The team at South Street Capital Management (SSCM) has recently been engaged in some interesting conversations with current and potential investors. As mortgage-backed securities specialists and the manager of a private mortgage REIT, investors often look to SSCM as a resource into a variety of different asset classes. Whether it is about interest rates, mortgage spreads, or the public mortgage REIT sector, we try to provide a unique perspective on the markets and share some of those perspectives with a broader audience.
In speaking with investment professionals many conversations end up touching upon the concept of leverage. There are a variety of misconceptions in the marketplace regarding leverage due to the negative connotations given to it based on its association with a particular event. In this piece we hope to give the reader a better understanding what leverage is, who takes leverage, and the different types of leverage available to an investor.
LEVERAGE – All Leverage IS NOT Created Equal
When did leverage become a bad word?
Google Trends which provide access to a largely unfiltered sample of actual search requests made to Google and allows users to examine interest in a particular topic may give us an approximate starting point.
After the Great Financial Crisis, the term leverage was weaponized in soundbites by media pundits to attribute cause. Certainly, history has left a road littered with those that either had too much leverage or were leveraging investments that were too volatile. However, the entire world financial system is built on some variation of leverage: Leverage is all around us. Debt and leverage are the same thing, even a simple 20% down payment on a house implies 4-to-1 leverage. Investment committees focus heavily on leverage without dissecting two key elements, what and how?
One of the first rhetorical questions to ask potential investors who writhe at the thought of leverage is “Do you own [INSERT Favorite Bank Name] in your stock portfolio?” Why is bank leverage of 8-10x acceptable and a mortgage REIT with leverage of 5-9x met with skepticism? The most obvious answer is that banks get the benefit of “sticky” deposits on the liability side and mostly illiquid loans on the asset side that are difficult to value (and therefore require margin calls). On the one hand, there is the benefit of deposits and on the other hand, REITs possess more transparent balance sheets. REITs get to allocate capital specifically to areas where they find the best relative value as opposed to banks whose regulations force them to lend in markets where they take deposits. Let’s also not forget that REIT distributions are tax advantaged. In theory, both borrow short, lend long, and attempt to capture a spread.
Since all leverage IS NOT created equal, we are presenting the difference between financial and structural leverage.
Financial leverage is the easier of the two to understand but the common definition of using borrowed money to potentially enhance the return of the investment neglects the fact that leverage can also magnify losses (“Leverage works both ways”). Purchasing an Agency MBS pool and obtaining financing through a reverse repurchase agreement (“reverse repo”) where the buyer posts an amount, say 5% of the purchase price and the repo counterparty provides the cash for other 95% of the purchase price, is a common example. Financially levered strategies should weigh the duration and structure of financing against the creditworthiness and variability of cash flow and pricing of the underlying assets. Equally important is to evaluate the access, depth, breadth, and durability of the financing, culminating in the motto “leverage is a function of liquidity.” Therefore, liquidity drives leverage, not the other way around. In the end, it is all about making margin calls.
Providers of leverage need to be as aware of the attributes of assets they finance as the investment managers who purchase them. Credit may give a false sense of security as a rating only relates to ultimate return of principal and not potential price volatility before maturity. March 2020 taught a tough lesson to some that a 5% haircut on Agency MBS with spread durations in the 3-5 year area and Agency CMBS with a spread duration ~7-9 years were less than ideal.
Currently, there is a tremendous amount of cash in repurchase agreement (“repo”) markets looking for high quality Agency and Investment Grade collateral. With yields and spreads at historically low and tight levels some may feel the urge to increase leverage but just because you can does not mean you should.
Structural leverage is investing in a security where a disproportionate mark-to-market occurs based on an event affecting the value of the underlying collateral of the security. The most obvious example in securitized products is buying subordinated tranches that take losses before more senior tranches. The more nuanced example are Interest Only (“IO”) certificates structured within Collateralized Mortgage Obligations (“CMOs”) transactions where a large portion of the prepayment risk is concentrated.
Below example shows that a 5 conditional prepayment rate (“cpr”) difference on a mortgage pool creates a 30 basis point (“bp”) drop in yield while at the same time an IO created off that same pool has a ~570bp drop in yield.
Adding financial leverage to the pool in attempt to enhance the return by obtaining financing at 15bps and cost of hedging of 65bps creates a net interest margin of ~125bps. With 8x leverage you can get a projected return of around 10.0% (125bps x 8). Some investors would get nervous with an 8x leverage, but the same investor may look at the IO return and want to dig deeper. What type of investor are you? Are you more comfortable with financial leverage or structural leverage?
Like with any investment, you need to identify the risk, quantify it, and derive a price that compensates you for taking it.
Leveraged strategies inherently have a thinner margin of error so an investor’s return profile is correlated with the manager’s expertise in asset selection and risk management.
When evaluating securitized product focused funds and/or managers, there are two critical elements to consider:
- Identify the sort of leverage employed and how it is communicated by the manager.
- Does the manager emphasize “liquidity”?
Financial or structural leverage alone is fine but the wrong composition over an economic cycle (interest rate and credit) may also require an investment in a hard hat.
We hope this clears up some of the misconceptions with regards to leverage. If there are any further questions, do not hesitate to reach out and suggest other topics for discussion.
 Basis points equals 1/100th of 1 percent or 0.01%.
Senior Portfolio Manager
Souths Street Capital Management
This document is not an offer to purchase or sell, nor a solicitation of an offer to purchase or sell an interest in a Fund or any other financial instrument. Any offering or solicitation will be made only to qualified prospective investors pursuant to the offering memorandum, and the subscription documents, all of which should be read in their entirety. The information contained herein is not complete, may not be current, is subject to change, and is subject to, and qualified in its entirety by, the more complete disclosures, risk factors and other terms that are contained in the Offering Memorandum.
Alternative investments provide limited liquidity and include, among other things, the risks inherent in investing in securities and derivatives, and using leverage. An investment in an alternative investment fund is speculative, involves substantial risks, and should not constitute a complete investment program. An alternative investment fund may be highly leveraged. These funds may not be subject to the same regulatory requirements as mutual funds, and their fees and expenses may be high. An investment in alternative investments is not suitable or desirable for all investors. Investors may lose all or a portion of the capital invested.
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