Fed Alert: Is More Stimulus on its Way?
Adnan is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
The Fed Chairman along with his fellow policymakers are scheduled to meet next week for two days to consider going ahead with their unprecedented easing or not. The debate on when to end bond purchases began in December last year, however, the US labor market has yet to show significant gains Fed wants to see before halting bond purchases. While unemployment hovered around 7.8% since the beginning of 2009, the Federal Open Market Committee participants see no immediate threat from inflation, which has reached 1.4%.
At least two district bank presidents who have advocated record easing gained voting rights this year, while six Fed officials have indicated their willingness in allowing the bank to continue easing. Therefore, I believe the Fed Chairman can count on the FOMC to endorse the current programs of buying $40 billion in mortgages and $45 billion in treasuries each month.
The markets overreacted when the minutes from last month’s meeting showed differences on how long the easing should last. The S&P 500 index fell 0.2% while the yields on 10-year treasuries edged up 0.07%. Supportive outcomes of the FOMC’s two day meeting would push stocks up and the yields down. However, one sector, the US Agency mortgage REITs might get hit further. Agency Mortgage REITs have been taking since the launch of the third round of quantitative easing (QE3). Annaly Capital Management (NYSE: NLY), American Capital Agency (NASDAQ: AGNC) and Armour Residential (NYSE: ARR) are the major players.
Annaly Capital Management
At the end of the third quarter, Annaly Capital owned 93% fixed rate securities, while the rest were adjustable rate securities. The average maturity of the company’s securities was 4.93 years, while the conditional prepayment rate increased from 19% in the linked quarter to 20% at the end of the third quarter. Due to the actions of the Fed, Annaly experienced a 52 basis point year over year decline in its annualized interest rate spread. As a result Annaly was forced to decrease its quarterly dividends 10% to $0.45 per common share.
American Capital Agency
American Capital Agency owns a majority of fixed rate securities, which are relatively shorter-term in nature compared to Annaly Capital. Around 63% of the company’s entire MBS portfolio is composed of 30-year fixed rate securities, while 32% is 15-year fixed rate MBS. 20-year fixed MBS is 3% of the entire MBS portfolio of the company at the end of the third quarter of 2012. The average maturity of the company’s MBS was 4.3 years, while the CPR rate was 9%. The company’s net interest spread of 1.42% declined 23 basis points compared to the linked quarter to 1.65%. However, the company’s prepayment protected portfolio enabled American Capital to continue its quarterly dividend of $1.25 per common share.
Armour Residential REIT
Armour Residential invests exclusively in Agency mortgage REITs, 90% of which are fixed rate securities and 10% ARMs and Hybrid ARMs. The company is largely invested in 15 and 20-year MBS, with low coupons and loan balances, making them prepayment protected. Armour reported 13% CPR at the end of the third quarter. Its interest rate spread decreased to 1.82%, while the company was forced to cut its monthly dividends by 11% to $0.08 per common share.
Conclusion
I believe enough compression in the net interest spreads for these pure play Agency mortgage REITs has already occurred. Next week, if the Fed decides to continue easing for an unprecedented period, the above mentioned REITs will be the biggest losers. In such a scenario, I will favor hybrid RIETs. American Capital has a prepayment protected portfolio. Armour’s charter allows it to invest in assets other than Agency MBS, while Annaly Capital is already in negotiations with CreXus Investment for an acquisition. In my opinion such diversification is the only way out for AGNC, ARR and NLY.
equityfinancials has no position in any stocks mentioned. The Motley Fool owns shares of Annaly Capital Management. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!
