Coming into Focus
[September/October 2007]
Mortgage REITs of all stripes tighten their lending practices to improve their outlook
going forward
By Dees Stribling
When the worldwide credit crunch hit in August, with liquidity grinding to a halt and central banks working overtime to grease the world's financial wheels, the subsector of REITs specializing in owning and originating mortgages was already all too familiar with the subprime contagion. Mortgage REITs were among the first affected by the subprime meltdown, and even as the larger credit drama plays out, they continue to be affected—whether they owned subprime mortgages or not.
"A black cloud has been hanging over any company that has 'mortgage' associated with it," says Steven Marks, a managing director at Fitch Ratings, adding that in light of the wider credit crunch, it isn't clear how long the troubles will last.
"The subprime challenges were precipitated by asset quality reversal," says John Kriz, a managing director at Moody's Investors Service. "There was some spill over from that market into the commercial mortgage market, obligating commercial mortgage REITs to raise capital on less favorable terms."
The subprime event may also mark a permanent change in the business environment for mortgage REITs, as well as mortgage lenders and investors, probably through tighter underwriting and securitization standards for all. "Credit standards aren't going to get any easier," says Leonard Mills, director of debt research and risk management at Property & Portfolio Research, even after liquidity is at more-or-less normal levels. "The pressure is going to be on for another year at least, before the housing cycle turns."
A Storm Brewing
The reversal of fortunes for some mortgage REITs has been worthy of Greek drama, so complete have their downfalls been. Only a year ago, the now-bankrupt New Century Financial Corporation was touting itself publicly as "a new shade of blue chip," and the mortgage REIT sector was thriving.
Generally, investors were happy with the state of affairs. After all, the value of many residential mortgages, either as whole loans or as securitization fodder, ultimately depended on understanding and managing risk.
However, that observation was drowned out, recalls Leonard Mills, director of debt research and risk management at Property & Portfolio Research.
"The mortgage sector was a good play for a while," Mills says. "There was good volume from 2003 and 2004, and the high interest rate spread enabled those subprime specialists to make a lot of money. However, the tide has turned."
What a difference a year can make. By the early summer of 2007, a number of mortgage REITs with subprime exposure—either through originating and holding whole subprime loans or through investing in lesser pieces of mortgage-backed securities (MBS) collateralized by such loans—had chosen among bankruptcy, selling subprime exposure to other deeper-pocketed buyers or taking steps to rebuild themselves and reinvent their business models, Mills says.
The Road to Recovery
The strategies for dealing with the subprime event vary among mortgage REITs. For some, subprime was the end of the game, and as the summer of 2007 unfolded—with its increasing liquidity squeeze—more mortgage REITs were is dire straights. Early victims included New Century, which went bankrupt in April, while Encore Credit Corporation left the subprime banking business altogether by selling its platform to Bear Stearns & Co. in February of this year for $26 million.
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Segments of Mortgage REITs
There are several different segments of mortgage REITs:
COMMERCIAL PROPERTY: lends to commercial projects
PRIME: lends to residential borrowers who qualify for loans from mainstream lenders
SUBPRIME: lends to borrowers who do not qualify for loans from mainstream lenders
ORIGINATORS: lend to non-operating properties
COMMERCIAL MORTGAGE-BACKED SECURITIES (CMBS): provides commercial debt
RESIDENTIAL MORTGAGE-BACKED SECURITIES (RMBS): provides residential debt |
During the liquidity crisis in the summer, American Mortgage Investment Corporation suddenly folded in early August, while Luminent Mortgage Corporation cancelled its dividend payments. Luminent seemed to be hard-pressed not because of subprime exposure, but because the credit crunch had made it hard to meet its margin calls.
Other mortgage REITs are implementing recovery plans. "There is some liquidity coming back to the market," says Scott Hartman, chairman and CEO of NovaStar Financial Inc. (NYSE: NFI), sounding optimistic during the company's first quarter 2007 conference call in May, though perhaps the timeframe for renewed liquidity will be a little longer than he anticipated, given the global scope of the credit crisis that the subprime contagion has inspired.
Hartman said that in early spring, there was virtually no market for A- or BBB-rated securities, but that buyers were slowly coming back. "The goal now is to drive this business back to profitability," he says, which will also be helped by a recent narrowing of MBS spreads.
NovaStar is also taking a radical restructuring step as part of the path out of its difficulties: as of the beginning of next year, it will no longer be a REIT, although it will remain a public company. According to CFO Greg Metz, the company is projected to have no taxable income between 2007 and 2011, "thus negating the tax advantages, for the most part, of being a REIT," he says.
Rising Above
Two examples of mortgage REITs that are enduring the subprime situation is Thornburg Mortgage, Inc. (NYSE: TMA) and Annaly Capital Management, Inc. (NYSE: NLY). Until early August, when the credit crunch depressed its stock price below $20 ($18.06 on August 10), Thornburg was trading at in the mid-20s, with a peak 2007 of $26.80 in late July. Annaly's price has remained more stable in the low to mid-teens. It was trading at $12.67 on Aug. 11, 2006 and $14.97 on Aug. 10, 2007.
"There are two kinds of risk in this business," says Larry Goldstone, president and COO of Thornburg. "We're very cognizant of those risks. In terms of interest-rate risk, we match-fund our assets and liabilities as best we can, making loans with fixed-rate terms. At the same time, we are borrowing money at comparable fixed rates and terms."
