The adage "Where there's smoke there's usually fire" probably explains the concerns about regulators' queries into whether REITs still warrant an exclusion permitting them to use significant leverage in their business models. The issue is especially relevant since REITs are primary buyers of agency RMBS and many view them as the likeliest buyers of private-label RMBS when that market's health returns .

The Securities and Exchange Commission's (SEC) concept release, published Aug. 31, explicitly said that companies engaged in the mortgage banking business were excluded from regulation under the Investment Company Act of 1940 because they were not considered to be issuers in the investment company business. Times have changed, however, and today a wide variety of companies, many unforeseen 70 years ago, now rely on that exclusion. The SEC is concerned that current guidance is insufficient for companies to judge correctly their status under the 1940 act, and that SEC staff no-action letters over the years may have led firms to interpret the exclusion beyond its intended scope. "The commission is concerned that certain types of mortgage-related pools today appear to resemble in many respects investment companies such as closed-end funds and may not be the kinds of companies that were intended to be excluded from regulation under the act by Section 3(c)(5)(C)," the concept release said.

Concept releases are the initial stage in the SEC's rule making process, when the agency seeks input from the industry. However, some REITs' high leverage placed many of them in perilous positions when liquidity dried up during the financial crisis starting in 2008, and the last time the SEC took a substantive look at the REIT market was in 1960, suggesting there may be more to come.

"Some of the questions raised by the SEC in the comment release are quite pointed and difficult to ignore," said Barclays Capital in a recent report. "Unless the SEC chooses to ignore evidence for the sake of capital formation, there are likely to be strong grounds to equate the REIT investment strategy with that of traditional investment companies."

Kenneth Kohler, senior council at Morrison & Foerster, noted, "Now that the SEC has put out a concept release, it's going to be hard-pressed to walk away from it." The question then becomes how far the SEC will take it. The likelihood of the SEC fully subjecting mortgage REITs to 1940 act restrictions appears unlikely, given the mortgage market's dire need for capital and liquidity as well as the REIT industry's relatively strong performance throughout the financial crisis. However, on the question of leverage, many REITs deviate far from 1940 act requirements.

Barclays said the 1940 Act restricts investment companies' debt-to-equity level to 0.5 times, and that most mutual funds operate well below that level to account for market movements. Agency MBS REITs, on the hand, operate with leverage between 5.5 and 8 times. "This is even higher than traditional REITs and non-agency mortgage REITs," Barclays said. "In the event of the exemption being withdrawn, the MBS REITs will have to bring their leverage below 0.5x."

"That would be a sea change to the mortgage REIT business model," said Tom Siering, CEO of Two Harbors Investment Corp., a Minnetonka, MN-headquartered mortgage REIT with more than $6 billion in assets.

"REITs have always been recognized as a leveraged business, justified by their underlying real-estate collateral," he added.

Two Harbors reported leverage of 4.2% at the end of 2Q11, up from 3.4% the quarter before, placing it on the more conservative side of the leverage spectrum. Siering said his firm plans to submit a comment by the Nov. 7 deadline. "We continue to believe our businesses should be excluded from the 1940 Act and intend to work with regulators to ensure that is the case going forward," Siering said.

Some REITs, such as Annaly Capital Management and American Capital Agency, take an arbitrage strategy, ramping up returns through leverage. In its filing, the SEC noted Carlyle Capital, an off-shore REIT that had leverage of 32 times and had collapsed by March 2008. Other REITs, such as PennyMac and Redwood Trust, act more like lenders and more closely fit the profile of the types of vehicles for which the 1940 act exclusion was intended. Kohler said one outcome of the concept release may be some restrictions on highly leveraged REITs. Another, he said, would be to apply to REITs the 1940 act's strict restrictions on affiliate and interested party transactions by investment company sponsors and insiders, who prior to the law at times benefited from misusing assets and engaging in other self-interested transactions to the detriment of investors. "That's low-hanging fruit for the SEC, and it can say it is protecting investors," Kohler said.

Such a move would probably require REITs to divulge more information about their inner workings and processes. Some REITS, such as Two Harbors, have sought to provide that transparency. The firm noted in a recent letter to shareholders that it already uses third-party pricing services and other independent sources to value its assets, provides extensive disclosures of its leverage to investors and regulators and seeks to align management's interest with shareholders, displayed in part by significant purchases of the firm's stock by top executives.

"We believe the [REIT] sector has acted responsibly," Siering said. " If out of this there is the requirement for higher levels of disclosure and granularity, we're all for that because we think we're there already."

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