Nice tap
By Eric Leininger and Michael Riddle
At a glance
- Recent events suggest there is potential for a structural shift in the REIT sector in terms of hedging efficiency as the Eris SOFR markets show themselves ready for wider use.
- By our estimate, top REITs could save $1.5 billion in written margin by switching to Eris SOFR swap futures.
During the pandemic-induced market disruptions in March 2020, real estate investment trusts (REITs) were hit hard, with the S&P US REIT Index falling 44% from its peak a month earlier. As the real estate market absorbed new realities about how people live and work, the REIT market recovered more slowly than the broader market.
Necessity drove several REITs to hoard cash by shedding interest rate swap hedges and replacing them with lower-margin Treasury futures. These events shed light on REIT hedge efficiency that persisted even after the market returned to relative normalcy, prompting analysts to pay more attention to margin minimization as a differentiator for maximizing Earnings for Distribution.
Recent Events for Swap Futures
Three recent events in the world of swap futures caught our attention and got us thinking about how much capital the largest mortgage REITs could free up by replacing their interest rate swaps with Eris SOFR Swap futures (Eris SOFR).
First, Minnesota-based REIT Two Harbors Investment Corp. (TWO) released its 10-Q and Q1 investor presentations in April, both of which disclose hedging activity using 10-year Eris SOFR. The initial position size is modest, but it caught our attention because it’s the first time we’ve seen Eris SOFR in TWO’s filings.
So we called TWO and they confirmed our findings. They said, “We’re always looking for ways to manage capital more efficiently. Hedging with swap futures combines the risk exposure of SOFR swaps with the margin efficiency of futures.”
Second, Eris SOFR swap futures got multiple shout-outs in the May 20 and June 25 editions of the BTIG Mortgage Finance Roundup, which covers this sector. The May 20 edition (available upon request here ) cites “value in mortgage lenders and REITs migrating from bilateral swaps to lower-margin products such as Treasury and swap futures…” (emphasis ours) and highlights several REITs where moving to futures could provide “even more room for valuation improvement.”
The June 25 version (available upon request here) highlights “low-margin Eris swap futures” and estimates that major REITs AGNC and Annaly could each “realize $300+ million in potential margin savings… (by) migrating from bilateral swaps to futures.”
Finally, the Eris SOFR markets have recently absorbed significant directional trading activity, including $3 billion in notional trades on April 22nd, $2 billion on June 13th, and another $2 billion on June 14th. This activity occurred in the 5-year and 10-year maturities, and the market data and subsequent jump in open interest suggest it was an influx of end-user activity. The primary broker responsible for the first round of flows was publicly quoted as saying that markets remained solid despite this influx of nearly $2 million in dollar duration, or DV01, terms.
We have seen Eris SOFR markets tighten and deepen since CME Group enabled portfolio margining using interest rate swaps in March 2023. However, it is illuminating to see that markets have experienced this level of outright risk transfer multiple times recently.
Taken together, these events suggest that there is potential for the REIT industry to consider a structural shift in hedging efficiency, just as the Eris SOFR markets are poised for broader use. The BTIG analysis, in particular, has prompted us to consider just how much money REITs can save by using swap futures.
Cash is always important for REITs
With the launch of Eris SOFR Swap futures by CME Group in 2020, REITs now have a viable alternative to hedging SOFR-indexed risks with low-margin futures.
Whether they plan to use the excess cash to reinvest, improve liquidity ratios, or distribute it to investors, REITs will likely find margin savings from improving hedge efficiency an attractive alternative to liquidating assets or raising capital. And at some point, rates will fall and prepayment rates will increase, leaving REITs needing cash to fund the timing mismatch between the publication of factors (which reduces the face value of their collateral) and the receipt of prepayment money, which occurs a week or more later.
Finally, REITs use interest rate swaps to hedge bulk duration while ensuring they meet REIT tax, accounting, and distribution requirements. This use case does not require highly customized swaps. They should therefore seek to take advantage of the low margin and liquidity efficiencies of standardized derivatives, rather than forgoing these benefits as is often required when using more customized structures.
Eris SOFR Margin Savings
CME Clearing requires participants to post significantly more margin to collateralize interest rate swap positions than they do for Eris SOFR Swap futures. By using Eris SOFR instead of swaps, REITs can therefore achieve similar market exposure while paying much less margin.
For example, Figure 1 shows recent margin savings of 59-72% between $100 million Eris SOFR positions (1,000 contracts) and equivalent structured interest rate swaps, by maturity.
Eris SOFR Margin Savings
Figure 1 Source: Eris Innovations
As another example, inspired by the April 22 trading activity, we can calculate the theoretical margin savings of using Eris SOFR instead of fixed rate swaps for $3 billion, split evenly across 5- and 10-year maturities. As shown in Figure 2, a REIT would book $43.5 million of Eris SOFR margin versus $134 million for swaps, over $90 million less.
Figure 2
How much can REITs save in total by switching to swap futures?
To calculate the savings, we reviewed the public filings of the top 20 Residential Mortgage REITs from the recent BTIG Mortgage Finance Roundup. Based on the public filings, we calculate the following, as of March 31, 2024:
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14 REITs have interest rate swap positions, with a total notional value of $141 billion
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84% of the swaps, $119 billion, can be easily replaced by Eris SOFR Swap futures (i.e. cleared swaps, indexed to SOFR, with a maturity of 10 years or less)
Using the CME CORE margin calculator and with reasonable assumptions, we estimate the following:
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The REITs collectively book $2.4 billion for these $119 billion in “addressable swap positions”
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Eris’ SOFR margin for a near-equivalent risk exposure would be $0.95 billion ($1.5 billion lower, or 63%)
To translate the margin reduction into annual savings, we multiply the margin reduction by each company’s dividend yield, as we believe this is the appropriate discount rate for evaluating the value of excess cash for highly leveraged entities. This leads us to our final conclusions:
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By replacing their SOFR-based swaps with Eris SOFR Swap futures within 10 years, the largest Residential Mortgage REITs could reduce their booked margin by $1.5 billion, a significant amount for an industry with a total capitalization of approximately $34 billion.
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This results in savings of $197 million per year, with the dividend yield applied as the cost of capital.
Of course, it’s worth noting that more than 80% of the savings are attributable to the two largest participants, Annaly and AGNC, which could each save more than $300 million in margin, confirming BTIG’s estimate. That said, the other 12 REITs could cut margin by almost $270 million (compared to a market cap of $17 billion), in each case by amounts that are material given the size of the company.
As more firms move into Eris SOFR swap futures and the market quickly absorbs spikes in Eris SOFR activity, it is clear that awareness is growing around the benefits of saving money. Soon, the momentum-building news we are seeing now may become less flashy and more routine.
Original Post
Publisher’s Note: The summary points for this article were chosen by the editors of Seeking Alpha.