As for credit risk, "much of the industry over the last few years migrated away from prudent mortgage lending practices," he says. "In an attempt to generate volume, the industry eased credit standards. The industry average for delinquencies is 220 basis points, or approximately 2.2 percent of prime loans."
In contrast, according to Goldstone, Thornburg will survive by being the polar opposite of a subprime lender. The company is a single-family mortgage lender that owns the whole loans that it originates.
The REIT has had a longstanding strategy of having nothing to do with the subprime segment either in origination or ownership, in fact tending toward a specialty in jumbo and super jumbo adjustable-rate mortgages (ARM), Goldstone says.
"For us, the subprime situation wasn't just a non-event, it was a positive," says Jeremy Diamond, managing director of Annaly. "In March, we were able to come to market with a secondary offering that was our largest stock offering. Its success was perhaps a reflection of the market's new-found risk aversion."
Diamond characterizes the REIT as "fairly opportunistic, depending on market conditions." The defaults of the subprime lenders were hitting the market in force in late February, he says, with "our offering at the beginning of March. The opportunity was there to raise capital that embraced high-quality credit assets. The timing was serendipitous, and the market responded."
Todd Parriott, president and CEO of Desert Capital REIT, Inc., a publicly registered non-exchange traded REIT, says that the subprime situation had very little reverberations on the company because its business model emphasizes short term lending for the acquisition and development of land for residential and commercial projects.
However, he says that the industry is mending itself after the subprime situation and making modifications. "The industry has been making strong adjustments along the way including aggressive inventory management in the housing sector, including the use of incentives in some cases, and the re-evaluation of development projects," he says. "These initiatives will continue to keep the industry on track and create even more stabilization for upward growth over the next 12 to 18 months."
Impact on Commercial Mortgage REITs
Surprisingly, though the subprime situation directly affected only mortgage REITs with subprime residential exposure, the immediate wake of the troubles this winter also depressed stock prices on REITs that specialize in non-subprime residential and even commercial mortgages.
"They've suffered, and I'd say they've suffered unfairly," Marks says. "Commercial mortgage REITs continue to perform well. The distinction is sharp between the kinds of mortgage REITs, but investors didn't seem to notice that for a while."
Steven Brown, managing director of Neuberger Berman LLC, says there was a rush to sell everything affiliated with a mortgage REIT, even commercial mortgage REITs. "Many assumed that the subprime situation would impact other classes of mortgage securities. Investors felt that securitized mortgage debt was a riskier asset than they'd previously believed, so they backed away from all types of it, including commercial. Then the rating agencies made noises about tougher underwriting criteria for residential and CMBS."
For a while in the spring and early summer, after the initial shock of the subprime incident, stock prices of REITs specializing in commercial mortgages firmed up, Brown points out. "The credit quality of commercial mortgage bonds and securities has been strong all along," he says. "Investors realized that the commercial credit performance is essentially unrelated to subprime residential."
But with the larger credit crunch in August, investors hit the stop button on practically everything. How mortgage REIT stocks will fare during the rest of 2007 is still unclear, given investors' new aversion to risk.
CDO Financing
Another area in which the subprime situation caused indirect troubles for commercial mortgage REITs is in their use of collateralized debt obligation (CDO) financing. "Maybe REITs that buy CMBS or mezzanine debt and package those securities together to issue a CDO have found that the pricing on the CDO has been impacted to some degree," Marks says. "The more junior traunches are being sold at very wide spreads, or not being sold at all. They're generating lower returns off portfolio financing."
Kriz says that, to the extent that the CDO market becomes less appealing, the commercial mortgage REITs could find
it more difficult to put together profitable deals. "CDO's spreads have to be at a certain level to make the transactions economic."
According to Marks, rating agencies' views on pricing and leverage within CMBS have been driving the change in CDO finance. "Some of that thinking has drifted into the CDO world," he says. "CDOs have been great vehicles for commercial mortgage REITs, and they still will be. However, they do expose the mortgage REIT to additional credit risk. Investors have to trust that the underwriter has done a good job in analyzing and pricing, and some investors aren't comfortable with companies that take that kind of risk."
Following a Cycle?
Even before the summertime credit drama, opinion among mortgage REIT observers held that the reverberations from the subprime incident were hardly over for either the mortgage industry or mortgage REITs. The consensus is even stronger on that point, now that the credit troubles are wider.
"It isn't over yet, not by a long shot," Diamond says. "Credit cycles take a while to play out. Defaults and delinquencies on all MBS, not only subprime, will grow in times of slow home-price appreciations."
There's a demonstrated relationship between home-price appreciation and credit performance, he notes. "When homes are rising in value, it's easier for marginal buyers to refinance out of a problem, but they cannot do that as the rise stops or reverses. The poor underwriting standards of the last few years will be felt throughout the market going forward," Diamond says.
Property & Portfolio Research's Mills agrees. "There are definitely some elements of a cycle in the current situation," he says. "However, underwriting standards have never been as loose as they were in the last few years—at least not since the low-doc/no-doc era of the late 1980s—and that added more to the cost of securitization than a more ordinary dip in the cycle would."
As the cycle unfolds, mortgage REITs will find themselves on a new playing field, which could be a good thing. "In our view, the effects of the subprime incident are going to continue for the rest of this year," Goldstone says.
Moreover, the subprime incident hardly spells the end of investment opportunities in mortgage REITs. "Investors will come back to mortgage REITs," Brown says. "That will eventually include mortgage REITs with some subprime exposure."
Dees Stribling is a regular contributor to Portfolio.
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