Capital Destruction, Inc.

A version of this article was published in the December 2013 issue of Morningstar ETFInvestor. Download a complimentary copy here.

Share prices of the two biggest mortgage real estate investment trusts, Annaly Capital Management (NLY) and American Capital Agency (AGNC), are down more than 30% since last April. Both firms, as of this writing, offer double-digit yields and are buying back shares. Insiders have been buying, too.

I took a hard look at owning the sector through  iShares Mortgage Real Estate Capped (REM). MREITs are unusual creatures. They buy mortgage-backed securities or make loans directly, usually with heaps of borrowed money, and then try to hedge the risks. They earn the spread between interest income and funding costs. This makes them much like specialized banks without access to sticky, low-cost deposit funding and without prudential oversight. What could possibly go wrong?

Plenty. For as long as they've been around, mREITs have blown themselves up like clockwork once a decade. Exhibit 1 shows the price return of the FTSE NAREIT US Mortgage REIT Index. From the end of 1971 to October 2013, the annualized price return of the index was negative 12.43%. The total return was 4.89%, barely ahead of inflation over this period. Many of the biggest mREITs from as recently as 2007 don't exist today or are shadows of their former selves--anyone remember TMST, American Home Mortgage Investment, or New Century Financial?

The biggest mREITs today, of course, have weathered past storms well. Some might find solace in this fact. However, one would expect the past survivors to be the biggest today even if no mREIT manager exhibited any skill. Without some judgment about whether today's winners were lucky or not, you cannot point to size and historical performance as solid proof of skill. You need to examine a manager's process, way of thinking, and current capabilities.

Even if a manager jumps these hurdles, I'm skeptical of the structure. The problem with mREITs is that their managers have incentive to take on irresponsible levels of debt and grow their assets as fast as possible. During good times, which can last for years, they earn huge bonuses by borrowing as much money as they can get their hands on. When the inevitable bad times come, their pay isn't clawed back. Heads, I win; tails, you lose.

Of course, the same could be said of banks. Prior to the financial crisis, many banks leveraged up through off-balance-sheet financing. However, banks are special. They can borrow cheaply by using deposits. Thanks to federal deposit insurance, they don't have to worry about their funding fleeing at a moment's notice. And last, but not least, regulators are willing to prop them up. During the 1980s Latin American debt crisis, many American banks had a ton of bad loans on their books. They were insolvent. Regulators let the banks avoid marking down the value of their debt, burying the problems, and the banks earned their way out of the hole. The price of these privileges is the heavy hand of government oversight.

If traditional banks are like Volvos, mREITs are like race cars--without seat belts or airbags. They have to borrow money short-term from financial intermediaries, usually by putting up their assets as collateral. You can rest assured mREITs will face margin calls when their assets are declining in value, forcing them to liquidate holdings in fire sales. This is exactly what happened during the financial crisis and to a lesser extent in the middle of last year when interest rates spiked.

In all fairness to mREITs today, their leverage ratios are much lower than they were in the past. The typical leverage ratio is around 7 and falling. It might be a good time to buy.

However, I don't want to own them all through an index fund. It's a good bet that over the long run the sector will blow up. And buying every single mREIT is kind of like owning every mutual fund in a category--a recipe for mediocrity.

There's plenty of room for skilled managers to add value in this area. Mortgage-backed securities are among the most complicated fixed-income instruments out there. Unlike Treasuries, MBS have negative convexity. Their duration increases when rates rise as borrowers slow down payments and lock in favorable rates. Their duration decreases when rates decline as borrowers refinance their mortgages at lower rates. Managing these yield-curve risks requires a world-class team. If you're talking about nonagency MBS, which aren't guaranteed by Fannie Mae, Freddie Mac, or Ginnie Mae, you also face the risk of defaults. On top of it all, MBS blend together mortgages from many different borrowers in far-flung locations. There's no easy way to forecast how borrower behavior, defaults, and changes on home prices will affect the income from an MBS. You need to do a lot of fine-grain data collection and modeling to come up with reasonable and robust estimates of these risks. Because of these challenges, mREITs are in large part a bet on the jockey rather than on the horse, more so than in many other industries out there.

This is actually good news for the discriminating mREIT investor today. Money managers have in recent years launched mREITs to take advantage of the carnage in the sector. The level of MBS expertise available through mREITs is probably the highest it's ever been. For example, Two Harbors Investment Corp. (TWO), was launched by well-regarded hedge fund managers Pine River Capital. Other money managers who have launched mREITs include Apollo, Invesco, and Western Asset.

However, if you're entertaining buying an mREIT, there's no reason to exclude closed-end funds from consideration. MREITs are closed-end funds in all but name. Like CEFs, most hire external managers who charge asset-based fees, usually 1.0%-1.5% of book value.

Against this expanded pool of competing options, mREITs don't look as attractive. The standard against which I compare mREITs is PIMCO Dynamic Income (PDI). Manager Dan Ivascyn has proved to be an eminently capable MBS investor, and he's bet a big chunk of money on the fund. (Full disclosure: I own PDI and own it in my newsletter's model portfolios.)

PDI can be thought of as a nimble specialty finance company with the backing of a trillion-dollar bond shop. As such, it has several advantages over most mREITs: potentially lower financing and hedging costs; greater data and analytical capabilities; and the ability to pick off the most attractive bonds that flow through PIMCO.

The biggest advantage, however, to owning PDI and its like over mREITs is the lower risk of a blow-up. Unlike many other mREITs, especially ones focused on agency securities, PDI does not have to resort to dangerously high levels of leverage to produce acceptable earnings. And Ivascyn's compensation in large part is tied to the performance and asset bases of funds limited in their use of leverage. He does not have a strong incentive to engage in "heads-I-win, tails-you-lose" bets. Even if he wanted to, PIMCO's risk managers would likely limit his exposures. The same can't be said of many mREITs.

 

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