*By John O’Brien
Warren Buffett came to my wife in a dream and told her to put all her retirement savings in Berkshire Hathaway stock. So, she did. Not to be outdone, I lay in bed waiting for inspiration. The only person I could come up with was Michael A.J. Farrell, who invented the mortgage REIT.
I had met Farrell twice, once briefly in 2006 when a manager interview with his company, Annaly Mortgage Management, that was going poorly required sound-bite intervention from him, and a second time in early 2007 when he arrived in our office in an expensive camel hair coat, looking as if he had just gotten over low-grade pneumonia.
Perhaps it wasn’t the finest inspiration, but it was the best I could do. Plus, no-one I ever knew had ever invested in a mortgage REIT. Plus, they all paid 10 per cent dividends. So, I duly invested in two of them and then excitedly wrote to their investor relations departments, explaining that Australians had a lot of big, income-hungry investors who would love to learn more about their mortgage REITs. I never heard back from any of them.
What is a mortgage REIT? It is a REIT that invests in mortgage-backed securities. The best way to quickly understand mortgage REITs is to read (or re-read) Michael Lewis’ ‘Liar’s Poker’. The book’s name is perhaps unfortunate, because the book is primarily about how mortgage-backed securities were originally put together and how they work. The book is not about mortgage REITs per se, but to understand a mortgage REIT you need to understand mortgage-backed securities, and in particular how they are issued, regulated and traded in the US. The existence of a regulated market in mortgage backed securities makes mortgage REITs possible.
Neither the issuance, regulation or trading of government-sponsored mortgage backed securities has materially changed in the past 20-25 years, including through the financial crisis of 2008-2009, nor are they expected to change in the future. This is an asset type and strategy that is both stable and unchanged (although they are able to take advantage of new types of mortgage securities and practices). It has little to no risk from technological or regulatory change. Its primary risk – leverage – is one that poses low risk if managed prudently.
At a reasonable valuation (close to book value), mortgage REITs are an attractive asset type in most markets. It is just that, like mortgage-backed securities, they have largely fallen from investor consciousness. That represents an opportunity for investors, particularly those that are interested in income streams.
Why invest in a mortgage REIT? Because it must pay 90 per cent of its income and because it uses leverage, a mortgage REIT generally pays a 10 per cent dividend to its investors. In a world in which high-risk credit funds can generally only get you in the high single digits and even high-yield bonds only pay 4-5 per cent, that is significant. In addition, virtually all mortgage REITs are trading at book value, so an investor is not paying a premium for its net assets.
How does a mortgage REIT work?
In essence, a mortgage REIT is like an investment company: it invests in mortgage-backed securities and mortgage pools, and it does so through equity and by borrowing money.
Mortgage REITs basically fall into two types:
- those that invest primarily in agency (guaranteed) mortgage-backed securities, and
- those that invest in non-agency (non-guaranteed) securities.
The first kind don’t generally have credit risk because they’re backed by the US government. The investment company’s skill here is in managing interest rate risk, as well as prepayment risk. These mortgages don’t pay a lot (3-4 per cent yield), so the mortgage REIT increases the yield by pledging mortgage backed securities as collateral in short-term repurchase agreements.
The second kind do have credit risk. These include private mortgage company (so-called private label) securities, non-performing, re-performing, and real estate-owned mortgages, as well as securities that have been created by the government agencies to transfer credit risk (so called credit risk transfer securities). Because of the credit risk (as well as interest rate and prepayment risk), these mortgages pay more (5-7 per cent). Again, the mortgage REIT increases the effective yield by pledging the securities as collateral in repurchase agreements.
Let’s get back to Michael Farrell for a moment. Farrell, who was so tall that you wondered how he fit behind his desk, started as a bookkeeper and never completed college, figured out that since you could use government-guaranteed mortgage securities as collateral for other loans, then you could borrow from the repo market using these securities. With the amount you borrowed you could invest in more government guaranteed mortgage securities.
Repurchase agreements are therefore the key financing tool used by mortgage REITs to increase their equity investor returns. The mortgage REIT may issue preferred stock and some long-term debt, but the majority of its funding comes from repurchase agreements. In a repurchase agreement, the mortgage REIT pledges mortgage securities as collateral to a bank or other counterparty in return for cash.
It agrees to take back the securities after a fixed period of time (usually less than a year). It takes a haircut on the cash it gets (85-95 per cent), and because it maintains ownership of the security, it also has to pay an implicit financing cost to the bank at the end of the repurchase period.
This is how the mortgage REIT generates leverage. It is, therefore, dependent on the repurchase market functioning, but it would take a financial crisis of larger proportions than the last one to destroy a functioning repo market, which as we have seen over the past six months has become a basic financial liquidity tool that most financial regulators are motivated to keep functioning.
Farrell passed away in 2012, but his company, Annaly Mortgage Management, is still chugging along, as are the 10-15 other mortgage REITs that also realised he had a good idea. Warren Buffett seemed old the last time I saw him, in 1996, but is still producing insightful commentary 25 years later.
Who did better? My wife’s Berkshire Hathaway B shares investment is up 10-15 per cent over 18 months, but of course Warren does not pay dividends, as I have to keep reminding her. Still, she has people like Bill Ackman copying her strategy, and I have… a couple of local US stockbrokers who always seem to initiate coverage at a price a couple of cents above where the mortgage REIT is trading. My mortgage REIT investments were down an average 3 per cent on a capital basis, but each paid 15 per cent cumulative dividends over the same time period. So, we’ll call it a tie for now.
The mortgage REIT investments were hindered during most of the last 18 months by an inverted yield curve, which meant that their short-term funding cost wasn’t that low compared with their investment yield. And there was the repo market scare in October 2019, which even though the Fed fixed it scared me too and led me to declare the experiment over. If I saw them in an income fund, though, I wouldn’t be scared. The problem is that very few investment managers anywhere know anything about them. But now you do.
*John O’Brien, CFA, is a principal advisor at Whitehelm Capital, an investment advisor and consultant with offices in Canberra, Sydney and London. This article reflects his own thoughts and opinions rather than those of his employer.