A huge thank you, to those that have trusted us with their capital and partnership over the last ten years. We are nothing without our people and our partners.
Regan Capital launched its first investment vehicle ten years ago on August 11th, 2011. We had opened our custodial account, had documents ready for subscribers and had several bonds already picked out to purchase on our first day of trading. What were we waiting for? I thought we needed some type of green light, so we asked our legal team whether we could start, and they said, “Why not?”
We had one subscriber on day one: me. The phone wasn’t ringing off the hook and most of the folks I thought would subscribe didn’t or at least didn’t want to be the first to jump into the pool. We spent all our available cash within a few days, and I started wondering “now what?”
Many of the reasons Regan Capital was started still hold true today.
Compelling Risk-Adjusted Returns:
The first bond I purchased, for myself, in 2009 was:
- Issued in 1986 (23-year-old mortgages at the time)
- 10% coupon
- Senior bond
- Purchased at $70
- 0% delinquencies
- 20% yield
While it seemed improbable to be able to buy this profile on 20+ year old home loans, it existed when we opened our doors in 2011, and it still exists now, albeit at lower yields. While yields are lower today, we now have 15+ years of loan-level history and deleveraging in our portfolios through both home price appreciation and amortization. We’ve shown examples over the past few months of buying this kind of profile at 9-10% yields.
United States residential real estate is one of the largest markets in the world at around $40 trillion in value. Roughly half of that is mortgaged ($20 trillion) and half of those mortgages are securitized into bonds ($10 trillion). We run into very large institutions, with fixed income and credit portfolios that have no exposure to US mortgage-backed securities. Treasuries, corporate and municipal bonds have broad access via mutual funds, ETFs and individual securities. The same is not true for MBS. We started Regan to bring access to this market; one that has exhibited strong outright and complementary returns to other fixed income instruments.
The MBS market continues to offer unique opportunities to transact off-market and with little information reported to counterparties and the market in general. Whereas all other fixed income trades are reported to other participants, the MBS market has avoided the spotlight of price transparency. Armed with our 20+ years of experience, a broad network of relationships, and our tilt towards active trading that creates our own liquidity and transparency, Regan continues to exploit market inefficiencies to its advantage.
There are very few better ways to invest in the existing US residential housing stock than through RMBS. This is primarily true in the space that’s our bread and butter: legacy, discounted bonds that benefit from stronger prepayment rates, lower default rates and better recoveries upon defaults. Buying new issue fixed income, issued at $100, hopefully guarantees you a regular coupon payment and eventually your principal back, but with downside to potential defaults. Investing in homebuilders, mortgage originators, mortgage servicers and home improvement companies rely either on new homes being built or a steady stream of income from folks staying in their homes.
Where we stand now (2021) vs then (2011):
- Homeowners now have +40% equity in their homes today vs -20% in 2011
- Homeownership was on the decline in 2011, from a peak in 2004 of 69%. It troughed in 2016 at 63.4% and is currently on the upswing, standing at 63.9%
- We’ve experienced the best runup in housing prices since 2005 vs facing multi-year declines up through early 2012
Taking a Step Back to Review What Formed Us
Deep Data and Analytical Framework:
Twenty years ago, I was hired by one of the largest non-agency mortgage originators in the country to help program pricing models for distressed mortgage loans that they were looking to acquire. This involved taking a deep dive into loan-level liquidation timelines, servicer performance and the likelihood of borrowers to re-default if they catch up on their payments. Some incredibly interesting stuff – we were at the forefront of investing in these re-performing and non-performing mortgages, helping the borrowers get back on track and eventually monetizing our gains through securitization. Much of what we were learning and putting into action back then is now common knowledge in the marketplace as the bulk of these non-performing loans exploded post-2008. Key to creating this framework back then was gathering and properly working with data. A big part of why we love legacy (pre-2008) mortgages is that there’s significantly more data available on these homeowners than newly issued deals. While new mortgages are being given primarily to very high-quality borrowers, even those borrowers grossly underperformed between 2008 and 2012.
