Interest Rates and Residential Mortgage REITs

June 8, 2022 | Premium Service | A number of subscribers to The Institutional Risk Analyst have been asking about different regions of the mortgage and asset management complex. Creators and servicers of loans are currently in disfavor, but some investors are beginning to nibble on the real estate investment trusts (REITs). We’ll be looking at a number of asset gatherers and managers in upcoming issues of the Premium Service.

Here’s the key questions: First, do you expect the yield on financial assets and particularly mortgage-backed securities (MBS) to rise faster than funding costs? And second, how do you feel about mortgage servicing rights (MSRs), which seem to be the plat du jour among the REIT community in this cycle? As the housing market rolls over and asset prices begin to fall for the first time in a decade, credit costs will reappear in at least equal measure.

Interest Rate Volatility

The big worry we see ahead is the fumbling approach of the Federal Open Market Committee to normalizing monetary policy combined with the rapid pace of change in the markets. Bill Nelson, Chief Economist of The Bank Policy Institute, illustrates the problem faced by the FOMC compared to the Bank of England:

“The BoE plans to set the interest rate on its collateralized loans equal to Bank Rate, the rate it pays on deposits (reserve balances). It then plans on shrinking its securities holdings at least until borrowing picks up, which should happen at roughly the unknown structural short-run level of reserve demand,” Nelson noted in a missive earlier this week. He continues:

In other words, the FOMC staff in Washington is modeling the demand for total reserves based upon GDP and the BoE is going to let the markets decide. Obviously we give the latter policy course a higher chance of success. Speaking of bad models, the FOMC continues to buy mortgage-backed securities even as new issuance of agency MBS is plummeting. The chart below shows dollar swaps vs the Treasury yield curve, which is essentially flat now from 2 years out to 30 years.

Source: Bloomberg

Given that new issuance is falling across the board in the fixed income markets, buyers of assets such as New Residential (NRZ) and Annaly (NLY) are going to be part of a much larger crowd that is chasing a shrinking pool of opportunities. The change in new issuance in areas such as high-yield and MBS is large in relative terms, thus we will be watching for signs of expansion in bank yields when the Q1 2022 bank peer data is released by federal regulators next week.

Mortgage Issuers & Servicers

The elevated velocity of change we alluded to with respect to interest rates is evidenced in the housing sector, with new mortgage applications at a 22-year low and aspirational prices for high-end dwellings softening. The fact that sales volumes are falling on the high-end properties is partly driven by lean inventories and provides little relief to low-income households, who face continued shortages of homes in many markets.

“There is a massive shortage of housing in Arizona and California,” notes Alan Boyce in an email earlier this week. “Imperial County has 40 homes for sale with a population over 200,000 people.”

With the shortage of housing assets for sale and falling lending volumes, it is difficult to paint a rosy picture of rising yields for investors in loans, servicing and MBS. This is not to suggest that astute managers cannot make money in this market, but the fact remains that bellwethers such as NLY and NRZ have been going sideways in the equity markets since the COVID selloff in March of 2020. NRZ has suffered the most severe decline, but since 2020 has clawed back about half the ground lost due to COVID and the FOMC’s response.

Source: Bloomberg

We sold our position in NLY earlier this year. While we continue to like the diversification of the NLY balance sheet into servicing assets, the outlook for the agency REIT market overall in terms of the FOMC is so unclear that we are just not comfortable holding the stock.

We see an at least equal chance that margins will get squeezed for agency and MSR investors before they expand in response to higher benchmark interest rates. The flat yield curve and tight swaps curve both speak to a general scarcity of assets, yet the bid for non-agency loans and even MSRs has fallen away in recent weeks. Investors are running away from risk and back into Treasury and agency assets.

The velocity noted above also applies to credit exposures, meaning that returns on GNMA mortgage servicing rights may start to be impacted as short-term interest rates rise. When we talk of interest rate spreads and credit, this all gets boiled down to net-interest income. As with banks, REITs such as NLY and NRZ have seen an erosion of net interest income since 2020. Now, as credit costs rise and lending volumes fall, some investors are starting to look at nonbank mortgage lenders as a distressed asset class.

