Annaly Capital Management Inc. (NLY:US) Chief Executive Officer Mike Farrell was paid $35 million last year, more than the CEOs of the six largest U.S. banks, from JPMorgan Chase & Co. (JPM:US)’s Jamie Dimon to Goldman Sachs Group Inc.’s Lloyd Blankfein, and more than double their average compensation.
The bounty underscores the growing influence of real estate investment trusts that buy U.S. home-loan debt, mostly with borrowed money that costs almost nothing as the Federal Reserve keeps rates low to bolster the economy after the worst financial crisis since the Great Depression.
Holdings of government-backed mortgage securities by the lightly regulated firms have almost tripled to about $270 billion since 2009. Annaly, the 15-year-old New York-based REIT that more than doubled its assets over four years to enter 2011 with $110 billion, is the largest, followed by American Capital Agency Corp. (AGNC:US), the debt buyer guided by former Freddie Mac investment chief Gary Kain. The company, which started in 2008, sold enough shares in March to reach more than $70 billion.
“The industry has been playing an increasingly important role in the mortgage-securities market,” said FBR & Co. CEO Richard Hendrix, whose Arlington, Virginia-based investment bank was spun off from a REIT. “And right now, they’re providing great returns to shareholders, though there’s no question that when short-term rates rise, those returns will be compromised.”
Record Low Rates
Mortgage REITs’ purchases of agency mortgage bonds, those guaranteed by government-backed Fannie Mae and Freddie Mac or U.S.-owned Ginnie Mae, are contributing to record low 30-year home-loan rates that are bolstering homeowner refinancing and the housing market.
The industry is picking up the slack as the U.S. remakes its housing-finance system, starting with a reduction in the holdings of taxpayer-supported Fannie Mae and Freddie Mac. (FMCC:US) REITs, which are also helping fuel a rally in non-agency debt, have driven the only issuance of private home-loan securities since markets seized up in 2008 and will be central to providing mortgage financing as the government withdraws, according to Redwood Trust Inc. (RWT:US), the main sponsor of the deals.
The growth may also create new risks. The Securities and Exchange Commission is examining whether REITs should retain their ability to use unlimited leverage. Annaly and American Capital Agency also face tests for determining which firms aside from banks need special oversight because they’re too-big-to- fail, some of which they meet.
“They pose systemic risk because their financing structure is so poor,” said Doug Dachille, CEO of investment firm First Principles Capital Management LLC and former head of proprietary trading at JPMorgan. The borrowing is dangerous because it’s short-term and subject to daily margin calls, meaning that they may be forced to sell assets when values are falling, he said.
Since 2007, when a previous generation of REITs with lending arms including New Century Financial Corp. and American Home Mortgage Investment Corp. started failing, the compensation of Annaly’s Farrell has climbed to $35 million from $12.5 million. The amount is tied directly to its book value, which increases as Annaly sells shares, an incentive for growth at a number of the firms, regulatory filings show.
“If mortgage REITs were not delivering to investors they would not be in a position to raise capital,” Farrell, 61, also Annaly’s chairman and president, said in an e-mailed response to questions. “Last I checked, the United States was still a capitalist country despite efforts to the contrary.”
Mortgage REITs have sold more than $5 billion of stock this year after a record $16.8 billion in 2011, data compiled by Bloomberg and JMP Securities LLC show. Individual investors are lured by annual dividend yields of 13.8 percent, or about seven times the average for Standard & Poor’s 500 companies, according to data compiled by Bloomberg.
‘Pillar of Support’
Mortgage-bond analysts at Morgan Stanley and JPMorgan said they were surprised by this year’s pace of capital-raising. The top-rated JPMorgan research team called REITs a “pillar of support” and “one of the main sources of levered mortgage buying” in the $5.4 trillion market for securities guaranteed by Fannie Mae and Freddie Mac or Ginnie Mae.
Annaly and American Capital Agency buy only that mortgage debt, wagering on interest rates and the pace of homeowner refinancing. They also have affiliates that mix those bonds with securities with default risk, joining rivals such as MFA Investment Corp. (MFA:US) and Two Harbors Investment Corp. (TWO:US) that have accounted for about 40 percent of share sales this year.
