Mortgage Sector

# of REITs 20 Market Cap. $5,355,991 Industry Market Cap. $168,248,660 % of Industry 3.2% Average Dividend Yield 10.5% YTD Total Return 15.7% 1-year Total Return 54.4% 3-year Total Return 14.3% 5-year Total Return 2.8% Weighted Daily Volume (shares) 31,783,245 *Data as of April 30, 2002 Source: NAREIT

In order to properly explore this sector, it is important to keep in mind the wide range of balance sheets and business strategies among mortgage REITs, and the diverse drivers of value-creation and risk that relate to them. There are three basic types of mortgage REITs. The largest type in terms of asset size and number of firms concentrates on investing in Fannie Mae, Freddie Mac, Ginnie Mae and highly rated, private-label residential mortgage backed securities (RMBS), earning its money off of the spread in interest rates. This group includes firms such as Annaly Mortgage Management, America First Mortgage Investments and FBR Asset Investment Corporation.

A second type of mortgage REIT acquires mortgages on a bulk basis, and some companies of this type originate single-family mortgages for securitization for their own portfolios or for sale. Impac Mortgage Holdings and Thornburg Mortgage are examples in this group. These operations are akin to the activities of mortgage banks, and these REITs’ risk profiles can vary depending on the details of their strategies.

A third type of mortgage REIT invests in assets such as commercial mortgages, subordinated Commercial Mortgage backed securities (CMBS) tranches, as well as associated servicing, origination and securitization activities. Such activities are often complex and can carry material risk. CRIIMI MAE, Inc. is an example of this type.

But even beyond the numbers, mortgage REITs today are better prepared to deal with adverse environments than in the past. However, given their diverse business models and risk exposures, there are still challenges that remain.

Three Key Risks

Mortgage REITs’ main risks include interest rates, funding and credit risks. Interest rate risk largely stems from the asset-liability mismatch that is typically employed by mortgage REITs to capitalize on the usually upward-sloping shape of the yield curve. REITs generally fund their investments in long-term mortgage assets with short-term variable-rate debt, such as repos, to earn the arbitrage spread between their cost of funds and the yield on their portfolios. To the extent that the short-term variable rates rise, this spread can be squeezed, and can disappear entirely if the yield curve slopes negatively. Similarly, adverse interest rate changes can reduce the value of their mortgage investments. For example, declining long-term rates can result in faster-than-anticipated prepayments.

Mortgage REITs primarily fund themselves with short-term repo or other secured facilities that are uncommitted and often subject to daily margin calls. Because of this, they can potentially face sudden funding and liquidity challenges. This is especially true of companies that invest in less liquid commercial mezzanine loans, junior CMBS tranches, or similar assets that are less liquid, contain material credit risk and are subject to potentially substantial price volatility. Those REITs that invest in Agency RMBS securities have much more robust funding options, do not require substantial over-collateralization, and have not experienced the funding challenges of some of their commercial mortgage-focused brethren.

The asset risk profiles of mortgage REITs vary widely. Agency RMBS collateral, and highly rated private label RMBS, carry very low credit risk. On the other hand, some firms invest in subordinate CMBS tranches, complex whole mortgages, mezzanine loans and commercial construction loans that can carry high credit risks, may not be transparent and tend to be highly illiquid to boot; in contrast to most RMBS.

Risk Profiles and Risk Mitigation Strategies

Mortgage REITs tend to thrive in interest rate environments characterized by falling short-term rates and a steep yield curve, as has been the case in recent quarters. Because these market conditions can shift rapidly, it is important to focus on the risk profile and risk mitigation strategies in each of the mortgage REIT sectors.

Companies that invest primarily in RMBS have been striving to mitigate some of their risks. For example, many of these companies have reduced their exposure to interest rate volatility risk associated with their asset-liability mismatch by investing primarily in adjustable-rate RMBS and loans. However, these companies cannot completely eliminate interest rate risk because ARMs are often indexed to different short-term benchmarks than are the corresponding liabilities, have lifetime and adjustment caps, as well as rate resets that do not match their liabilities. These characteristics limit these REITs’ ability to match interest rate changes with their liabilities. Investment by mortgage REITs in assets that pay fixed rates, but are funded with repo financing, has been less frequent and involves greater interest rate exposure, which can be contained for fixed periods of time with interest rate swaps, as carried out by Apex Mortgage, for example.

The risk profile of REITs that have adopted a business model similar to single-family residential mortgage banking/portfolio lending is not unlike that of the more conventional RMBS-oriented mortgage REITs. However, firms in this sector also have a special set of challenges. Like their RMBS-oriented cousins, these companies can mitigate interest rate risk by originating and investing in adjustable-rate mortgages while funding them with short-term secured debt. However, they are constrained by some consumers’ appetite for hybrid mortgages, which for a period of one to five years carry fixed-rate terms. Because these REITs tend to hold non-conforming mortgage assets and often residuals remaining after securitization, they can have elevated levels of credit, funding and liquidity exposure. Firms can address some of their funding risk in these whole loans, and further mitigate interest rate risk, through securitization and subsequent issuance of floating rate long-term CMOs.

The portfolio lender model confers other advantages, including the potential to build a more defensible business franchise. However, this model is not without its own risks. Risks include having to enter the highly competitive mortgage banking industry and build the infrastructure associated with mortgage origination and underwriting, or be dependent on third parties to perform such vital functions. Franchise building can also be achieved by commercial mortgage REITs by developing business strategies stressing complex, value-added financing solutions. Franchise building is more difficult for mortgage REITs whose business activities are limited to managing leveraged mortgage portfolios.

REITs that specialize primarily in investment in, and securitization and servicing of, credit-sensitive, less transparent, and often illiquid commercial mortgages and subordinate CMBS are most vulnerable to credit risk and funding challenges. These REITs’ investment portfolios can experience substantial credit losses during economic stress. However, funding risk has been a key challenge for this mortgage REIT subsector. The global liquidity crisis in the second half of 1998 hit investors in subordinate CMBS hard, reducing both the value and liquidity of their portfolios, while forcing margin calls on their repo facilities from often skittish lenders, which sometimes proved difficult to meet.

CRIIMI MAE, one of the companies affected, re-emerged from bankruptcy protection in 2001 and is currently exploring options (including privatization and being acquired) to maximize shareholder value. However, Dynex has ceased its commercial mortgage lending and investment activities.

REITs in the commercial mortgage sector have been able to mitigate their interest rate risks through resecuritization, which helps them match fund their assets. Moody’s considers this commercial mortgage sector to be the most challenging niche in the mortgage REIT industry due to significant funding and credit risks, as well as intense competition from non-REIT originators and securitization conduits.

Mortgage REITs with Over $1 Billion in Assets REIT Ticker Investment Focus Assets at YE 2001 Annaly Mortgage Management, Inc. NLY RMBS $7,717,313 Capstead Mortgage Corporation CMO RMBS; Residential loans $5,895,425 Thornburg Mortgage, Inc. TMA Residential loans $5,803,648 Impac Mortgage Holdings, Inc. IMH Residential loans $2,854,734 Anthracite Capital, Inc. AHR Junior CMBS tranches; RMBS $2,611,781 Redwood Trust, Inc. RWT Residential loans; Residual interests in RMBS $2,435,644 America First Mortgage Investments, Inc. MFA RMBS $2,068,933 Apex Mortgage Capital, Inc. AXM RMBS $1,535,425 FBR Asset Investment Corporation FB RMBS $1,325,125 CRIIMI MAE Inc. CMM Junior CMBS tranches $1,315,004 Source: Moodys, SNL Financial