How one REIT investor prepares to buy MBS as Fed shrinks portfolio

June 1, 2022 3:01 PM

Keeping an eye on the Federal Reserve’s plan to shrink its portfolio is Byron Boston, the CEO and co-chief investment officer at Dynex Capital.

Boston sees the slow process of unwinding the Fed’s balance sheet, which officially began Wednesday, as potentially leading to an opportunity for his company, a real estate investment trust.

“As the mortgage assets cheapen and provide better returns, then we've got solid capital to deploy,” he said in a recent interview.

A former Wall Street mortgage-backed securities trader who later helped lay the foundation for investments in Freddie Mac’s retained portfolio back in the 1990s, Boston has been working with publicly traded companies since the early 2000s, and is wary of current risks to the housing finance system, but confident in his ability to navigate them knowledgeably.

In his interview with this publication, Boston shared his views on the Fed’s plan for its portfolio and the current market environment, including what credit risks he is watching most closely, and why he thinks officials at government-related housing agencies should be equally vigilant about them.

What follows are further excerpts from the interview with Boston, edited for clarity and length.

Byron Boston, chief executive officer and co-chief investment officer of Dynex Capital Inc.

How is Dynex responding to the Fed’s plan to shrink its balance sheet?

One to two years ago, we started preparing for this moment. We've raised capital without deploying it, which allowed us to decrease our overall leverage with anticipation that the market would reprice as the Fed chose to shed assets, and that repricing would create a better return opportunity for us to deploy capital for our shareholders. So that's exactly what is taking place.

On a relative basis to some other players, we made it through last year and this first quarter in very good shape. If you look at the margins across all market sectors, they're very negative for the first quarter, whereas our returns are positive. The relevance of that is not so much just that we have generated a positive return both last year and the first quarter this year, it's that we protected our capital through this massive selloff as the market prepared for the Fed to tighten financial conditions. By doing that to date, that puts us in a very good position to take the other side of the Fed as they start to sell assets

We're pretty excited about this. The mortgage market literally almost always functions for the most part with a large government entity operating within it. So this is a big moment as the Fed attempts to step away.

What's one under-recognized way you think that the Fed’s plan could affect mortgages?

I don't know if I would call it under-recognized but over my career, even when risks are recognized, market participants (and I'm not speaking just at the mortgage market, I'm speaking of across Wall Street) as long as they can try to make money, they will continue to take risk, which I think is unfortunate.

One of the big keys here is the movement in mortgage rates. I don't think we've seen anything like this for years. Rates have moved from a 2.5% mortgage environment to a 5.5% mortgage environment in a short period of time. That will have a negative impact on lenders and the market will contract. Lenders could be desperate for business and in that type of environment, you will tend to see decreases in FICO scores, and you'll see increases in debt to income levels. So as a country, since we've already had one great financial crash that originated within the housing arena, GSEs and the regulators of Washington should just to stay alert for excess risk taking in terms of loan underwriting as mortgage originators will scrap and fight to maintain certain levels of business.

The ARM product may come back and my understanding is that it has. For some borrowers that ARM product may not be appropriate. They may be better off with a fixed rate instrument. I think that the main focus should be really on some of the core underwriting factors, FICO scores, debt-to-income levels and trying to ensure that those risk metrics do not get out of line across the industry.

We have the ability-to-repay rule now. Do you think that helps?

Yes, but I always worry that (and this is just not only in mortgages), that when lenders have tons of cash in their pockets and are desperate for business, they can be dangerous in terms of the loans that they make. That's a generalized statement. Our housing finance system is very important and has a real global advantage, so I just believe we should be, as a country, on alert to try to maintain standards, given that we've got the GSEs and Ginnie Mae.

That sounds like it's a risk you're going to keep in mind when investing?

I will. In fact, we went up in credit and up in liquidity some years ago, out of concern about not only where that risk was being priced, but that surprise events could create really negative economic shocks. So we are up in credit, meaning that we are almost exclusively invested in Freddie and Fannie Mae-type paper. We continue to be there and in the commercial space.

The best position for me to invest over the long term is in commercial assets married with residential assets. The commercial assets provide us with really solid prepayment protection, unlike the residential sector. The residential sector will provide us with more liquidity and in most situations, more yield. So my ideal portfolio will combine the two, and it would be diversified. We sold most of our commercial assets in 2020. Most of those assets were all in the multifamily sector and we were uncertain as to what a government moratorium would mean. We had made a ton of money off those assets, and since that time, the commercial sector has held up fine coming out of 2020, but from our perspective, they're not offering attractive enough returns given the global macro risk environment. So we love commercial and multifamily, but the spread is not wide enough at this time to diversify the portfolio, given the global risk.

How do you think Fed policy will affect the latest wave of publicly-traded nonbanks?

This is a big question because the nonbanks pretty much took over home mortgage lending. Now we're in a cycle where rates have gone up and volumes have gone down, especially refi volumes, and a lot of nonbanks have relied upon those. You've got some nonbanks that have gone public. So I think the Fed actions will be very, very harsh for nonbanks because in many situations, they're a monoline business. If you're a nonbank without a servicing portfolio, then the best thing you can do is start cutting costs, shrinking your business and normalizing your business to the current environment. Then there will be mergers that take place.

One question to ask is how experienced are the senior management teams in running a public company and how experienced are they in running a public company in a downturn? With these types of challenges, anyone who wants to be a CEO needs to be willing to accept that they may be challenged in this manner at some point with their businesses. Many of these nonbanks went public in the boom times. So it's a big area of the market to keep your eye on. The unfortunate side is the layoffs as companies right-size their businesses.

Given your experience, I wondered if you’d been approached about being a GSE CEO?

As CEO of Dynex I’ve been approached a lot for that kind of role and other potential positions. What I have said to the multiple search firms is that I'm very dedicated to the Dynex shareholders, so without getting too specific about our phone calls, I do get approached.

I do have a really strong opinion about those roles and Freddie and Fannie. I don't believe the current structure with the regulatory environment really serves to embrace the best or the most knowledgeable talent around these product sectors. I think that as a country, the housing finance system is an extremely valuable asset. We've got 30-year mortgages in the United States. Other people don't have 30-year mortgages. So the GSEs play a very, very important role and I would like to see the regulators acknowledge that and stop with the compensation caps. I think all the senior jobs there should be structured to attract the best talent because our housing finance system is extremely important for our country.