Real estate investment trusts have been quietly accessing a cheap source of funding previously available only to banks and insurance companies: the Federal Home Loan Bank System.

They are using it to acquire, and eventually securitize, residential mortgages, among other things. While current volumes are low, REIT use of this funding has the potential to provide much-needed liquidity in the secondary mortgage market, assuming that regulators don’t shut it off.

Over the past several years, a number of REITS have joined Federal Home Loan Banks, which are regional cooperatives of mortgage lenders.

While REITs themselves do not qualify for membership, their captive insurance subsidiaries do.

That's how Annaly Capital Management, Invesco Mortgage Capital, Two Harbors Investment Corp., Ladder Capital, Arbor Realty Trust, Redwood Trust and possibly others are tapping FHLB funding.

A member can access loans, known as "advances," that are secured by collateral such as mortgages and Treasury bonds. Advances are not only cheap, but flexible. They can be either fixed- or floating-rate, with different payment characteristics, optionality and terms ranging from overnight to 30 years.

In other words, they're well suited for warehousing long-term assets like residential mortgages that are sensitive to fluctuations in interest rates.

"What this does for us is that it gives us access to permanent financing," said Michael McMahon, managing director of Redwood Trust, which has been a member of the Home Loan Bank of Chicago through its RWT Financial subsidiary since June 2014.

While only a few REITs currently access advances, their growing use of this funding concerns the Federal Housing Finance Agency, which regulates the 11 FHLBs. The agency thinks this could create a taxpayer liability, because REITs are much more lightly regulated than banks.

On Sept. 12, 2014, the regulator proposed new rules that, among other things, redefine qualified insurance companies as those "whose primary business is the underwriting of insurance for nonaffiliated persons or entities." REIT insurance captives are set up to manage only directors and managers liability insurance; they generally only have one policy.

The regulator opened up the proposed rulemaking for a comment period of originally 60 days that was extended another 30 days. It received over 1,200 comments, though only a small number addressed the prohibition on captive insurers.

"We have yet to hear from the FHFA what the outcome will be," said McMahon. The FHFA did not respond to a request for comment.

REITs still depend heavily for funding on sale-and-repurchase agreements, or repos, a form of collateralized short-term borrowing that is facilitated primarily by Wall Street broker-dealers. For example, in the first quarter of 2015, Redwood Trust financed $606 million of short-term debt purchases through repos that were secured by $734 million of residential mortgage-backed securities.

However, repos are not ideal for warehousing mortgages. They must be rolled over, or refinanced, frequently. This exposes REITs to the risk that repo lenders, when concerned about the value of collateral, will demand a higher interest rate, apply a larger haircut to their valuation of the collateral, or curtail lending altogether.

"There is no way that we or anyone else would hold onto $1 billion worth of mortgage loans on whole-loan repo facilities," McMahon said. "The risk is just too great. It's a classic mismatch in maturities as well as interest rates."

Two Harbors has already drawn down $2.75 billion of its $4 billion FHLB credit facility. On a May 7 conference call to discuss the REITs' first-quarter results, CFO Brad Farrell said that this funding "provides us greater flexibility when responding to repo market shifts."

This allows Two Harbors to securitize mortgages even if market conditions prove difficult. For example, the REIT was able to complete its first deal of the year, Agate Bay 2015-1, in February despite the fact that spreads on triple-A rated senior tranches "widened dramatically" as a result of an interest rate drop at the time, Farrell said during the call. "We retained the majority of them as the expected ROE [return on equity] was attractive using FHLB financing," the CFO said.

"On the other hand, Agate Bay 2015-2 came to market at a time when triple-A spreads had tightened back to more normal levels [in March], and we sold all of the senior bonds," he said.

FHLB exposure to all captive insurers (not just those of REITs) is still relatively small; as of Sept. 30, 2014 it accounted for $67 billion, or 12%, of the total $540 billion in FHLB advances, according to the Urban Institute.

Only 129, or 5% of the roughly 4,400 FHLB member borrowers, were insurance companies as of the same date. While specific data for captive insurer members are not available publicly, anecdotal evidence suggests that captives are a fraction of FHLBs' total insurer members, currently fewer than 20 members system wide.

Still, the billions of dollars that REITs immediately borrowed "has raised some red flag somewhere in the government," said McMahon.

He says that there are a lot of reasons why the risks of captive insurance companies accessing FHLB advances is manageable.

For example Redwood's captive is set up in Delaware, which does not subject assets collateralizing FHLB advances to bankruptcy stays. This is important, since, in the event the borrowing entity goes bankrupt, the FHLB wants to be able to seize its collateral and not sit around for 90 days and wait for things to deteriorate.

McMahon says that Redwood has also properly capitalized its subsidiary. Although it is possible that other REITs have not, a captive insurance company should have a few million dollars' worth of equity in it, based on the guarantee from the parent.

"The FHFA wants to make sure that people aren't gaining the system and increasing risk to taxpayers," McMahon said. "We would argue that if the captive insurance company is well capitalized and is chartered in a state that is friendly to the FHLBs, the risk can be minimized to the point where REITs can provide additional liquidity to the mortgage market, which is much needed and will really be needed once the world rights itself and banks aren't holding on to mortgages."

Moreover, McMahon said, most of the residential mortgage assets held by mortgage REITs are mortgage-backed securities that are either implicitly or explicitly guaranteed by the U.S. government and are therefore free from credit risk. If these REIT captives pledge this risk-free collateral for FHLB advances, that should further reduce credit risks to the system.

The Urban Institute also thinks that REIT access to FHLB financing can boost liquidity in the mortgage market.

In a paper published in January, co-authors Laurie Goodman, director of the Urban Institute's Housing Finance Policy Center; Jim Parrott, a senior fellow; and Karan Kaul, a research associate; argued that banning captive insurers from FHLB membership may be overshooting the mark in the name of safety and soundness.

The authors believe that, without the proposed rule change, REITs' use of advances will gradually increase, which would deepen liquidity in the secondary mortgage market, particularly for loans that do not meet the criteria for qualified mortgages under ability-to-repay rules.

The lack of liquidity for non-QM lending has "essentially stranded a segment of borrowers who are not necessarily excessively risky," the report states.

The authors assert that the FHFA can manage the potential risks that REITs' access to advances poses to taxpayers by using tools already in place. For example, reducing the market value of collateral or charging a higher interest rate on advances would mitigate concerns regarding captives that might pose a greater risk. The FHFA could also work with FHLBs to create "common eligibility criteria" for approving captive insurer member applications, limiting approval to captives whose business is mission-related.

Goodman currently sits on the board of MFA Financial, Inc., a self-advised REIT, and Parrott serves as a policy advisor to a REIT. The authors submitted a comment letter making these same points to the FHFA on Jan. 9.

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