This is the 3rd post on mortgage REIT basics. In my last post on mortgage REITs (mREITs) I discussed interest rate risk. Today, I’ll discuss the other two major risks in investing in mREITs, credit risk and liquidity risk. Both of these risks can lay dormant for long periods of time and then rise quickly to severely impact mREIT prices. As they say in investing, everything is fine until it isn’t. Lets look at credit and liquidity risk and what an investor can do to mitigate them.

Credit risk in mREITs is relatively easy to address. The bulk of investments by mREITs are in what are called Agency mortgages. Agency refers to the fact that the mortgage securities are 100% guaranteed by an agency of the federal government, usually Fannie Mae or Ginnie Mae. That means that for mREITs that invest in agency mortgages there is zero credit risk. Let me say that again. There is no credit risk when investing in agency mortgage REITs. For non-agency mortgage investments credit risk is back on the table and an investor needs to pay attention to the credit characteristics of the mREIT investments. This vast difference in credit risk between agency and non-agency portfolios is clearly evident in the economic numbers of mREITs. For example, lets compare NLY and CIM which invest primarily in agency and non-agency mortgages respectively. See table below.

NLY’s asset yield is lower than CIM’s. NLY’s cost of funds is lower, and their leverage is higher. This makes intuitive sense. Non-agency mortgages are riskier and thus command a higher yield. The banks who loan funds to the mREITs also factor credit risk into the interest rate they charge the mREITs. And because of the credit risk to the portfolio non-agency investments are done at lower leverage. The net effect of these factors is shown in the difference in gross ROE for NLY and CIM. The question for the investor then becomes is the credit risk taken by the non-agency mREIT worth the extra return? For me, all else being equal, a non-agency REIT should offer a higher yield to compensate for the extra risk and extra volatility in the share prices. Investors not wanting to deal with the nuances of credit risk can just contain their investments to agency REITs and avoid the issue all together. The importance of this was evident this week in the share price of CIM. Due to rising concerns of a housing double dip, lower equity by homeowners, and fear of higher defaults, credit fears seem to be raising their heads again in the non-agency mortgage market. CIM was down over 7% on Wednesday alone.

Liquidity risk is much harder to judge. mREITs are subject to liquidity risk because they operate at such high leverage. Their borrowings are of short duration and their assets are of long duration. This mismatch in duration can create major problems if the mREITs cannot rollover their borrowings. This creates liquidity risk, i.e. not having access to funds when you need them. An mREIT’s borrowings are predominantly made up of repos, repurchase agreements, from various counter parties, usually big banks. There is no guarantee that the counter parties will renew the loans once they come due. This is only a problem during times of crisis and was fully on display during 2008. Because of the government guarantee agency mREITs have less liquidity risk than non-agency REITs. The bigger mREITs will tend to have better access to funds than smaller cap REITs. Also, I think experience matters. Many of the REITs today have never been around for an interest rate cycle. AGNC, IVR, HTS, CYS, PMT, TWO are all post financial crisis creations. They have never been through a full mortgage cycle nor have they experienced a freeze up in the credit markets. This doesn’t mean this in and of itself is an issue. It’s just another thing to consider when choosing an mREIT. Personally, in terms of risk, I judge all mREITs versus the biggest, probably the best run, and longest running mREIT around, NLY. NLY has been around for two full mortgage cycles and survived the financial crisis relatively unscathed. During times of tight liquidity it will hold up the best. The other mREITs should be judged against it. So, in order to minimize liquidity risk an investor should stick with the large agency REITs and/or seek higher returns from non-agency or hybrid REITs.

In summary, credit risk and liquidity risk are important considerations for mREIT investors. Both of these risks are ever present in mREITs. Unfortunately, they only seem to pop up to the surface during times of distress or crisis. mREIT investors need to have a plan to deal with these risks such as avoiding non-agency REITs or demanding higher returns for the extra risk. To paraphrase Buffett, the tide will go out again some day, you want to do everything you can to make sure your mREIT is wearing bathing trunks when that happens.

P.S. One potential risk in mREITs I did not discuss is political risk, i.e. the risk that agency mortgages lose the full backing of the US government. While there has been a lot of talk and several proposals made for a new role for the mortgage agencies, all the proposals involve some type of federal guarantee. I don’t think the political environment will allow the government to exit the mortgage environment and thus I think this is a minimal risk.

9 thoughts on “ Credit and liquidity risk in mortgage REITs

  1. Paul:

    That was simple novice level material I can understand. Thank you.
    I am one year into CIM, still ahead after the dip, uncertain of buy/sell or hold. Are there any indicators as to the valuation of non-agency REITs like CIM? What would be the best stretegy to hold the return long and diminish the price/loss factor? NLY and HTS have done very well. Held value and paid well. So have NZF and JNK, but that is another story.

    How about the RSO model? A short novice level explanation would be very appreciated.


    1. Rick, there is a ton of stuff to look at but the best thing is the current yield of CIM vs NLY or other agency mREITs. The market is pricing in the riskier portfolio that CIM has and the potential impact of a slower economy on their mortgage portfolio. At current yields that are not that different , or even lower if you compare to AGNC, CIM is not the place for new money. For existing positions it depends on your buy price. Personally, I swapped out most of my CIM for NLY. I kept a small position. If this is truly a slow down in the economy CIM will come out good in the back half of the year. We’ll see. Like I said in the post, non agency mREITs need to offer higher returns to compensate for the extra risk. The market is in the process of adjusting that.

      I would only touch companies like RSO if they offered significantly higher returns. The risk in their loan portfolio is quite high. At today’s yields, they are not worth the risk IMO.


  2. Paul,
    Good post. Thank you.
    There are so many variables in mREITs. Other than the ones you have mentioned, there are a few other important ones, such as the debt/equity leverage, asset allocation between fix-rate and variable rate securities, and % of invesment hedged.
    HTS, for example, is 100% in agency securities like NLY but unlike NLY, it is only in variable-rate securities.
    I kind of like MFA. It has a mixed of both agency and non-agency securities that are mostly varialbe rate. It also has long management history (IPO in 98). And it is lightly leverage (at 3 to 1). But the yield is lower at 12%.

    1. Tony, good points. Yes, there are a lot of variables especially if you expand to non-agency. For agency, I think 3 variables encompass most of the others; NIM, % change in NIM and book value from interest rates changes, and % of repo book hedged. NLY, MFA, and CMO have been around the longest so they should get much more credit for the experience of having survived two full mortgage cycles and the financial crisis.


  3. Hey Paul, Another great post. I wish the underlying assets in these structures were more straightforward, plain vanilla mortgages. If this were the case, it would be a whole lot easier to know the impact that changes in interest rates will have on valuations of the underlying securities. Unfortunately, in order to generate the cash flow to get the level of returns necessary to make them appealing, they are compelled to invest in some dicey MBS and CMBS tranches. When the dynamics of these type of structures start to crumble and the tide starts to rush out, whether you have a bathing suit on or not, won’t matter.

    1. Chris. True but with agency mortgages you get to bypass all that stuff due to the government guarantee. Yet another reason to stick with agency REITs. Agency REITs are pretty much all interest rate plays. You can see the impact of interest rate changes by looking at the interest rate tables in the 10Qs that all the mREITs are required to publish, i.e. the tables that say for a +100bps rate increase the impacts on NIM and book value will be X. If you don’t buy the gov’t guarantee then all bets are off.

      For me these are securities to be rented for a while and not owned for the long term. Over the years I’ve developed metrics that help me determine when to get in and out of these things.


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