‘Master of Mortgage Market’
Farrell stands out for his colorful conference calls and shareholder letters that discuss broader themes through historical allusions and literature such as Christopher Marlowe’s “Doctor Faustus” and the 1970 book “Future Shock” by Alvin Toffler.
In November, Michael Diana, at the time an analyst with Cantor Fitzgerald LP, in a research report called Farrell a “Master of the Mortgage Market” who would “pontificate about anything and everything except what Annaly actually did during the quarter,” the Wall Street Journal reported. Diana, who has left the firm, couldn’t be reached for comment.
JPMorgan’s Dimon was awarded $23 million last year, to top the pay of leaders of the six largest U.S. banks, which averaged $14.2 million, according to their filings. BlackRock (BLK:US) Inc. CEO Laurence D. Fink, who oversees the world’s largest money manager with $3.7 trillion in assets, received $21.9 million.
Farrell, who disclosed in January he has cancer that he said “was caught early and is treatable,” started Annaly in 1997, following a career in bonds that began at E.F. Hutton and Co. in 1971 and included stints at Morgan Stanley and Merrill Lynch & Co.
Censured and Fined
In 1994, when he was president of Citadel Funding Corp., Farrell was censured and fined along with the Colorado-based broker and two other executives for failing to maintain required capital and filing inaccurate reports, according to regulatory records. Jay Diamond, a spokesman for Annaly, declined to comment on the episode.
By the time Annaly was started, Farrell had concluded that REITs and mortgage bonds were a “perfect marriage between asset class and vehicle structure,” in part because they can be “buy-and-hold” investors, he said. Unlike hedge funds or many mutual funds, REIT shareholders can’t withdraw money from the firms. Instead they buy and sell shares in the companies.
In 2007, Annaly created Chimera Investment Corp. (CIM:US), which buys non-agency residential bonds, and two years later, CreXus Investment Corp. (CXS:US), focusing on commercial real estate debt. The separate publicly traded firms, which are overseen by one of its units, owned a combined $9 billion assets of as of Dec. 31.
Return to Shareholders
Annaly’s returns (NLY:US) to shareholders since its initial public offering have totaled more than 580 percent, compared with about 85 percent for the S&P 500 in the same period. That includes a 44 percent decline in its stock price in 2005 as the Fed raised rates, or 39 percent assuming reinvested dividends.
With short-term rates now as low as they can go, long-term yields near nadirs and government efforts boosting refinancing of high-rate home loans, the best days for REITs that wager on government-backed securities are already behind them in this economic cycle, said Richard Eckert, an analyst in San Francisco at securities firm B. Riley & Co. Some are sure to be tempted to take larger risks as conditions worsen, he said.
“You’re going to see some people make mistakes, big mistakes, perhaps fatal,” said Eckert, who worked as a risk management analyst at the Federal Home Loan Bank of San Francisco in 1990s and started covering REITs in 1998.
REITs don’t save much for tougher times because they have to pay out 90 percent of most types of earnings in dividends, a provision that allows the firms to avoid taxes on the income.
Unlike other vehicles used by retail investors in the bond market such as mutual funds, mortgage REITs aren’t subject to the Investment Company Act, which limits leverage. Most that invest in agency securities borrow between 6 and 9 times their equity, compared with between 1 and 3 times for non-agency debt, according to the companies’ financial reports.
The exemption is being questioned by the SEC, which last year sought comments on altering the treatment. The agency’s “staff is actively considering the issues raised in the comment letters, but no determinations have been made,” John Nester, a spokesman, said in an e-mail.
Kain, American Capital Agency’s president and chief investment officer, disagrees a shift in fortunes has begun.
The biggest factors making REITs such as his successful are still in place -- low funding costs, relatively steady yield premiums on agency bonds and generally low levels of home loan prepayments -- he said. Those aren’t going away soon, and when they do, the firms can adjust, he said in a telephone interview.
“If you look at the next three years going forward, it’s pretty logical that the conditions will still be there,” said Kain, 47. “The challenge for us as a management team is to handle the transition from one environment to another.”
American Capital Agency was started in 2008 by its outside manager, America Capital Ltd. (ACAS:US), an asset manager and investor in companies such as a dental-practice management services firm and a provider of technology-based programs for schools. Last year, it began a REIT that also buys non-agency debt, American Capital Mortgage Investment Corp. (MTGE:US), with Kain as president and co-CIO.
