2023-03-15 12:08:59 ET
Summary
- The MORT ETF provides exposure to mortgage REITs. MREITs primarily invest in mortgages and mortgage-backed securities.
- MREITs typically hedge interest rate exposure and provide levered returns to mortgage spreads.
- In the short term, mortgage spreads may widen significantly as distressed sellers like SIVB hit the markets.
- In the long run, with the Fed engaging in Quantitative Tightening, mortgage spreads have widened to levels not seen since the depths of the 2009 Great Financial Crisis.
- Although the MORT ETF pays a high distribution yield, I believe mREITs will continue to struggle in this environment.
In the last few days, I have written several articles on the SVB Financial Group (SIVB) debacle. This article explores how SIVB's failure could affect the mortgage REIT market.
The VanEck Mortgage REIT Income ETF (MORT) provides exposure to an index of mortgage REITs. In the short-run, FDIC seizure of SIVB and other failing banks with large investment securities portfolios may create a firesale that could hurt mortgage spreads and mREIT valuations. In the long-run, with the Fed actively shrinking its balance sheet, the mortgage finance market is missing a large buyer and spreads have widened to 2009 levels.
I am hesitant to invest in the MORT ETF until the banking situation stabilizes and/or the Fed pivots back into quantitative easing mode.
Fund Overview
The VanEck Mortgage REIT Income ETF gives investors exposure to an index of mortgage REITs ("mREITs"). The MORT ETF tracks the MVIS US Mortgage REITs Index ("Index"), an index designed to measure the overall performance of the U.S. mortgage REIT market.
The MORT ETF has $164 million in assets and charges a 0.41% net expense ratio.
What Are Mortgage REITs?
A mortgage REIT is a real estate investment trust that provides financing for real estate by buying or originating mortgages and mortgage-backed securities ("MBS"). MREITs give investors exposure to real estate without having to own or operate actual real estate properties.
MREITs typically hedge out interest rate duration risk, giving investors levered exposure to mortgage spreads. For example, Annaly Capital Management Inc. ( NLY ), the largest mREIT in the market, has an $81 billion investment portfolio that is mostly hedged for interest rate risk, giving investors a levered return on its ~2.0% net interest margin ("NIM") (Figure 1).
Figure 1 - NLY portfolio overview (NLY Q4/22 investor presentation)
Portfolio Holdings
Figure 2 shows the holdings of the MORT ETF. Overall, the MORT ETF has holdings in 26 mREITs, with the top 10 holdings accounting for 62.8% of the portfolio.
Distribution & Yield
One of the main attractions of mREITs (and MORT by virtue of its holdings) is their high distribution yields. The MORT ETF pays a high quarterly distribution, with a trailing 12 month distribution of $1.53 / share or a 13.7% trailing yield (Figure 3).
Figure 3 - MORT pays a high distribution yield (Seeking Alpha)
Returns
Although mREITs pay very high distribution yields, that does not mean they generate high total returns. In fact, MORT's historical returns show that an index of mREITs have provided very modest total returns of -9.3%/-1.9%/1.3% over 3/5/10Yr timeframes to February 28, 2023.
What Happened At SIVB?
Coming back to the main point of this article, what effect, if any, will SIVB's failure have mortgage-backed securities and mREITs?
First, a quick recap of what happened. On March 9th, 2023, SIVB surprised markets by announcing plans to raise $1.75 billion in equity capital to shore up its balance sheet. This caused the company's shares to plunge .
SIVB, like many other FDIC-regulated institutions, had run up billions in unrealized mark-to-market losses on MBS and other investment securities. As it became evident to management that the Federal Reserve was not going to 'pivot' any time soon, SIVB tried to offload its available for sale ("AFS") securities portfolio, recognizing a $1.4 billion after-tax loss, which prompted the equity raise.
Unfortunately, SIVB bank depositors saw the equity raise as a sign of weakness and decided to withdraw their money from the bank en masse . This caused a liquidity crisis at SIVB, which scuttered the equity raise and forced the bank into FDIC receivership by the afternoon on March 10th.
