Mortgage investment funds become ‘epicentre’ of crisis

Real estate investments trusts that specialise in buying mortgage-backed securities are playing a prominent role in the current market turmoil, dumping their holdings in response to margin calls by their banks.

The mortgage Reits entered the coronavirus crisis owning an estimated $500bn of bonds backed by property loans and have come under pressure because they use short-term borrowings to squeeze higher returns from their holdings.

“The Reits are at the absolute epicentre of this crisis, given that their business requires leverage,” said Matthew Howlett, Reits analyst at Nomura.

Shares in Annaly Capital and AGNC Investment, the two largest mortgage Reits, have been cut in half in recent weeks. A smaller peer, AG Mortgage, fell 38 per cent on Monday after saying “it does not expect to be in a position to fund the anticipated volume of future margin calls under its financing arrangements in the near term”.

The mortgage Reits fund themselves by pledging bonds in return for cash in the short-term funding, or “repo”, markets, and have assets valued at as much as 10 times their common equity. The high leverage allows them to pay dividends well in excess of the yields on the bonds they buy. Because of their legal structure, the Reits are obliged to pay out substantially all of their earnings to shareholders. 

The falling value of their mortgage bonds, driven down by the rush for cash and worries about defaults as the coronavirus leaves homeowners unemployed, has pushed the Reits past their leverage limits, forcing them to sell bonds into an already weak market. 

“We expect there was a steady pattern of forced selling in recent weeks by Reits to try to manage leverage levels,” wrote UBS analyst Brock Vandervliet in a note to clients on Monday. 

Other types of investors are trying to raise cash by selling mortgage bonds as well. Mortgage traders said multiple companies sought to offload mortgage debt on Sunday, including one mutual fund that sought offers on more than $1bn of bonds.

Mortgage Reits own roughly $500bn in mortgage-backed bonds, or about 5 per cent of the market, according to Nomura. 

The banks the Reits depend on for financing are increasingly hesitant to accept mortgage bonds as collateral — and are pressing the Reits with margin calls, threatening to liquidate the bonds if the Reits do not post more cash. “The dealers want cash, they don’t want collateral,” said Mr Howlett. “They are saying, ‘I have no exit for these loans — I’m going to protect myself’.” 

The mortgage Reits are selling mortgage bonds as the Federal Reserve has been trying to support the market. The central bank said on Monday it would buy “agency” mortgage bonds — which are guaranteed by the government-backed Fannie Mae and Freddie Mac — “in the amounts needed to support smooth market functioning”.

Even as shares of its peers fell, AGNC rose 6 per cent, reflecting the fact that its portfolio is heavily weighted to agency bonds. They accounted for 98 per cent of its portfolio of the end of the fourth quarter. Half of AG’s portfolio, by contrast, was non-agency, and included subprime residential and commercial real estate exposures.

“Based on the Fed’s actions, the thing that should recover first should be agency exposure,” said Mr Vandervliet. 

Annaly, AGNC and AG did not respond to requests for comment.

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