By Eric Leininger and Michael Riddle
At a Glance
- Recent events suggest the potential for a structural shift in the REIT industry in hedging efficiency as the Eris SOFR markets are demonstrating readiness for more widespread use.
- By our estimate, top REITs could save $1.5 billion in posted margin by switching to Eris SOFR swap futures.
During pandemic-driven market dislocations in March 2020, Real Estate Investment Trusts (REITs) were hit hard, with the S&P U.S. REIT Index falling 44% from its peak a month earlier. As the real estate market absorbed new realities of how people live and work, the REIT market was slower to bounce back than the broader market.
Necessity drove multiple REITs to hoard cash by shedding interest rate swap hedges and replacing them with lower-margin Treasury futures. These events shined a spotlight on REIT hedge efficiency that persisted even after the market’s return to relative normalcy, spurring analysts to pay increased attention to margin minimization as a differentiator for maximizing Earnings for Distribution.
Recent Happenings for Swap Futures
Three recent events in the swap futures world caught our attention, prompting us to contemplate how much capital the top 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) published their 10-Q and Q1 investor presentation 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 mentioned in TWO’s filings.
So we called TWO, and they confirmed our finding, saying, “We’re always looking for ways to manage capital more efficiently and hedging with swap futures combines the risk exposure of SOFR swaps with the margin efficiency of futures.”
Second, Eris SOFR swap futures got several 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 by request here) calls out the “value in mortgage originators and REITs migrating away from bilateral swaps into lower-margin products like Treasury and swap futures…” (emphasis ours) and highlights multiple REITs whose transition to futures could allow “even more room for valuation improvement.”
The June 25 version (available by request here) highlights “low-margin Eris swap futures” and estimates that large REITs AGNC and Annaly could each obtain “$300+ million of potential margin savings… [by] migrating from bilateral swaps to futures.”
Last, the Eris SOFR markets have recently absorbed significant directional trading activity, including $3 billion notional of trades on April 22, $2 billion on June 13, and another $2 billion June 14. This activity was in the 5-year and 10-year tenors, 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 flow was quoted publicly saying the markets stayed solid despite this influx of nearly $2 million in dollar duration, or DV01, terms.
We’ve observed Eris SOFR markets grow tighter and deeper since CME Group enabled portfolio margining with interest rate swaps in March 2023, but to see the markets withstand this level of outright risk transfer on multiple recent occasions has been eye-opening.
Taken together, these events suggest the potential for the REIT industry to contemplate a structural shift in hedging efficiency just as the Eris SOFR markets are demonstrating readiness for more widespread use. The BTIG analysis, in particular, prompted us to contemplate exactly how much money can REITs save by using swap futures.
Cash is Always Important for REITs
With CME Group’s launch of Eris SOFR Swap futures in 2020, REITs now have a viable alternative for hedging SOFR-indexed risk with low-margin futures.
Whether they plan to use the excess cash for reinvestment, improving liquidity ratios or distributing it to investors, REITs are likely to find margin savings from improving hedge efficiency as an attractive alternative compared with liquidating assets or raising capital. And at some point, rates will go down and prepayment speeds will increase, requiring REITs to have cash to fund the timing mismatch between the publication of factors, (which reduces the notional value of their collateral), and the receipt of prepayment cash, which occurs a week or more later.
After all, REITs use interest rate swaps for hedging bulk duration, while ensuring they comply with REIT tax, accounting and distribution requirements. This use case doesn’t require highly-customized swaps. They should, therefore, look to take advantage of the low margins and liquidity efficiencies of standardized derivatives, rather than forgoing these advantages, as is often required when using more bespoke structures.
Eris SOFR Margin Savings
CME Clearing requires participants to post substantially more margin to collateralize interest rate swap positions than they do for Eris SOFR Swap futures. Thus, using Eris SOFR instead of swaps enables REITs to achieve equivalent market exposure while encumbering much less margin.
For example, Figure 1 shows recent margin savings of 59-72% between positions of $100 million of Eris SOFR (1,000 contracts) and equivalently-structured interest rate swaps, by tenor.
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 from using Eris SOFR instead of pay-fixed interest rate swaps for $3 billion, split equally between 5-year and 10-year tenors. As shown in Figure 2, a REIT would post $43.5 million in Eris SOFR margin versus $134 million for swaps, more than $90 million less.
Figure 2
How much can REITs save overall by switching to swap futures?
To calculate savings, we dug into the public filings of the top 20 Residential Mortgage REITs from the recent BTIG Mortgage Finance Roundup. Based on public filings, we calculate the following, as of March 31, 2024:
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14 REITs have interest rate swaps positions, with a total notional value of $141 billion
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84% of the swaps, $119 billion, can be readily replaced by Eris SOFR Swap futures (i.e., cleared swaps, indexed to SOFR, with tenor 10 years or less)
Using the CME CORE margin calculator tool with reasonable assumptions, we estimate the following:
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The REITs collectively post $2.4 billion for these $119 billion of “addressable swap positions”
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Eris SOFR margin for nearly-equivalent risk exposure would be $0.95 billion ($1.5 billion lower, or 63%)
Finally, to translate margin reduction into annual savings, we multiply the margin reduction by each firm’s dividend yield, as we believe it’s the appropriate discount rate for evaluating the value of excess cash for highly-levered entities. Thus, we arrive at our final conclusions:
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By replacing their SOFR-based swaps inside of 10 years with Eris SOFR Swap futures, top Residential Mortgage REITs could reduce their posted margin by $1.5 billion, a meaningful number for a sector with total capitalization of approximately $34 billion.
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This results in savings of $197 million annually, applying the dividend yield as the cost of capital.
It’s worth noting, of course, that more than 80% of the savings are attributable to the two largest participants, Annaly and AGNC, each of which can save well over $300 million in margin, confirming BTIG’s estimate. That said, the other 12 REITs can reduce margin by nearly $270 million (compared to a market cap of $17 billion), in each case with amounts material to the size of the firm.
As more firms switch to Eris SOFR swap futures, and the market readily absorbs surges in Eris SOFR activity, it’s clear that awareness is building around the cash-saving benefits. Soon, the momentum-building news we’re seeing now could become less eye-catching and more routine.
Original Post
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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