For many months the residential mortgage market has, for lack of a better term, “relied” on news that Real Estate Investment Trusts (REIT’s) were helping to support the market by buying large chunks of Fannie, Freddie, and FHA (agency) production. In the last month or two, however, REIT share prices have been on a roller coaster ride due to various headlines, the latest of which occurred on August 31.
On that day, the SEC issued a “concept release” and asked for comments about the application of the Investment Company Act (“ICA”) to mortgage REITs. Many believe that this is a meaningful negative factor for continued net demand for agency MBS from mortgage REITs in the short-term. To know why, however, it is helpful to learn more about the Act itself.
Section 3(a)(1)(A) of the ICA defines an investment company as any issuer which “is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting, or trading in securities.” Companies that are engaged in the business of acquiring mortgages and mortgage-related instruments, and companies that issue those securities, generally hold assets that are securities under the ICA and typically meet the definition of “investment company” under the Act.
But Section 3(c)(5)(C) of the Act, enacted in 1940, excludes from regulation, under the Investment Company Act, companies that were engaged in the mortgage banking business and that did not resemble issuers that were in the investment company business. Although these companies are engaged in acquiring mortgages and other interests in real estate, thus acquiring investment securities, such activities are generally understood not to be within the concept of a conventional investment company which invests in stocks and bonds of corporate issuers.”
Many different types of companies that engage in a variety of businesses rely on this exclusion. Such companies include those that originate and hold mortgages and participations of mortgages that they originated, companies engaged in the business of acquiring from affiliates or third parties mortgages and mortgage-related instruments (such as mortgage participations, mezzanine loans and mortgage-backed securities), companies that invest in real estate, mortgages and mortgage-related instruments, and companies whose primary business is to invest in so-called agency securities and other mortgage-backed securities.
The entire mortgage industry is under scrutiny, especially as the mortgage markets have evolved and expanded, and the provision has been used by a wide variety of types of pooled vehicles and other companies unforeseen at the time of enactment. These issuers include certain mortgage-backed securities issuers and certain REITs. The SEC is concerned that mortgage-related pools (the companies that do so) potentially are making judgments about their status under the ICA without sufficient SEC guidance on the interpretive issues that arise under that provision.
The SEC also is concerned that certain mortgage-related pools today appear to resemble investment companies such as closed-end funds and may not be the kinds of companies that were intended to be excluded under this section. Specifically, the SEC’s concept release highlighted several similarities between traditional investment companies and REITs and the Commission seems to be concerned that the exclusion was originally targeted towards commercial finance and mortgage banking businesses rather than firms engaged in investing in agency mortgage-backed securities.
At this point in time, since it is “only” a concept release, the SEC is collecting information and analyzing issues. It doesn’t represent a proposal to adopt new rules and the SEC needs to issue another proposal with details regarding the new rule if it determines to adopt them. Based on the tone of the SEC’s concept release and the similarities between REITs and the other traditional investment companies, there is a possibility that mortgage REITs focused on agency MBS may lose exclusion from the Investment Company Act. However, it is likely that the ICA needs to be amended for the exclusion to be eliminated, which means the process is likely to take a few years, if it happens at all.
Regardless, markets are easily spooked, as we saw about a month ago with rumors of a massive government refinance program. If mortgage REITs lose the exclusion provided by Section 3(c)5(C), they will be treated as investment companies under the Investment Company Act. So the most significant change for mortgage REITs focused on agency MBS comes from the limitations on leverage they could use under the rules governing investment companies. Since mortgage REITs focused on agency MBS have historically used very high leverage ratios, the new leverage ratios are likely to require them to reduce exposure to agency MBS from a long-term perspective. Thus we see Wall Street firms telling clients that this is a negative factor for continued net demand for agency MBS product from mortgage REITs in the short-term. Aside from mortgage rates being at historic lows, this is yet another factor with which the industry must contend.
3 Comments
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According to reports Chery, the Chinese auto maker that DaimlerChrysler AG has previously formed a limited partnership with the intention of building Chrysler-branded cars, wants to re-examine the deal again in lieu of the sale to Cerberus.
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william goss
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How do I keep on top of this, can you take my e-mail address and keep me informed about the situation as it means a lot to me my e-mail address is BILLGOSS@CHARTER.NET
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