US Mortgage Real Estate Investment Trusts (Mortgage REITs) have been crushed by the coronavirus crisis, substantially underperforming the US equity market as a whole, as their risk has skyrocketed to levels not seen by any US industry in at least three decades.
While considered equities, Mortgage REITs’ business model makes them much more bond-like than equity-like. The recent underperformance and risk profile of Mortgage REITs could reflect the disconnect between stock and sovereign-bond markets. While equity investors have once again begun to buy shares in anticipation of gains from the easing of lockdowns and stimulus measures, their fixed-income counterparts appear to be more cautious. Could Mortgage REITs, therefore, be another omen of a long-term downturn in the US economy?
After falling abruptly in late February and March, the US equity market as a whole rebounded strongly, buoyed by unprecedented government stimulus and the prospect of a quick recovery following the reopening of the US economy. Mortgage REITs not only dropped much lower than the US equity market during that earlier period, but experienced only a minor recovery after bottoming out in late March.
Mortgage REITs’ reliance on leverage makes the industry more dependent on the bond market, which has not been partaking in the equity market’s optimism. Long US Treasury yields have been trading mostly sideways since hitting historic lows in early March, while shorter-dated paper and interest-rate futures imply long periods of ultra-low central-bank rates.
The highly leveraged business model of Mortgage REITs amplified their losses, driving the industry’s risk up to unprecedented levels. Mortgage REITs posted the second-largest year-to-date active loss of 45% (net of the US market) , after Airlines, among 68 US industries. The industry reached a volatility level not seen for any US industry in at least 30 years, and its risk is now more than double its peak during the global financial crisis. Even a small exposure to Mortgage REITs could act as a black swan in an equity portfolio’s targeted level of risk.
Coronavirus Crisis vs Global Financial Crisis
During the global financial crisis (GFC), Mortgage REITs’ demise was brought about by overly aggressive lending practices, which led to questionable loans (subsequently pooled and sold as bonds to investors in capital markets). In contrast, the current crisis in Mortgage REITs has been driven by coronavirus-imposed lockdowns. As a result, the impact of the current crisis is far more widespread, while the crisis during the GFC centred around a certain subset of homeowners unable to meet their mortgage obligations.
The closing of businesses across the US resulted in loss of revenues and a subsequent shortage of cash flows to meet companies’ financial obligations (e.g. rent and mortgage payments, salary payments, and other operational expenses). Multiple businesses have already filed for bankruptcy. Delays or defaults in commercial mortgage payments severely impact Mortgage REITs, especially since most commercial mortgages are not backed by the federal government (i.e., they are non-agency loans). Residential mortgages—though they are agency loans—are also at great risk of payment delays: with over 33 million people unemployed, many homeowners will be unable to write those checks.
The collapse of the US subprime mortgage market in 2007 triggered a dry-up of the credit market, causing a liquidity crisis that had a long-term impact on the US economy. Mortgage REITs fell more than 40% in the first eight months of 2007, while the US equity market bottomed one and a half years later.
While the mortgage market is not the immediate culprit in the current crisis, the sharp drop in Mortgage REITs shares reflects increased liquidity and solvency risks, which could once again have long-term effects on the US equity market. This risk had not been priced in over the last 10 years due to quantitative easing programs and a strong economy that drove unemployment to a 50-year low in February. But now, this risk will need to be priced in, with unemployment at a 50-year high. Quite a reversal in just three months!
Mortgage REITs provide investors with the means to hold an equity investment in the mortgage market, by buying shares of companies that generate revenue from interest income from residential and commercial mortgages and mortgage-backed securities. Hence, they are quite interest-rate sensitive.
Mortgage REITs invest in mortgage-backed securities (with fixed long-term rates), which they finance through short-term funding on the “repo” market, earning money from the spread between the interest income and funding costs. Hence, Mortgage REITs’ profits are proportional to the spread between long-term interest rates and short-term interest rates, making them highly dependent on the level of interest rates and the shape of the yield curve.
Residential Mortgage REITs are more interest-rate sensitive, while commercial Mortgage REITs are impacted more by credit risk, especially if a recession hits and default rates rise on their underlying loans. While most residential mortgage securities are backed by the federal government (i.e., they are agency mortgages), most commercial loans are non-agency mortgages and subject to credit risk.
The repurchase financial market is essential for the commercial real estate mortgage-backed securities. Banks provide liquidity by purchasing commercial mortgage loans from Mortgage REITs. Banks also impose minimum liquidity requirements and mark-to-market the mortgage-backed securities they are financing, requiring Mortgage REITs to cover any resulting “margin call” within one or two days. Mortgage REITs do not have the luxury of waiting out a crisis; instead, they tend to become much more volatile as economic and liquidity concerns rise.
