“Give me a lever long enough and a fulcrum on which to place it, and I shall move the world”.
Archimedes
Short-term interest rates have been close to zero for nearly three years. This is highly unfortunate for the few virtuous souls who have saved in the past and hoped to generate retirement income from those savings. With money market fund rates and bank CD rates extremely low, there is strong demand for higher yielding investment vehicles. One such alternative is to take on greater interest rate risk by reaching out on the yield curve to buy longer-term bonds. Supporting such a strategy is the fact that the yield curve is extraordinarily steep today; that is, the difference between long-term yields and short-term yields is extraordinarily wide. On average over the past fifty years, the spread between 30-year Treasury yields and 3-month Treasury yields has been about 2 percent. Today this spread is nearly double.
The obvious problem with this thinking is that the short-term return to investing in long-term bonds depends crucially on the direction of long-term rates. If long-term yields rise, the holder of bonds suffers a capital loss (the price of the bonds he owns falls). The longer term the bonds, the greater the potential loss. Today, even though long-term yields are at historically high spreads compared to short-term yields, the absolute level of long-term yields is historically very low. In all likelihood, long-term yields are going to rise significantly over the next few years. And if this occurs, those savers who have purchased long-term bonds will suffer capital losses.
A variant of this strategy is the Agency MBS REIT1. A REIT is a Real Estate Investment Trust which is a vehicle designed to invest in real estate assets on a tax-advantaged basis. The key idea is that if a qualifying REIT earns income from real estate or mortgage investments, and pays out at least 90% of its income in dividends to shareholders, then it is not subject to tax at the corporate level. The investor in a successful REIT earns a high dividend income, which is taxed at favorable dividend rates. Today, investors are flocking to Agency MBS REITs.
In today’s low interest rate environment, the appeal of the agency REIT idea is that agency Mortgage Backed Securities (that is, mortgage backed securities (MBS) guaranteed by Fannie Mae or Freddie Mac) are easily financeable and offer yields today substantially in excess of financing cost.
Example
Consider the following example: MBS yield=4%, financing haircut=10%, financing cost=0.5%, management fee=1.5%. So long as interest rates are unchanged, the levered unhedged return to the investor is equal to
Return = Yield-Fees + Leverage*(Yield-Cost of funds), or in our example
34% = 4%-1.5%+9*(4%-0.5%)
This clearly is a lot better than 1% in a bank Certificate of Deposit.
But, it is a lot riskier as well. Most people believe that the current level of the federal funds rate is at least 2% below a normalized level. If short-term interest rates were to rise by 2% then the dividend payout would decline significantly and, to the extent that long rates rose along with short rates, the market value of equity would decline as well. The sensitivity of the market value of equity to changes in long-term interest rates is approximately
(-1)*Equity Duration * (Change in interest rates)
where the Equity Duration is given by
A/E*(Duration Assets-L/A*Duration Liabilities)
Assuming the asset duration is four years and the liability duration is six months, then the equity duration is 10*(4-.9*.5)=35 years.
So, in this example a one percent rise in interest rates implies roughly a 35% decline in shareholder equity.
Hedge strategies
Professional REIT managers who believe interest rates have a nonzero chance of rising are likely to employ hedging strategies to reduce the interest rate risk of the strategy. Broadly speaking, there are two ways to reduce rate risk. First, by paying fixed on interest rate swaps, the manager can extend the effective maturity of the short-term funding position. Second, by taking long positions in interest rate options, the manager can offset the negative convexity of the MBS portfolio. The issue is the degree to which the dividend and expected return are dampened by these hedge positions. There is also a timing issue. Managers who are confident that interest rates will remain low in the near-term may well choose to postpone implementation of hedge strategies.
Based on some back of the envelope calculations, I estimate that an MBS portfolio hedged with swaps could be established now that would offer a dividend yield of approximately 10% along with the volatility of the 30-year Treasury bond (the difference between this 10% dividend yield and the 4.2% current yield on a 30-year Treasury bond primarily reflects superior convexity characteristics of the latter). There is substantial investor interest in this asset class and there is a backlog of new equity issuance by MBS REIT asset managers.
Virtual bank
The asset-liability strategy described above is conceptually similar to that of some banks or thrifts: fund short-term, hold capital equal to 10 percent of assets, and attempt to acquire assets with a positive spread to the cost of funds by investing loans or securities further out on the yield curve (“lend long borrow short”) in order to take advantage of the normally positive slope of the curve. One major difference is that the liabilities in the MBS REIT are collateralized borrowings (repurchase agreements) instead of deposits. Deposits are insured by the FDIC, so the likelihood of a run on a bank is small even if the market value of the bank’s assets declines. The REIT, on the other hand, is subject to market discipline. If the value of the REIT assets declines, lenders will demand additional collateral. The assumption of a 10% haircut is based on the liquidity of MBS securities and the overall risk of the position. Presumably, REIT managers that maintain a high quality hedge position would have the opportunity to enjoy smaller haircuts (conversely for those that do not).
Bank capital requirements
Suppose a bank adopted the asset/liability strategy of the MBS REIT. The ability of the bank to lever is constrained by regulatory capital requirements. It is interesting to contemplate the capital requirements that would be imposed. Under Basle I, bank capital must satisfy three requirements – the minimum equity rule, the Tier 1 capital ratio and the Tier 2 capital ratio. The minimum equity must be at 3% of assets (5% to be “well-capitalized”). This would be the binding ratio since the Tier 1 and Tier 2 ratios are based on “risk weighted” assets and the risk weight for agency MBS is just 20%.
With 10% equity, a bank following the MBS REIT strategy would easily qualify as well-capitalized, even without hedging the interest rate risk. Thrift regulators have for many years applied additional tests relative to interest rate sensitivity. In particular, the market value of portfolio equity (MVPE) is estimated under a range of yield curve shocks and these calculations are used to assess the degree of interest rate risk. These thrift tests would tend to prompt management to implement hedging strategies such as we have outlined above. Apparently, bank regulators do not formally apply such tests. The closest they have come is the stress testing applied to the largest banks in 2009. The idea of stress testing should be expanded to address interest rate risk as well as credit risk and should be applied to all banks.
Bottom Line
The MBS REIT faces market discipline. This along with management prudence is what constrains leverage and induces management to implement appropriate hedge strategies. The analogy to a bank is informative. The bank is constrained by regulatory capital requirements, as well as management prudence. As implemented today, regulatory capital requirements are probably less effective than market discipline in constraining risky strategies.
1Disclosure: as of the publication date of this document, the author was long shares in NLY and PMT