Alan Brazil SOM Macro

May 10, 2020

The Case For Residential Mortgage REITs

BY Alan Brazil

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Step 1: Macro Theme: The Case For Residential Mortgage REITs
– Residential mortgage REITs are cheap because they represent buying Resi assets at distressed levels at a discount

  • Step 2: Fundamental Economic Framework
    • –  Sell-off in residential mortgage REITs have followed the sell-off in the entire mREIT market
    • –  Sell-off in residential mortgage REITs reflects the impact of the dislocation in the underlying resi assets and the resulting margin calls during the last week of March
      • REITs are a leverage strategy with leverage funded with short-term repo
      • Sell-offs in the underlying resi assets driven by historical widening of spreads drove margin calls across the business models of the REIT
      • All REITs delveraged, reduced repo lines, and raised cash
    • –  Risk across their business models have subsided
  • Step 3: Identify Potential Repricing Events
    • –  Residential REIT pricing should improve as the headwinds abate, and reflect the improvement in the underlying asset values
    • –  Leveraging agency pass-throughs offers mid-to high ROEs, while the Fed has reduced repo funding pressures on REITs and given a strong bid for agency pass-throughs
    • –  Non-agency credit assets offer double digit yields because the market is pricing in an unrealistic repeat of the GFC HPA/default cycle
      • HPA is unlikely to fall as much given the improvements in the underlying housing market versus the years prior to the GFC
      • Mortgage underwriting has tightened, particularly in the reduction of closed-end seconds (CES), e.g. silent second
      • Defaults projections are biased upwards reflecting the impact of silent seconds: e.g. reported 80 LTV could perform like be a 100 CTV
    • –  Mortgage originations should accelerate offsetting the markdowns of MSRs

• Limit on 4 months for advances should help their servicing book

Step 4: Find Asymmetric Trades

  • –  Trade 1: Buy residential mortgage REITs
  • –  Trade 2: Buy double-B and single-B agency CRT bonds

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