Mortgage REITs: Funding Management Is Key
by Jay Siegel

Creative funding strategies are driving mortgage REIT activities. Far more than equity REITs, mortgage REITs rely on significant levels of direct or indirect leverage to generate adequate returns on inherently low margin assets. The nature and terms of their financings thus become critical components of their profitability in good times, and of their survival in tough times.

An Often Volatile REIT Sector

Mortgage REITs have historically been a volatile REIT sector, with speculative-grade credit ratings reflecting concerns over high leverage, low profit margins, periodic funding challenges and often-illiquid assets. Risks vary greatly among the companies in this sector, however. This reflects the variety of managements' risk appetites, product types (portfolios consist of highly rated adjustable-rate mortgage-backed securities, subordinate classes of commercial MBS, residual interests in securitizations of a variety of asset classes, and mezzanine whole loans on commercial properties), and business activities, with some firms focusing on originating loans, and others on investing. Yet for each mortgage REIT, access to reliable funding is its lifeblood.

Reliable Funding Is a Key Need

Mortgage REITs traditionally do not have broad access to equity and unsecured debt funding because their business profiles limit their investor base. Mortgage REITs usually have high effective leverage, and limited franchise values compared to their commercial bank, diversified finance company, and mutual fund competitors. Returns and funding are frequently volatile, and sensitive to macroeconomic factors.

In most cases, however, their retained mortgage-related assets can be financed on a secured basis, and these REITs rely on the repurchase market as a core funding source. Unfortunately, those repurchase-funded mortgage REITs that hold illiquid assets can be suddenly squeezed by margin calls and by funding disruptions.

The experience of CRIIMI MAE, a large buyer of subordinate tranches from commercial mortgage securitizations, is a recent example of this. Margin calls helped to drive CRIIMI MAE to file for Chapter 11 bankruptcy protection, even though its GAAP balance sheet showed solid capital levels and its underlying loans were performing well. The company has since pulled out of Chapter 11 through reorganization and refinancing.

New Funding Techniques Emerge

Mortgage REITs are not always dependent on repurchase financing. Several funding techniques have been introduced that allow mortgage REITs to limit or remove much of their risk of margin calls and funding disruptions.

One new technique to remove margin call risk is to enter into a committed asset financing facility. Rather than tying the funding amount for a loan to its market value, and thus remaining susceptible to margin calls, funding commitments are set in place at agreed-upon levels based on collateral characteristics. REITs benefiting from such agreements hope to be more assured of the availability and pricing of funding. In general, these agreements are limited to REITs that hold or sell whole loan collateral. Lenders are less willing to fund subordinate tranches of securitizations this way due to their more volatile nature.

Other REITs may try to take advantage of the funding available to savings institutions by acquiring banks or thrifts. If successful in purchasing a savings institution, the mortgage REIT may benefit from funding in the form of retail and wholesale deposits, as well as Federal Home Loan Bank advances for appropriate collateral.

At Moody's we expect this sort of funding will represent only a small portion of total financing for mortgage REITs. Capital regulations limit the types of assets that may be efficiently funded this way. Also, REITs might have to adopt complex structures to continue to maintain their tax status.

Securitizations should continue to loom larger as a means of funding whole-loan assets. Mortgage REIT loan originators are discovering that funding can be more efficient and stable if the senior cash flows on their loans are converted into highly rated mortgage-backed securities and then sold or financed. In fact, some REITs, like CRIIMI MAE, have employed the same strategy in re-securitizing owned subordinate securitization classes.

Of course, the increase in securitization does create added complexity for REIT investors. Some REITs that securitize assets and sell highly-rated classes are electing to leverage their holdings off-balance sheet. Securitizing REITs need to maintain a beefed-up infrastructure in order to effectively conduct or oversee securitization servicer functions.