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Recommendation: REITs can take shrapnel from the shutdown battle

Brent Nyitray, CFA, MBA

Realist Real Estate Roundup: The shutdown continues (Part 7 of 7)

(Continued from Part 6)

Okay, I hold mortgage-backed securities or mortgage REITs and the government defaults. Now what?

Given that Ginnie Mae and Fannie Mae mortgage-backed securities are essentially obligations of the state, you’d think that if the government hits the debt limit and can’t pay its outstanding obligations, then agency mortgage-backed securities will be at risk. This isn’t really the case, as the government is backstopping the obligations of borrowers to pay principal and interest, and isn’t directly paying bondholders. The principal and interest payments therefore don’t flow through the government’s balance sheet. In other words, the government doesn’t collect the payment from the borrower and then decide whether to send it to you as an investor. The servicer (who’s a private entity) has that responsibility, and if the borrower defaults, the servicer is still responsible for forwarding the payments. So a government default could impact servicers in that they won’t get their reimbursements in a timely manner, but agency REITs like Annaly (NLY), American Capital Agency (AGNC), and MFA Financial (MFA) won’t suddenly find themselves exposed to credit risk.

The risk is that the REITs take shrapnel from general financial stress

That doesn’t mean REITs are immune. One worrisome development in the financial markets is the rise in the yield of the one-month T-bill. T-bills are used as collateral for repurchase transactions (repos) and the increase in the yield of the one-month means the market is discounting a real risk that we have a default. The question on everyone’s mind is how will T-bills be treated if the government hits the debt limit? Will they be considered “defaulted securities”? If so, then they’re ineligible for use as collateral for repurchase transactions. This risks creating financial contagion, as firms are unable to roll over short-term borrowing costs.

While no one anticipates a rerun of 2008, there have been difficult market events before where credit seized up, such as the Long Term Capital Management implosion. It doesn’t have to be a repeat of 2008 to still be disruptive. Generally, during these sorts of financial contagions, lenders re-liquify as much as they can. Credit lines are pulled for the flimsiest of reasons. REITs rely on leverage and can find themselves in a tough situation.

If the government defaults, is there a port in the storm?

The unfortunate answer is “not really.”  The agency REITs may be in the best position, and it may make sense to look at the ones with less leverage. The non-agency REITs like Two Harbors (TWO) and Newcastle Trust (NCT) will probably be in the worst position, as they have credit risk as well as interest rate risk, although they use less leverage. The originators like PennyMac (PMT) and Redwood Trust (RWT) could find themselves losing their warehouse lines and Redwood could find itself with no bids for its newly created securitizations. This is a risky time for the REIT sector.

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