Value Investing in Mortgage Bonds:
I’ve been scratching my head for the last 12-13 years, as to what we will be able to buy tomorrow. The opportunity to buy deeply discounted cashflows on very high-quality mortgages and borrowers continues to present itself at least twice a week. It’s striking, as there seems to be an endless flow of indiscriminate sellers. Couple that with imperfect information, off-market opportunities and a market that is still 100% over the counter and you can assemble portfolios with deep moats.
While individual loans backing our deals can trade between $100 and $120, the bonds that they back can trade at meaningful discounts. Why?
- 95% of the non-agency universe is not Investment Grade and thus constrains many investors
- Many folks are still scarred from the Great Financial Crisis when most of this universe was Investment Grade
- These assets were never constructed to default. They were constructed to pay off in full within 5-7 years. Now that we’re 15+ years into these securities and they have realized losses, they present challenges that many investors aren’t able to overcome
- Putting the proper systems in place to analyze this universe is costly (20-30k per month) and presents a barrier to entry
Trading to Add Alpha to Investing:
We quickly spent our available cash within a week of opening our doors. Now what?
Prior to starting Regan, I worked at Cantor Fitzgerald in New York, where I was the only person on the desk that knew how to price defaults and credit deterioration when the market started unraveling in 2007. I quickly assumed command over most of the non-agency trading efforts; while most of Wall Street had bloated balance sheets of marked-down bonds and was hemorrhaging cash, we were lean and able to act quickly to make hay. At Cantor, my balance sheet was limited to only $10mm and I only had a 30-day holding period limit. If I held bonds for more than 30 days, I was fired. Over the course of four years, I generated $132mm in profit for the firm under these constraints.
All of this comes in handy when we have to find our own liquidity at Regan. If we want capital to spend tomorrow, we have to trade out of what we bought yesterday. This gives us exposure to a wealth of superior information as we ferret out distressed sellers and act as market makers to extract additional returns.
Fast forward to today and we’re still generating healthy 3+% additional yearly returns from trading our book versus just sitting on paper and earning a coupon.
We found out early, the tax advantages of buying low dollar-priced mortgage bonds. Starting in 2009, through diligent research with my personal accounting firm, we were able to start using distressed security treatment on all bonds we purchased under $55. The profit on all principal and interest paid to us on bonds we purchase for under $55 is tax deferred. For many bonds, we don’t start paying taxes until year four or five of payments flowing through. Furthermore, by buying low dollar bonds that benefit from borrowers paying both scheduled and unscheduled payments (prepayments through refinancing or moving), we get capital gains treatment versus earning interest and paying full freight on that income. This has greatly benefited our partners, who have enjoyed effective tax rates in the low 20% range for the last five years.
Stick to our Sandbox:
We continue to focus on what we know. It took me eight years of working in data, analytics, structuring, trading, and taking risk for the light bulb to go off in my head that I could invest in these instruments personally and help others invest in them as well. In 2009, when I first got paid at Cantor Fitzgerald, I spent every dime of my bonus investing in non-agency mortgage bonds. Twelve years later, that is still largely the case. While it amazes me that there’s still $200+bb of legacy mortgage bonds floating around and actively trading, we’re here to take advantage of it over the next 4-5 years. We have built out capabilities to invest in agency mortgage bonds ($8 trillion market) and new issue non-agency bonds ($100+ billion in issuance per year); however, these are not currently trading at attractive levels, relative to legacy non-agency bonds. “Off-the-run” paper has consistently traded cheaply to newly originated paper as it’s harder to put large sums of money to work and doesn’t have the baked-in origination fees for the seller. For non-agency mortgage bonds, the canyon between where new issue and secondary bonds trade is still very large and makes seasoned paper all that more attractive. The legacy market shrinking has led us to capping our two main funds ($400 million for RCOF and $50 million for RECOF). These caps may shrink as the market gets smaller and we’ll likely pay distributions if we were to get there.
