteras Financial Corp. and Redwood Trust Inc. are among other mortgage REITs considering FHLB memberships, their executives said on conference calls in the last two months. Spokesmen for Invesco Mortgage, Ladder Capital, Hatteras and Redwood declined to comment.
The REITs are diversifying their investments and funding sources after struggling to navigate the Federal Reserve’s moves to scale back its monthly bond buying, as well as facing dwindling returns on distressed debt. The FHLBs offer a better way to finance some of their new investments since the market for home loan bonds is stagnating, with issuance down 73 percent in 2014, according to data compiled by Bloomberg.
Some FHLBs aren’t ready to start lending to the mortgage REIT units. The Home Loan Bank of Atlanta is still weighing it, in part because of regulators’ concerns, Robert F. Dozier Jr., its chief business officer, said last month in an interview.
“We’re taking a methodical approach,” he said.
It makes sense for the FHLBs to expand their reach to firms such as mortgage REITs, with the proper controls, said Clifford Rossi, a former Citigroup Inc. risk manager who is now executive in residence at the University of Maryland’s Robert H. Smith School of Business in College Park.
“Anytime you’re increasing access to a low-cost, liquid source of financing, that’s a potentially a good thing, because it can be passed on to borrowers in the form of lower rates,” Rossi said. “The policy question is whether opening up the door to institutions that may not be regulated like banks might pose some sort of counterparty risk in the future.”
While the traditional membership base of the home loan banks has been contracting, interest from insurance companies has been expanding, Watt said in his speech last month. Borrowing by insurers in 2013 increased to 14 percent of the banks’ loans, known as advances, up from 1 percent in 2000. The number of insurance members is now 290, he said. The FHLBs have about 7,500 total members.
Marriage of Convenience
“If you don’t have primary members seeking advances and need to pay dividends you need new customers,” said Petrou of Federal Financial Analytics. “So this is a marriage of extreme convenience.”
While FHLBs provide a new source of funding, their advances are limited, providing only a small amount of the REITs’ necessary borrowings, according to Merrill Ross, an analyst with Baltimore-based Wunderlich Securities Inc.
Two Harbors can only get $1 billion from the FHLB of Des Moines. “It’s a much bigger company than that,” Ross said, with borrowings in excess of $12 billion.
As the FHFA considers how to address REITs gaining access to the lending network, the financing may alleviate a concern of other regulators. The International Monetary Fund and Financial Stability Oversight Council have said the investors’ reliance on short-term funding could dry up in a crisis, forcing asset sales that ripple across the financial system.
The banks’ regular bond sales allow them to offer advances with a range of maturities and terms. During the last credit seizure their steady financing of firms prompted New York Fed researchers to call the system the “Lender of Next-to-Last Resort” in a 2008 paper, ahead of the central bank itself. Member borrowing reached a year-end peak of $901 billion that year, from $642 billion at the start of 2007, as other providers of credit to banks and insurers retreated.
“If you go back to 2008, you saw the private guys completely withdraw,” Rossi of the University of Maryland said. “The Federal Home Loan Banks should be encouraged to widen their access, so long as they have the proper controls.”