2023-03-27 13:14:56 ET
Summary
- REM invests in mREITs that hold residential and commercial mortgages.
- I believe regional bank deposits are structurally unattractive vs. money center banks and money market funds. Whatever solution is used to solve this crisis will lead to lower profitability for regional banks.
- Lower profitability will cause banks to further tighten lending standards. As they are large players in real estate, this could throw real estate markets into a deep freeze.
Recently, I provided some thoughts on the VanEck Mortgage REIT Income ETF (MORT). I was cautious on MORT and mortgage REITs ("mREITs") in general, as I was worried about a possible firesale of mortgage-backed securities ("MBS") and the Fed's continued quantitative tightening program.
This article looks at the iShares Mortgage Real Estate ETF (REM), an ETF that invests in the same securities as the MORT ETF, and the implications from continued deposit flight from regional banks.
I believe regional bank deposits are structurally unattractive compared to money center banks with implicit government guarantees or money market funds with far higher yields. The solution to deposit flight will likely inevitably lead to higher funding costs for regional lenders, which may lead to tighter lending standards and a possible 'deep freeze' in real estate finance.
Brief Fund Overview
The iShares Mortgage Real Estate ETF provides exposure to mortgage REITs that hold U.S. residential and commercial mortgages. The REM ETF tracks the FTSE Nareit All Mortgage Capped Index ("Index"), an index which measures the performance of the residential and commercial mortgage real estate and related sectors of the U.S. equity market.
The REM ETF has $562 million in assets and charges a 0.48% net expense ratio.
Similar to the MORT ETF, REM's portfolio is mostly comprised of mortgage REITs like Annaly Capital Management Inc. (NLY) and AGNC Investment REIT Corp. (AGNC).
Unlike traditional REITs, mREITs do not own or operate real estate properties. Instead, they are real estate investment trusts that provide financing for real estate by buying or originating mortgages and mortgage-backed securities ("MBS"). MREITs typically operate by originating mortgages and then hedging out interest rate exposure, so investors get levered exposure to mortgage spreads. mREITs require well functioning real estate finance markets with banks providing loans and liquidity.
Figure 1 shows the full holdings of the REM ETF.
The REM ETF and MORT ETF share many overlapping holdings. In fact, the historical performance of the REM and MORT ETFs are virtually identical, measured from September 2011 (MORT's inception date) to February 2023 (Figure 2).
Figure 2 - MORT and REM have nearly identical historical performance (Author created with Portfolio Visualizer)
How Deposit Flight Could Lead To Credit Tightening
Returning to the main topic of this article, I believe the recent regional bank failures and deposit flight may lead to a deep freeze in real estate markets.
First, a recap of what has happened so far. On March 9th 2023, SVB Financial Group ( SIVB ) surprised markets by announcing an equity raise to plug a capital hole from selling a portfolio of available-for-sale ("AFS") agency MBS securities at a deep loss.
Investors were blindsided by the capital raise and scale of the capital deficits at SIVB, and by the weekend, SIVB and Signature Bank ( SBNY ) had suffered classic bank runs and were placed into FDIC receivership. FDIC and the government vowed to protect all depositors, even those that had more than $250,000 in insured deposits.
Unfortunately, the two regional bank failures shone a light on the scale of the unrealized losses sitting on bank balance sheets and actually exacerbated the run in public confidence (Figure 3).
Figure 3 - FDIC-regulated banks have $620 billion in unrealized losses on investment securities (FDIC)
Furthermore, the government's actions have now created a 3-tiered banking system. First, there are SIVB and SBNY depositors, which now enjoy 'explicit' guarantees from the FDIC. Then there are the money center banks (JPM, BAC, C, WFC) that are 'too big to fail' and have 'implicit' guarantees of support from the government. Financially, there is everybody else.
Faced with the prospect, however remote, of potential losses on one's deposits, depositors did the rational thing and transferred their deposits out of regional banks and into either one of the large money center banks or into money market funds.
Bear in mind, with the average deposit account paying only 37 bps in interest, there was also an economic incentive to move one's money out of regional bank deposits into money market accounts earning 4 to 5% (Figure 4).
Figure 4 - Average bank deposit is only paying 37 bps (St. Louis Fed)
So in the week ended March 15th (the week after SIVB failed), bank deposits fell by $98 billion overall. However, deposits at small lenders slumped by $120 billion while those at the 25 largest financial institutions rose by $67 billion, highlighting the flight to 'too big to fail' banks.
In the same time period, money market funds saw $121 billion in inflows, mostly in institutional money market accounts (Figure 5).
Furthermore, in the week ended March 22nd, money market funds saw another $117 billion in inflows, suggesting that deposit flight out of regional banks has not slowed down, despite repeated assurance of support from government officials like Treasury Secretary Yellen.
While regional banks can source liquidity to fund deposit outflows from the Federal Reserve through lending facilities like the discount window or the newly created Bank Term Funding Program ("BTFP"), there are economic costs to these facilities compared to 'ultra cheap' deposits. For example, BTFP loans must pay overnight index swap rates ( currently 4.73% ) plus 10 bps. Alternatively, regional banks can try to stem the outflow of deposits by raising deposit rates to attractive levels compared to money market funds to retain customers. However, both options would lead to lower profitability for banks.
When faced with lower profitability, regional banks are expected to tighten lending standards and credit conditions, since the marginal loan will no longer be profitable with higher funding costs.
This deposit flight / credit tightening process is what Chairman Powell was referring to, when he said in his post-FOMC press conference that "events in the banking system over the past two weeks are likely to result in tighter credit conditions for households and businesses".
Regional Banks Are Large Real Estate Lenders
The challenge for the real estate finance market is that small regional banks are actually very large players in real estate markets. For example, in the latest FDIC Quarterly Review , we can see small and medium sized lenders (those with less than $250 billion in assets), collectively hold $3.9 trillion in real estate loans (68% of total real estate loans held by FDIC-regulated banks) (Figure 6).
Figure 6 - Regional banks are large real estate lenders (FDIC)
Even before the latest regional bank failures, banks were already tightening lending standards (Figure 7).
Figure 7 - U.S. domestic banks have been tightening lending standards (FT.com)
If funding costs for regional lenders go up, we should expect even further tightening from the banks. This could lead to a deep freeze for real estate finance markets.
It is no wonder that large real estate investors like Barry Sternlicht of Starwood Capital have been warning of a serious 'hard landing' on national TV.
Conclusion
The iShares Mortgage Real Estate ETF provides exposure to mortgage REITs that hold U.S. residential and commercial mortgages. In addition to short-term risks from a fire sale of seized bank assets and long-term risk from the Fed's quantitative tightening, I believe there is a very real risk of a deep freeze in real estate markets as regional banks are forced to pull back on real estate lending due to the developing deposit flight crisis.
Regional bank deposits are structurally unattractive compared to money center banks with implicit government guarantees or money market funds with far higher interest rates. Any solution to deposit flight will reduce bank profitability which will cause them to tighten lending standards.
I am hesitant to invest in mREITs and ETFs like REM and MORT until this banking crisis is resolved.
For further details see:
REM: Real Estate Facing A Deep Freeze