SEC looking at Leverage in Mortgage REIT's

An SEC request for comments on the interpretation of a clause in the 1940 Investment Company Act is wreaking havoc on the prices of publicly traded agency mortgage REITs.  These REITs typically apply leverage ranging from four to eight times capital based on the interpretation that their holdings of mortgage securities exempt them from Investment Company Act leverage restrictions.

Annaly Capital (symbol NLY) is the poster child and 800 pound gorilla in the industry and the stock has fallen 11%  since September 21 to a close today of $15.68.  The market capitalization of approximately $15 billion easily dwarfs its nearest competitors. (Other agency REITs include American Capital (AGNC), MFA, Hatteras (HTS), Invesco (IVR) and Anworth (ANH)). Per their most recent quarterly statement, the company employs a leverage factor of 5.7, implying that their capital supports an asset base of $85 billion in mortgages, mostly Fannie Mae and Freddie Mac MBS pass thrus.  

Because of the relative steepness of the US agency yield curve, employing that degree of leverage has allowed Annaly to generate dividend yields in the mid-teens.  Given the absolute low level of interest rates, that kind of yield has attracted significant investor demand.  In 2011 alone, the company has issued three secondary offerings totaling 270 million shares, raising capital proceeds of close to $5 billion.  With the Federal Reserve officially signaling “exceptionally low levels for the federal funds rate at least through mid-2013”, all manner of investors want to jump on the borrow short, lend long bandwagon.

The clause under review, section 3(c) (5) (c) to date has exempted  some money managers from Investment Company status, status which in turn would limit any leverage to 50% of assets.  The specific language excludes “any person purchasing or otherwise acquiring mortgages and liens on and interests in real estate”.  At the same time, any issuer which “holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting, or trading in securities” does fall under the Investment Company Act definition.  The problem is that mortgage-backed securities, which only came into being post 1968 arguably fall under both definitions.

The SEC request for comments was circulated on August 31 and will remain open until November 7.  In the event a narrower definition prevails, mortgage REITS will become net sellers and their headline dividend  yields will decline commensurately.  Recent price action would argue market participants are beginning to discount a very real possibility of that occurring.