Leverage increases risk by magnifying returns
Most REITs, but especially agency REITs such as Hatteras Financial (HTS) and Capstead Mortgage (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 (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) bumped its leverage ratio up to 3.4x—an increase from 3.3x at the end of 3Q15. 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 $9.4 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 2015, MFA Financial joined the Federal Home Loan Bank of Des Moines, or FHLB Des Moines. This ended up being short-lived, as the government changed the rules to prohibit mortgage REITs from joining. For the time being, however, MFA is able to obtain incredibly attractive financing.