Kain was lured to mortgages in 1988 after hearing about a financial modeling job at Freddie Mac from a family friend while working after college at Johns Hopkins University’s Applied Physics Lab. He ended up overseeing the portfolio of more than $800 billion of bonds and loans on the firm’s balance sheet.
He was recruited to American Capital after Freddie Mac and rival Fannie Mae were seized by the government in September 2008. The two companies are being forced to shrink their portfolios, which peaked at a combined $1.7 trillion in 2009. Both Republican and Democratic lawmakers say those holdings, which are separate from their credit guarantees, should be eliminated if the companies are reformed or replaced.
“I was extremely bullish on the future of the REIT industry, given that their two largest competitors were not going to be there anymore,” Kain said.
The Fed’s low target rate, which it’s pledging to restrain until 2014, has created a so-called steep yield curve, or large difference between short-term borrowing costs and long-term investment yields. One-month repo backed by agency mortgage bonds costs 0.29 percentage point, as yields on those securities average about 2.6 percent, ICAP Plc and Barclays Plc data show.
Mortgage REITs rose 0.1 percent today in New York Trading and have returned 11.9 percent this year including share gains and dividends, according to a Bloomberg index. In 2011, they fell 1.9 percent amid the SEC’s move and because of concern their funding could be roiled by Europe’s debt crisis and U.S. government downgrade, as well as rising agency prepayments and slumping non-agency prices.
The damage from rising rates will depend on how fast they increase, and probably won’t be as much as when the Fed under former Chairman Alan Greenspan in the mid-2000s contributed to a flat yield curve as it sought to “slow down a runaway housing market,” said Steven Delaney, an analyst at JMP Securities.
While higher long-term yields will boost margins on new investments, the prices of existing holdings will drop, damaging REITs’ book value, which is used as a stock valuation tool, and creating margin calls. Annaly is preparing by hedging a “significant portion” of its rate exposure via swaps, Farrell said, with other REITs also employing such protection.
Any downside may be limited by REITs trading at price-to- book ratios of one on average. Agency mortgage REITs have seen factors that would create premiums “negated by aggressive capital-raising” that benefit earnings when valued higher, and “fear of nuclear, policy-driven refinancing activity,” Merrill Ross, a Wunderlich Securities analyst, said today in a report.
The Financial Stability Oversight Council, a board of regulators including the Treasury and SEC established by the Dodd-Frank Act, under that law must decide which nonbanks need closer supervision because their collapse could roil markets.
JPMorgan and Nomura Securities International analysts say some consideration may be given to Annaly and American Capital Agency, before they escape the distinction. The FSOC says it will start with tests including whether firms have more than $50 billion of assets, and then study their short-term funding, leverage, ties to important entities and current oversight.
Unlike banks and insurers, REITs have no primary regulators. Their leverage averages about 7.7, down from 11 in 2008, JPMorgan says. More than 90 percent of Annaly and American Capital Agency’s debt is short-term, according to Nomura.
Survivors of Crisis
The size and liquidity of the agency mortgage-bond market suggest that even the biggest mortgage REITs aren’t a broader risk, said Bryan Whalen, co-head of mortgage bonds at TCW Group Inc. Many are survivors of the financial crisis, he said.
“We’ve seen a lot and they managed their way through it, there’s something to be said for that,” said Whalen, whose Los Angeles-based firm oversees $124 billion.
Taxpayers may need REITs to keep growing to shed their own risks. Along with Fannie Mae and Freddie Mac’s shrinking balance sheets, the Fed needs to eventually unwind its about $1 trillion of mortgage holdings, said Calvin Schnure, a vice president at the National Association of Real Estate Investment Trusts.
The government also wants to stop covering default risk on most new mortgages, after swelling to serve that role on about 90 percent, said Michael McMahon, a managing director at Redwood, the Mill Valley, California-based REIT specializing in so-called jumbo loans.
“The banks certainly can’t do it all, nor do we believe they want to do it,” McMahon said. REITs’ tax advantages and ability to invest for the long-term make them the “ideal” companies to lead the way on the rest, he said.
Until last month, Redwood was only issuer of non-agency securities backed by new home loans since the market collapsed in 2008. That’s when Annaly’s Chimera partnered with Credit Suisse Group AG to join it.
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