September 1, 2011
I am writing to comment on the review of the Investment Company Act exclusion for mortgage REITs. For reference I followed these companies as an equity research analyst for many years and currently am an active institutional investor in this sector.
First and foremost, these companies broadly serve as a captive source of capital to finance both the U.S. housing market as well as commercial real estate. Through several economic downturns these companies have readily invested capital into the real estate debt markets when the vast majority of domestic banks were actively decreasing exposure. They are a material dedicated funding source that as an industry has largely avoided the severe credit and capital related volatility experienced by the banking sector (subprime originators/investors excluded of course). Removing the exclusion for these companies will render them uninvestible in the public equity markets, and will effectively pull all of that capital and liquidity from the real estate debt markets in short order.
Second, these companies are not just passive investment vehicles. They are likely going to be major contributors to the eventual resurrection of the private securitized residential mortgage market. Given the inherent capital restrictions for banks on the horizon from Basel III, Dodd-Frank and qualified residential mortgage definition, it is unlikely the banking sector will generate adequate returns on risk-weighted capital to balance sheet mortgage loans or to retain equity/"skin in the game" in securities they create themselves. Mortgage REITs will thus be leaders in the rebirth of this market. As an example Redwood Trust (RWT) has so far been instrumental in spearheading this effort. Many of its peers are also interested in contributing capital to the second generation of private RMBS as the rules and guidelines are estabilshed. Without the securitization of home loans, non-conforming residential mortgages will continue to cost well in-excess of GSE conforming. With the stated goal to significantly shrink the role of the GSE's in the U.S. housing market, eliminating a large pool of capital to restart this market seems counterproductive to the recovery of the housing market and the economy more broadly.
Third, these companies provide a lower-risk alternative for retail investors to achieve attractive yield in today's historically low interest rate environment. With the ability to apply moderate leverage, mortgage REITs that invest primarily or even exclusively in Agency MBS (with no implied credit risk) are able to generate yields multiples in excess of the riskiest corporate debt securities, which themselves are levered many times to their own capital bases and cash flow streams. This ability to lever Agency MBS investments has worked very well over time, with the only major incidents occurring due to poor interest rate risk management at companies that have long since closed their doors. Speaking with the CEO of any mortgage REIT, you will hear countless stories of investors in retirement that depend on the dividends from these companies for a significant portion of their fixed-incomes.
Lastly, this interest rate carry trade is one of the most basic and prevalent yield strategies entailed at banks and private investment vehicles. The Agency repurchase agreement market has incredible depth and liquidity, thanks to the ability to post Agency MBS at the Fed discount window for a very small hair-cut. This stability has helped investors in these companies dramatically outperform public equity markets since the beginning of the financial crisis. Through the market gyrations surrounding the failure of Lehman Brothers and the unwinding of Bear Stearns and AIG, as well as the nationalization of the GSE's themselves, this financing market operated flawlessly. As such, mortgage REITs are quite similar to very low leverage thrifts and SNL's. They are able to use low cost, readily available financing (repo as opposed to deposits) to lever capital invested in AAA rated assets that have experienced very low levels of volatility historically. The exception of course is banks take inherent credit risk in the loans they underwrite, while investors in Agency MBS presumably take none. Thus, the ability for public investors to obtain the same returns that banks as well as private and corporate investors can generate themselves has inherent utility. These companies are run with low expense ratios and have adequate liquidity owing to their public market listings for even institutional investors such as myself to build and exit positions. Removing the Investment Company exemption would force retail and institutional investors alike off of regulated public markets to find this yield stream elsewhere.
In closing, the benefits of the mortgage REIT structure to the real estate debt markets, investors and the eventual U.S. economic recovery should not be understated. Ending the exemption from the investment company act would eliminate leverage and thus returns, making these public companies uninvestible based on their cost of capital and projected return profile. I strongly encourage the SEC to maintain this exemption for the benefit of the U.S. residential and commercial real estate markets, the domestic economic recovery as well as income seeking investors.
I would welcome the opportunity to speak with officials at the SEC on this subject, as I bring a unique perspective to the table given the time I have spent following the group on both the sell-side and buy-side.