I recently mentioned the Mortgage Real Estate Investment Trust (MREIT) industry while briefly commenting on high NAV-ror companies in the BDC universe. Recently I looked more deeply into several MREITs, and find that they are too complex to be worthwhile. I will pick on Annaly (NLY) primarily because they are the largest market cap MREIT that is publicly traded.
The primary source that convinced me was the Annaly 22Q2 earnings call [1]. You can find a transcript here (NLY earnings call transcript at Motley Fool). This passage in David Finkelstein's prepared remarks especially stood out:
After combining our book value performance at our first quarter dividend of $0.22, our quarterly economic return was negative 9.6%. As noted earlier, the portfolio generated EAD per share of $0.30. Earnings continued to be strong, resulting from high dollar roll income, increasing MSR net servicing income, reduced amortization due to lower CPRs and a benefit from our swaps portfolio as it turned to a net receipt position during the quarter on higher short-term rates. However, EAD was meaningfully aided this quarter by an increase in specialness and dollar rolls, primarily driven by a scarcity of TBA-type collateral and newer higher rate production coupons.
For those of you in the MBS (mortgage backed securities) business, you can stop reading here. This article will be too simplistic. The rest of us need a quick review of what this paragraph implies.
First, although you can Google the meanings of the specialized terms and acronyms and eventually get a mental picture of what they mean (EAD = exposure at default, MSR = mortgage servicing rights, CPR = conditional prepayment rate, CRT = credit risk transfer [2], TBA = to be announced, specialness = the extent to which implied dollar roll financing rates fall below prevailing market rates, dollar roll = to sell short MBS) as a whole the complexity implied by the jargon is irreducible. Some of these terms originate in the nature of the mortgage contracts. Others refer to typical practices in the MBS trading system. Unless you want to specialize in understanding MBS, it would be difficult to understand how to sort out one MREIT from another based on their business model.
Could you analyze management, probity, company values? Perhaps, but your analysis would be thin and fragile, with little to count on in difficult times. You would have to be confident that a company with better values could outperform companies without good values, in a commodity market. Thinking back to comments made by Ajit Jain and Warren Buffett about the reinsurance and property and casualty markets, when an commodity business gets crowded, margins thin and often the companies with the thinnest value systems win on price.
The MBS world, although not simple, is a crowded market, as alluded to here by NLY:
This correction will be welcomed for the Agency MBS market as it reduces elevated net supply, which has been the main headwind for the sector in the recent past.
Although there are many variations in the mortgage market (geographic, % of value, borrower demographics, contractual terms, MSR details, etc.) the primary business of buying and selling mortgage securities is liquid and competitive. The originator may be able to distinguish themselves by service, bundling, and so on, but secondary players like MREITs have little to no moat around their operations.
Monster in the Market: Super Artificial Intelligence
This leads me to speculate about the potential for a very serious difficulty for MREITs, which I will call the Super AI MBS Speculator (SAIMS). The SAIMS entity was constructed sometime around 2013 to 2017, although it is continually upgraded by the MIT quant engineers who developed it for the secretive hedge fund they work for. The goal: to extract value from the MBS market by out-thinking the rest of the MBS players and detecting trends faster than they do. Using deep learning augmented by specialized programming, the SAIMS continually analyzes interest rates, economic indicators, housing markets, consumer behavior, but especially the MBS markets and its players. It does not seek to dominate any one type of trade, but instead seeks to systematically shave an advantage off every type of trade available to it.
SAIMS is similar to the quant trading done by HFT players, but it seeks advantages in information interpretation more than it does in speed. Because it is automated, it can place trades for small amounts that are statistically consistently profitable without tipping its hand that it has an edge over its competitors.
In a SAIMS-dominated environment, the players like NLY are continually using very, very sophisticated methods of analysis that show them what just happened and why even though they are not able to anticipate the moves or tactics of the SAIMS. The best MREIT companies at their best are still several steps behind the SAIMS. Although the MREITs may make small amounts of money above trend in quiescent markets, when the SAIMS is paired with an active human-based trading strategy that generates disruptions in the market it can force the market into non-quiescent periods. Naturally, Government actions (or inactions, as when they fail to tighten rates in response to price movements) tend to generate market disruptions, so the SAIMS owners are close friends with Government organizations and politicians.
SAIMS works because it trades against the entire MBS and MREIT marketplace. It goes short and long, offers excellent liquidity and supplies narrow spreads to the market. It takes small amounts of money from all players, but makes up for the small amounts by dealing in volume. To the outside observer, SAIMS's success is mysterious and difficult to explain. Huge profits show up annually on the ledger of the investment bank/hedge fund, but rarely is much attention devoted to explaining the operation to outsiders.
While SAIMS is a speculation and not a prediction, I think that regardless of the actual shape of the risk to MREITs, it is highly useful to think of the MREIT environment as including SAIMS-like opponents. It could be the marketplace itself, a collection of SAIMS programs, or the machinations of a Federal Government that continually collects benefits from the gradual book value loss of the MREITs, even if those "machinations" are not realized in any single mind and are merely the product of bureaucracy plus legislation. If you want a 10% to 12% yield, you need to seriously consider why such a juicy yield is available in the market. Is it a Trojan Horse?
A Low Interest Rate Base Makes All Fixed Income Vulnerable
MBS are bond-like. As I published here before, low long-term interest rates pose problems for those seeking to invest in bonds. Likewise, low interest rates are a problem for MBS and MREITs.
They are also a problem for target date mutual funds, and for bond funds generally. And this time may be different (for bonds). This blog post at Allocate Smartly[3] says it well:
Importantly, an extended period of rising interest rates could have a more severe impact in today’s market than in the 1960’s and 70’s. Yields rose from a higher base then, and that helped to cushion the impact of rising rates.
Toxic Complexity
While digging through the MREIT acronyms and jargon, I kept encountering ideas that were explained primarily by academic papers. The first, "specialness", with an irony almost too profound to be believed, turns up in a paper you can get via an mit.edu URL [5]. Though maybe I didn't look hard enough, the best explanation for PAA I could find was in another academic paper [4] on obtaining higher yields with near-zero risk of capital loss.
Some years ago while at Hostfest in Minot, SD I met the aunt of a fellow MIT graduate, who put us in touch with one another. We corresponded by email. He mentioned that he was in the MBS business.
I'm in favor of using our intelligence to solve problems and make things better. But it is a problem when simply keeping up with the competition requires either being an MIT graduate or doing your homework just as well as one. If you are in a simple commodity business, then superior teamwork, processes, and a solid corporate culture could make you the low cost provider, and therefore make your business both profitable and stable. In the MBS business, it appears that external players can be leaders just as easily as the publicly-traded MREITs, and for that reason, I'm out.
Sources
1. NLY earnings call transcript at Motley Fool
2. PMT earnings call transcript at Motley Fool
3. https://allocatesmartly.com/government-bonds-have-failed-to-deliver-when-needed/
4. Keller, Wouter J. and Keuning, Jan Willem, Protective Asset Allocation (PAA): A Simple Momentum-Based Alternative for Term Deposits (April 5, 2016). Available at SSRN: https://ssrn.com/abstract=2759734 or http://dx.doi.org/10.2139/ssrn.2759734
5. Song, Zhaogang and Zhu, Haoxiang, Mortgage Dollar Roll (July 2, 2018). Review of Financial Studies (Forthcoming), Available at SSRN: https://ssrn.com/abstract=2401319 or http://dx.doi.org/10.2139/ssrn.2401319
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