The U.S. Federal Housing Finance Agency's (FHFA) final membership rule halting future access to the Federal Home Loan Bank (FHLB) system for certain nonbank financial institutions is a setback for mortgage real estate investment trusts (mREITs), says Fitch Ratings.
The Federal Home Loan Bank system includes 11 U.S. government-sponsored banks that provide liquidity to member financial institutions (not individuals) to support housing finance and community investment.
With their members, the FHLBanks represents the largest collective source of home mortgage and community credit in the United States.
Certain mREITs have established captive insurance subsidiaries in recent years as a means of gaining FHLB membership and improving the diversity, duration and cost of their funding.
The final rule adopts a provision proposed in the 2014 that defines "insurance company" to exclude so-called "captive insurers." The final rule, therefore, will prevent non-eligible entities from gaining de facto FHLBank membership through a captive insurer.
In defining "insurance company" to exclude captives, FHFA said it seeks to prevent entities that are not otherwise eligible for FHLB funding from unfairly gaining access to low-cost FHLBank money.
The loss of FHLB funding is a modest long-term credit negative for mREITs, Fitch analysts said.
The future loss of FHLB system borrowings for mREITs incrementally weakens the diversification of their funding sources, Fitch said. Total FHLB advances for the 10 largest mREITs were just 10.6% of their overall debt funding as of Sept. 30, 2015.
To minimize disruption of current members and the FHLBank System, the rule allows FHLBank captive insurer members that joined prior to FHFA's proposed rule up to five years to terminate their membership and those that joined after issuance of the proposed rule up to one year to terminate.
Redwood Trust Inc. through its captive insurance company subsidiary, RWT Financial LLC, currently has outstanding advances from the FHLB Chicago of $2 billion. These advances have a weighted average remaining maturity of approximately 9.5 years. It would have five years terminate its membership and find replacement debt sources.
Ladder Capital (through its subsidiary Tuebor Captive Insurance Co.), have used FHLB system funding more significantly. Tuebor is among the highest mREIT-affiliated borrowers of FHLB loans, at 42.4% of Ladder's total funding as of Sept. 30, 2015. It would have five years to find replacement sources of funding.
Five Oaks Investment Corp.’s wholly owned captive insurance company, Five Oaks Insurance LLC has been member since February 2015. It currently has $49.7 million of advances from FHLB-Indianapolis, Five Oaks said. That amount is 8.8% of its total financings as of Jan. 12, 2016. It would have one year to come up with alternative financing.
A key decision for affected mREITs will be whether to replace FHLB loans with low-cost, short-term, repo funding (shortening duration and increasing liquidity risk), or with higher cost, longer-term borrowings (increasing funding costs and impacting profitability), Fitch said. From a credit risk perspective, Fitch said it would view the latter more favorably because of the benefit to asset-liability duration matching.
Analysts at Nomura Securities found that FHLB offers financing at almost half the cost of repo funding and have maturities that are more than 10 times as long. Having to replace this cheaper source of longer-term funding with the more expensive repo funding would reduce the return mREITs would be able to generate. Although REITs may be forced to increase their leverage ratio to offset the higher funding cost, they have recently been hesitant to do so, Nomura said.