Leverage increases risk by magnifying returns
Most REITs, but especially agency REITs such as Hatteras Financial Corp. (HTS) and Capstead Mortgage Corporation (CMO), use leverage to increase their returns. As a general rule, the big agency REITs use more leverage than non-agency REITs such as Two Harbors Investment Corp. (TWO). Investors interested in trading in the mortgage REIT sector as a whole can look at the iShares Mortgage Real Estate Capped ETF (REM).
MFA Financial (MFA) kept its leverage ratio at 3.3x—the same level as in the last two quarters. This is a much lower leverage ratio than those of the big agency REITs such as Annaly Capital Management (NLY) and American Capital Agency (AGNC). At the end of the third quarter, AGNC’s leverage ratio was 6.8, and NLY’s was 4.8. Agency MBS (mortgage-backed securities) bear no credit risk, so they have a lower yield to reflect that lower risk. In order to generate an attractive return, the big agency REITs need to use more leverage than the non-agency REITs to get similar returns.
Financing and hedging
REITs generally use repurchase agreements to fund their balance sheets. At the end of the third quarter, MFA Financial had $9.5 billion in repurchase agreements.
Considering the mismatch between the expected maturity of the company’s MBS (mortgage-backed securities) portfolio and the maturity of its repurchase agreement lines, we see that MFA Financial would be exposed to significant duration risk without some hedging activity. Duration risk is caused by mismatches in interest rate sensitivity between a REIT’s assets and liabilities. Investors interested in making directional bets on interest rates can look at the iShares 20+ Year Treasury Bond ETF (TLT). In fact, it uses interest rate derivatives, primarily swaps. These hedge the interest rate risk for MBS.
At the end of July, MFA Financial joined the Federal Home Loan Bank of Des Moines, or FHLB Des Moines. FHLB membership gives MFA Financial attractive financing, and we’re seeing more REITs looking at joining their local FHLB. On the conference call, MFA Financial said it was able to secure five-year secured financing at 25 basis points from the FHLB.