OREANDA-NEWS. January 19, 2016. The US Federal Housing Finance Agency's (FHFA) final membership rule halting future access to the Federal Home Loan Bank (FHLB) system for certain nonbank financial institutions is a setback for mortgage real estate investment trusts (mREITs), says Fitch Ratings. Certain mREITs have established captive insurance subsidiaries in recent years as a means of gaining FHLB membership and improving the diversity, duration and cost of their funding.

The loss of FHLB funding is a modest long-term credit negative for mREITs, but the five-year phase-out for those obtaining funding prior to September 2014 provides existing borrowers with significant time to find replacement funding. A key decision for affected mREITs will be whether to replace FHLB loans with low-cost, short-term, repo funding (shortening duration and increasing liquidity risk), or with higher cost, longer-term borrowings (increasing funding costs and impacting profitability). From a credit risk perspective, we would view the latter more favorably because of the benefit to asset-liability duration matching.

The future loss of FHLB system borrowings for mREITs incrementally weakens the diversification of their funding sources. Total FHLB advances for the 10 largest mREITs were just 10.6% of their overall debt funding as of Sept. 30, 2015. Several mREITs, such as Ladder Capital (through its subsidiary Tuebor Captive Insurance Company), have used FHLB system funding more significantly. Tuebor is among the highest mREIT-affiliated borrowers of FHLB loans, at 42.4% of Ladder's total funding as of Sept. 30, 2015. We believe that Ladder benefits from the five-year phase-out provision.

Mortgage REITs should continue to have access to alternative funding sources, but short-term funding concentrations are likely to remain. Among the 10 largest mREITs with FHLB advances, repo represented 81.1% of total debt outstanding as of Sept. 30, 2015. Many of these mREITs invest in 'AAA' rated, federal agency-backed mortgages, which remain frequent collateral for bilateral repo providers.

In 2012, nonbank financial institutions gained wider access to FHLB membership through the establishment of captive insurance subsidiaries, with a significant ramp-up in 2015, even though the mREITs have no third-party insurance operations. Of the 7,255 total FHLB member institutions, as of Sept. 30, 2015, 346 were insurance companies. Of the insurers, at least 23 (of 40 total) were captive insurance subsidiaries of mREITs. FHLB advances to all insurance company members grew to represent 15.6% of par value as of Sept. 30, 2015, from 12.7% as of year-end 2014 and 11.6% as of year-end 2011.

The FHLB system's traditional mandate is to serve the US housing finance market by extending credit to commercial banks, credit unions, and savings/loan institutions. The FHFA's final rule is therefore unsurprising and follows its original proposal in September 2014. The change cuts off the potential that other nontraditional members (other than mREITs) could gain access to FHLBs. Hedge funds, investment banks, equity REITs, and finance companies were among market players expected to increasingly seek FHLB membership, which is inconsistent with the regulator's overarching strategy to minimize risks to the taxpayer in a future financial crisis.