The mortgage real estate investment trust (REIT) space has been hammered since the beginning of the COVID-19 pandemic. Even agency mortgage REITs have been slammed by margin calls and depreciating assets. As markets elsewhere start to recover, some are asking: Is it safe to reenter the mREIT waters?
For some mREITS operating right now, perhaps. For others, absolutely not.
MFA Financial (NYSE:MFA) is a mortgage REIT that invests mainly in non-government guaranteed mortgage-backed securities and mortgages. The company does have some agency (i.e. government-guaranteed) exposure, but it is only about 11% of its assets. MFA has been beaten up even worse than the typical mREIT and is down 81% year to date. The company has gone into forbearance with its repo counterparties and suspended its dividend. Forbearance means the company has been unable to meet its margin calls and has agreed with its counterparties to hold off liquidating until a specified date.
What is a repurchase agreement?
Pretty much every mortgage REIT has been hit by margin calls. The REITs that mainly invest in government-guaranteed mortgage-backed securities have been able to find a way to meet the margin calls, largely by selling investments. The ones like MFA have not been able to sell investments due to a lack of liquidity in the markets. Mortgage REITs generally finance their investments by using what is called a repurchase agreement (also called a repo). Here's how they work.
Say a mortgage REIT buys $100 million worth of mortgage-backed securities in the market and wants to buy more. It approaches a bank and asks about entering into a repurchase agreement. The bank says that it will do a 360-day repo at a 5% haircut. What that means is the mortgage REIT "sells" those securities to the bank for $95 million and then agrees to buy them back in a year at $100 million. The idea would be for the REIT to take that $95 million and go out and buy more securities. If the mortgage REIT is unable to pay back the loan, the bank has the securities worth $100 million as collateral and can use that to make itself whole. Under normal circumstances this whole process works smoothly.
Margin calls and forbearance
Unfortunately for the mortgage REIT sector, the value of the collateral (i.e. the $100 million worth of securities) began to depreciate. When it looks like the value of the collateral is in danger of falling below the value of the loan, the bank will ask for more collateral (usually cash). If the REIT cannot come up with the cash, then the bank has the right to sell that collateral in the market to make itself whole. Note this is identical to what happens if you trade on margin and fail to meet your margin call: Your broker will sell your stock to pay off the loan.
Most of MFA's portfolio consists of illiquid securities and whole loans, which are hard to trade even in a normal market. It is extremely hard to find buyers right now because every mortgage REIT is in the same boat. So, MFA entered into a forbearance agreement with its bankers where they agree not to sell the collateral while MFA tries to figure a way out of its predicament. MFA has been selling assets and using the proceeds to pay off repurchase agreements, but has only sold about 8% of the portfolio. MFA's forbearance agreement with its bankers ends on June 1.
Not a suitable investment for the long-term investor
Buying MFA now is like buying a stock on the edge of bankruptcy. The stock may or may not be worth something. As of Dec. 31, MFA had $13.6 billion in assets and $10.2 billion in debt. If the value of these assets falls by 25%, then the company is theoretically bankrupt. While fundamentals matter, in an illiquid market like we have right now, forced sellers never get full price. That is where MFA is right now. Until we have closure on where MFA is with its creditors and its portfolio, the stock is simply not something a long-term fundamental investor should consider.