Rates Socked it to Mortgage REITs in Q2: SNL

CHARLOTTESVILLE, VA-Mortgage REITs' book values took a shellacking in the second quarter amid the volatile market for mortgage-backed securities, although commercial mortgage REITs got off relatively lightly, according to SNL Financial data. In fact, in the case of Starwood Property Trust, book value actually rose 5.3% during the quarter.

One reason, SNL's Rodger Nayak and Dhavel Patel point out in an analysis of Q2 results, is that the Starwood REIT has relatively little exposure to rising interest rates. And rates rose more rapidly during 70 days of Q2 and early July than they did in the 1980s, when the 10-year Treasury climbed 66% over a 450-day period.

“We actually anticipated from the very start of the company a rising interest rate environment,” Barry Sternlicht, chairman and CEO of Greenwich, CT-based STWD, said during an earnings call earlier this month. “So with an average life of four years, you're not going to have the kind of volatility in your paper that you have in 30-year paper.”

When STWD announced its Q2 earnings on August 6, COO Andrew Sossen observed that the company benefited from “a highly efficient platform that should outperform in various economic scenarios, including a rising interest rate environment.” He credited a business model “which utilizes predominantly match funded Libor-based lending and borrowings and a financing policy of matching floating rate investments with floating rate debt and fixed rate investments with fixed rate debt.”

Sossen cited a pipeline of investments under term sheet that is over 90% LIBOR-based, “over $1.7 billion of LIBOR-based credit facilities and a legacy investment book that is either floating rate, fixed rate with hedges or investments with fixed rate returns well in excess of 10%.” He added that STWD capitalized on historically low interest rates earlier this year to raise over $1 billion of fixed rate convertible notes with coupons below 4.55%, “which we expect to be quite accretive in a rising interest rate environment."

Hedging efforts at some companies dealing in agency mortgage-backed securities helped stem their declines in book value, according to Charlottesville, VA-based SNL. For example, Ellington Financial LLC, which SNL classifies as an investment company rather than a REIT, saw its book value dip down just 1.45% during Q2, although a majority of its portfolio is invested in agency RMBS.

Rather than using primarily swaps or swaptions, a common practice among mortgage REITs, Old Greenwich, CT-based Ellington establishes short positions in to-be-announced mortgage securities. “This helps protect against the effects of basis widening, the bane of many mortgage REITs in the second quarter, while also hedging duration,” write SNL's Nayak and Patel.