While the U.S. Treasury Department and the Federal Reserve were able to paper over the issues at SIVB and protect bank depositors over the weekend, their emergency actions raises interesting questions for the mortgage finance markets.
Banks Loaded With Unrealized Losses On 'Safe' MBS Securities
What sank SIVB was not investments in risky securities like CDOs or high yield bonds. Instead, it was a simple case of risk-management, or lack of it. The main issue at SIVB really boils down to the fact that the bank held $120 billion in investment treasuries, of which over half were low-risk agency-issued MBS (Figure 5).
Figure 5 - SIVB held $120 billion investment securities portfolio (SIVB Q4/22 annual report)
Although these securities had little to no credit risk, they do have very significant interest rate duration risk. Unfortunately, SIVB did not hedge its interest rate exposure. With the Fed's rapid pace of interest rate hikes in 2022, SIVB's investment portfolio sank in value, leading to almost $18 billion in unrealized losses (Figure 6).
Figure 6 - SIVB racked up $18 billion in unrealized losses on its investment portfolio (SIVB Q4/22 annual report)
Ultimately, what sank SIVB was the capital hole from the unrealized losses, as depositors rushed out the door and the bank could not sell these securities without crystallizing the losses.
Unrealized losses were not an isolated issue at SIVB. A recent speech by FDIC Chairman Martin Gruenberg showed that the banks under his supervision have accumulated $620 billion in unrealized losses on investment securities as of the fourth quarter due to elevated market interest rates (Figure 7).
Figure 7 - FDIC-regulated banks have $620 billion in unrealized losses on investment securities (FDIC)
FDIC Receivership Risks Firesale Of MBS Securities
The main short-term problem for MBS securities and mREITs that I can see is that as failed institutions like SIVB are taken over by the regulators, they will be selling their investment portfolios in order to raise liquidity to pay back depositors.
Although the $5.5 trillion dollar agency MBS market is very deep and liquid, a distressed seller of SIVB's size risks widening mortgage spreads. Already, we are seeing news reports that mortgage spreads have been 'exploding' to the upside, as traders pull back from risk, before a likely distressed sale of SIVB's portfolio. If additional assets are seized by the banking regulators, that could create further widening of mortgage spreads, which could negatively impact MBS pricing and mREITs share performance.
Quantitative Tightening Is A Major Headwind For Mortgage Spreads
Another important aspect of the MBS market that could act as a headwind is that after years of quantitative easing ("QE"), the Federal Reserve recently began quantitative tightening ("QT"). During QE, the Fed bought investment securities like MBS in order to stimulate the economy. However, since June 2022, the Fed has been running off its massive $8 trillion balance sheet, turning from a net buyer of MBS securities to a net seller of MBS securities. Currently, the Fed is allowing $60 billion of treasuries and $35 billion of MBS securities to roll off its balance sheet each month (Figure 8).
Figure 8 - Fed is in process of rolling off its balance sheet (Federal Reserve)
Although the mortgage finance market is very deep and liquid, it is very hard to replace a buyer of the Fed's size. In fact, as the Fed slowed the pace of its purchases and reversed to become a net seller of MBS securities, the spread between the average 30Yr mortgage rate and the 30Yr treasury yield has blown out to over 2.5%, wider than even during the Great Financial Crisis ("GFC") (Figure 9)!
Figure 9 - Mortgage spreads are wider than during 2009 credit crisis (Author created with data from St. Louis Fed)
Until the Fed pivots and/or re-engage in quantitative easing, I expect mortgage spreads will continue to face upward pressure, which could pressure the valuation of mREIT holdings.
Conclusion
The VanEck Mortgage REIT Income ETF provides exposure to an index of mortgage REITs. In the short-run, FDIC seizure of SIVB and other failing banks with large investment portfolios of MBS may create a firesale that could hurt mortgage spreads and mREIT valuations. In the long-run, with the Fed actively shrinking its balance sheet, the mortgage finance market is missing a large buyer and spreads have widened to 2009 levels.
I am hesitant to invest in the MORT ETF until the banking situation stabilizes and/or the Fed pivots back into quantitative easing mode.
For further details see:
MORT: 2 Headwinds Facing Mortgage REITs