Mortgage REITS underperform the US market by 45 percentage points YTD
The Mortgage REITs industry has been pounded by the COVID-19 crisis, sinking much lower than the overall US equity market, which fell abruptly starting in late February.
High uncertainty triggered a flight to cash, which dried up liquidity, making short-term funding harder to come by. This directly impacted Mortgage REITs’ access to funds needed to support their leveraged business model. The flight to cash and increased credit risk (for non-agency mortgages) drove down the value of mortgage-backed securities, which act as collateral for Mortgage REITs’ short-term loans. As the value of collateral fell, Mortgage REITs were forced to sell their holdings in response to banks’ margin calls.
As a result, Mortgage REITs fell 56% in 13 days, bottoming out on March 24. Then, while the US market rebounded substantially from the trough reached around the same time, Mortgage REITs did not follow a similar pattern.
The industry did, however, see a short-lived rebound following the Fed’s announcement of an open-ended purchase program for Treasuries and mortgage-backed securities (including commercial mortgage-backed securities) on March 23.
The CARES act, which was signed into law on March 27, allowed for forbearance on federally backed mortgages and therefore contributed to the liquidity constraints, pushing Mortgage REITs down again. Mortgage REITs were boosted by the Fed’s decision on April 6 to inject more liquidity into the market by creating a new program to finance loans that banks and other lenders make through the government’s emergency small-business lending program, aimed at incentivizing businesses not to lay off employees during the coronavirus-induced shutdown. But this boost was small compared with the dramatic losses earlier in the crisis
To date in 2020, the US market has posted a cumulative loss of “only” 10%, while Mortgage REITs recorded a year-to-date active loss of 45%, as of May 8.
Mortgage REITs risk at 30-year record high across all industries
The back-and-forth described above means the volatility of Mortgage REITs has skyrocketed since the beginning of March, with industry risk reaching levels not seen in at least three decades. The current level of industry risk of 80% is more than double the peak level of risk Mortgage REITs recorded during the global financial crisis. Note that this measure of risk is over-and-above that of the US market and other factors comprising Axioma’s US short-horizon fundamental model, what we often call “extra-market” risk.
For the past 30 years, the risk of Mortgage REITs has generally stayed somewhere in the middle of the pack relative to other US industries. But clearly this pattern changed very quickly in 2020.
Although both Mortgage REITs and the US market risk surged this year, US Market risk went up more than fivefold since the beginning of the year, while the “extra-market” risk of Mortgage REITs went up ninefold.
To be sure, the shifting sands of relative risk have not just impacted Mortgage REITs. The US Market has seen large changes in industry risk. Other industries that were considered low volatility—such as Hotels, Restaurants & Leisure or Gas Utilities—turned into high-risk industries. Mortgage REITs became the riskiest US industry by far, its “extra-market” risk surpassing that of the second-riskiest industry—Energy, Equipment & Services—by 20 percentage points.
When looking at the riskiest industries based on the current level of risk, only Energy, Equipment & Services, Airlines, and Oil, Gas & Consumable Fuels remain among the 10 industries that have been the riskiest historically.
The highly leveraged business model of Mortgage REITs (which makes them more dependent on the bond market) led to the dramatic fall of the industry and a huge commensurate increase in the industry’s risk.
Mortgage REITs have been hit from all sides during the coronavirus crisis: by the real estate market, mortgage market, credit market, and the Fed’s moves, underscoring Mortgage REITs’ large downside risk in an economic downturn. Mortgage REITs return fell 45 percentage points below that of the US market year to date.
During good economic times, the industry’s volatility has varied little from the US average industry risk, but Mortgage REITs’ risk skyrocketed during this crisis, reaching levels not seen by any US industry in at least three decades. Only a small exposure to Mortgage REITs could sidetrack an equity portfolio’s targeted risk.
Mortgage REITs’ underperformance and risk profile could be a reflection of the discrepancy between the equity market, which saw a strong rebound since it bottomed out in March, and the more pessimistic bond market.
It may be the case that Mortgage REITs just happened to be at the epicenter of the coronavirus crisis, or perhaps the industry’s reaction to this crisis is reflective of more systemic issues in the US economy. The latter possibility may become more evident in the long run.
 This is the Mortgage REITs industry factor return in Axioma’s US4 short-horizon fundamental model, which is, in effect, an active return net of the US market.
 Instead of owning, managing, and developing commercial properties (as REITs do) Mortgage REITs invest in and own mortgages. Therefore, Mortgage REITs are not considered part of the Real Estate sector; rather, they are classified as financial stocks.