With the recent developments in the funding market, many market pundits have become experts in the repo market, literally overnight. Certain prices for short-term secured lending spiked dramatically in a market that’s about as sleepy as they come. — Historically pricing movements in benchmark rates of 2-3 basis points are considered “out of whack” for the space.
We saw a movement far greater than that earlier this month when the borrowing cost for overnight loans rose from 208 basis points to 270 basis points in one day. Much ink has been spilled about this price movement, and perma-bears are quick to point out that a similar spike in overnight funding borrowing costs precipitated the global financial crisis. The reality is that technical occurrences like this in an opaque market (one that trades over the counter) can move prices for reasons that cannot be dissected by market pundits. The important observation is that the Fed has stepped in to perform a function well within their mandate – by offering secured overnight loans on high-quality collateral to money center banks.
If you want to know the truth about the recent funding stress, the publicly traded mortgage REITs are the place to look.
By stabilizing the overnight funding market, the Fed has also helped one market participant that has been hurt by the recent inversion of the yield curve: mortgage REITs. A mortgage REIT’s basic business is as follows: borrow short term funds using their own credit, use the proceeds to purchase longer maturity instruments, and pocket the spread between the two rates. Suffice to say that mortgage REITs rely heavily on “term premium”, or the difference in yield between two loans based strictly on the duration of the loan. For example, you would expect a loan made for 2 years to carry a lower interest rate than that of the same loan made for 10 years, all else being equal. The recent yield curve inversion has severely damaged this part of the mortgage REIT business model: an inverted yield curve implies term premiums are negative! You’re being paid less to lend for a longer amount of time.
On top of this, mortgage REITs happen to be one of the most prevalent players in the repo market. Annaly Capital, an example of one of the biggest MREITs, had $105bn of repos outstanding on a balance sheet of $131bn of assets. It’s safe to say they rely heavily on the smooth functioning of this “plumbing” within the financial system. As with other mortgage REITs, pledging their longer-term assets as collateral for these short-term repo loans is integral to the business model. In order to continue making money, mortgage REITs will have to find another avenue to capture their spread —perhaps bearing more credit risk, finding cheaper ways to fund their assets, or being nimble with their hedges. However, the biggest boon for these companies will be when the yield curve is back to its normal, upward-sloping form.
Despite challenges, we currently own a diversified portfolio of mortgage REITs for a variety of reasons. Earnings revisions and dividend cuts have reset expectations in the space, and mortgage REITs have historically provided a tax-efficient yield structure because they are required to pay out at least 90% of their earnings as dividends. We expect the REM, the iShares Mortgage REIT ETF, to yield somewhere between 8-9% over the next twelve months, providing a solid risk-adjusted total return.
This earnings season look to the 10-Qs and conference call transcripts of the major mortgage REITs for clues and insight into both the overnight funding market, and the yield curve inversion. These are two of the biggest factors in their day-to-day business that will make or break the business model. Their health will be a key indicator for the financial system. Bottom line: If you want to know the truth about the recent funding stress, the publicly traded mortgage REITs are the place to look. If they are seeing stress, it’s time to be concerned. We are a cautious hold on the industry and remain invested in the space.