Re-hash of March 2020, Lessons Learned
March 2020 was vastly different than 2008-2009 for high quality mortgage paper. What happened over an 18-month timeframe during the Great Financial Crisis (GFC), unraveled over six days last March. This punished leveraged (mostly Mortgage REITS) and daily liquidity (mutual fund) players that became forced sellers, day after day to meet margin calls and daily liquidity needs. A very small portion of the market were forced sellers, but they caused ripples across the rest of the market in terms of pricing. We were conservatively positioned, running 0.9x leverage, which was modest compared to REITs who were running 6-12x leverage. The rapid selloff forced us to sell some positions at unfavorable prices to generate sufficient liquidity to meet margin calls and to provide a cash cushion to meet additional margin calls should asset prices continue to fall. We learned a lesson, using leverage to make an extra 2-3% of yield isn’t worth it when you can already earn 6%-8% outright and 10-15% inclusive of active trading.
We went into March 2020, wary of how tight spreads had reached, with a very high bent toward quality. 50% of our book was Agency (Government Guaranteed), 20% was Investment Grade, and the other 30% was senior, relatively high-quality legacy RMBS. The quality of our book didn’t matter when everyone was selling everything that wasn’t bolted down – we just lost less.
While we always have liquidity to buy our regular allotment of bonds every week, we didn’t have enough then. In times of low spreads and lack of opportunities, keep more cash. Better to be invested at 0.1% with no downside than to be invested at 3% with 15% of downside.
The Way Forward: Sticking to our Values and Broadening our Reach
If the opportunities aren’t there, hold out and potentially shrink to increase your opportunity set.
In sticking with what got us here, we’ll continue to run the two partnerships, RCOF and RECOF, keeping their sizes on point relative to the opportunities the market presents to us, so that we can generate attractive returns with relatively low risk for our investors.
We opened our mutual fund, Regan Total Return Income Fund, in October 2020 to capitalize on our institutional investment framework with a broader base of investors. While corporate, municipal, and total return strategies are broadly available to the public via mutual funds and ETFs, that is not the case for non-agency mortgage bonds. From our calculations, there is only $20bb in daily liquid funds available to institutions and investors out of a $1.5 trillion market. Our mutual fund brings investors the ability to invest in legacy mortgage bonds, earn a healthy 4-7% yield and get daily liquidity. We view this product as being able to grow into a $2+ billion product, while not affecting the performance of our limited partnerships. Our mutual fund is currently available on Schwab and Pershing for RIAs and Fidelity for all investors to access. It will also soon be available on TD Ameritrade. It is also available directly from US Bank for all investors. We see our mutual fund growing to $100+mm by the end of the year from strong demand within the RIA and wealth advisory channels. We reviewed what happened to RMBS mutual funds in March 2020; they saw average redemption amounts of 17% through the month. With that in mind, we aim to maintain 15+% in cash along with focusing on senior, high quality paper, that saw the least amount of drawdown last March.
We launched Regan Special Opportunities Fund (RSOF) in April 2018 to capitalize on inefficiencies we found in small private debt deals that didn’t fit our other vehicles. We have gravitated towards strong collateral, cashflows and covenants and have found ways to make 15+% yields in recent deals. RSOF II will be launching in Q4 2021 or January 2022 and is currently open for subscriptions. We see this area growing as we find off the beaten path real estate and small business lending opportunities that don’t fit into daily or quarterly liquidity vehicles.
While 2020 presented us with challenges, it also presented us with an opportunity to fine tune and focus on what got us here. It allowed us to envisage, launch and grow our mutual fund, which will provide access to this product to a much broader audience.
We appreciate the partnership of those that have entrusted us with their capital. We’ve been with you from the start and will continue to dedicate the bulk of our capital and time to invest prudently.
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