Given the clumsy behavior of the FOMC, we honestly do know when credit investors will once again see NII expansion. This is another reason why we and also the market remain circumspect on the bank, nonbank mortgage and agency REIT sector. The components of NII for NLY are shown below. Note the volatility of the results as market swings have hurt returns, in part by driving up the cost of hedging MBS 3x compared to pre-COVID.

NRZ has actually out performed NLY since 2020, particularly over the past year, and added significant operating assets and MSRs with the acquisition of Caliber. Now the largest non-bank owner of MSRs, NRZ took a $575 million positive mark on its servicing asset, accounting for most of the increase in servicing income for Q1 2022.

With lending volumes falling like a rock, NRZ will be under a lot of pressure to replace revenue and is reported to be employing unconventional valuation methods to boost the fair value of MSRs. Meanwhile, NRZ's once successful trade in Ginnie Mae early buyouts (EBOs) has reportedly turned sour and could be the source of losses later in the year. Overall, the EBO trade could cost the mortgage sector billions in losses in Q2 2022 with Ginnie Mae 2.5s trading at 90 and change in the TBA market.

Along with JPMorganChase (JPM), NRZ is reportedly using assumed revenue from cross selling opportunities to customers acquired via MSR purchases. A number of other banks have been purchasing conventional MSRs at multiples approaching 6x and, again, are referring to cross selling opportunities to justify MSR valuations. We find these reports troubling but not surprising since the flow of credit into MSRs is only increasing marginal demand. Of note, Bank of Montreal (BMO) and BNP Paribas (BNP) have jumped into the market for lending on MSRs.

A breathtaking number of conventional issuers are plunging into the opportunity for non-QM loans, a shift that is unlikely to bring relief to lenders fleeing the carnage in the conventional loan market. Many issuers are losing money on secondary market execution, a situation which is a function of overcapacity. Our mortgage equity surveillance group is shown below and is sorted by dividend yield.

The big concern in the near term is that market volatility and rising demand for risk-free assets will pressure residential and agency REIT returns even as new lending volumes fall. More important, we see growing pressure in the seller/servicer channel as debt prices fall to multi-year lows.

RKT 2 7/8s of 2026, for example, traded above par as recently as December 2021 but are now trading in the mid-80s. If there is a credit event in the world of nonbank issuers, bank lenders will step back from this sector. PennyMac Financial (PFSI) 4 1/4s of 2029 are trading at 79 and a spread of 500bp over the Treasury curve.

A winning strategy for survival is said to be one leg down in Ginnie Mae and the other in non-QM, leaving the conventional market out of the calculous. But we worry that the large and growing crowd in non-QM is going to drive the execution in that market into loss as well. Meanwhile, some of the bigger non-bank issuers have been leaning into large loan and MSR trades to capture assets, this in response to the reappearance of banks in the market for Ginnie Mae MSRs.

Outlook

In the background of the discussion of US interest rate policy and housing markets, there is a continued debate as to whether the FOMC will actually try to sell MBS from the system open market account or SOMA. It is important for investors and risk managers to understand that the flat yield curve imposed on markets by the FOMC, together with the threat of outright sales, is having pernicious effects.

So long as the FOMC needs to absorb $2 trillion in cash via reverse repurchase agreements (RRPs) and the Treasury is awash in cash, managing the process of reducing the size of the SOMA is going to be problematic – especially if the Fed is using a GDP-based model to guide its actions. The chart below shows some of the major factors impacting the supply and demand for risk-free assets in the near term, including SOMA holdings of Treasury paper and the Treasury's General Account.

If the FOMC wants to end all purchases of Treasury securities and MBS for the SOMA, then the Committee must also manage the availability of RRPs and slowly allow market rates to force investors out of RRPs. At the same time that the Fed is forcing money market funds out of RRPs, banks will be migrating out of reserves and back into coupons and T-bills.

Funds and offshore buyers have been outpacing last year’s pace of purchases of Treasury notes and bills even as new issuance has fallen. Dealers have been taking down significantly less paper at 10-year Treasury auctions than a year ago. Any way you cut it, demand for risk free assets and MBS is likely to keep the yield curve flat to inverted for 2022 and beyond. The FOMC may indeed get the fed funds rate to 3% or higher, but the yield on the 10-year Treasury note may be considerably lower. The financial implications of such an environment for leveraged lenders and investors is not very pleasant to consider.

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