Buy mREITs On Impeding Housing Recovery
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In the wake of the Fed's quantitative easing efforts, several factors are partly impeding the recovery of the US housing market. Yet three mortgage REITs -- American Capital Agency (NASDAQ: AGNC), Armour Residential (NYSE: ARR), and Annaly Capital Management (NYSE: NLY) -- look particularly well-positioned to benefit from this situation.
Background On Easing
The U.S. Federal Reserve has been busy doing its best to accelerate the US housing recovery through its quantitative easing programs. One such program, better known as QE3, aimed to purchase mortgage-backed securities worth $40 billion a month, with the objective of keeping mortgage rates at their lowest. The Fed thought low rates would make borrowing cheaper and housing more accessible. Furthermore, programs like Home Affordable Refinance Program (HARP) were launched to help borrowers with underwater mortgages refinance. The results of these efforts proved favorable, as mortgage rates touched their lowest point in recorded history, and refinancing picked up.
Mortgage Markets Update
However, since the beginning of the current year, mortgage rates started climbing, and refinancing slowed down. The 30-year mortgage rate climbed 19 basis points to 3.53% during the year, while the 15-year rate surged 12 basis points to 2.76%. According to the latest MBA weekly survey, mortgage applications decreased 3.8% over the prior week. A similar decline was observed in the prior weekly survey. The refinance share remained the same at 77% of the total applications, however, the same remains at its lowest since July 2012.
Part of the reason for such an obstruction in the recovery of the US housing sector was the lack of cooperation from some of the largest mortgage lenders. The five largest mortgage lenders have shown reluctance in originating mortgages, following unpleasant memories of the 2008 crisis.
mREITs Ready To Exploit
While this shortage of mortgage lenders is killing the Fed’s efforts to accelerate the US housing sector, US mortgage REITs are on their way to exploit the situation.
Mortgage REITs, which earn a spread between the MBS yields and the cost of their funds, were under tremendous pressure following the launch of the third round of quantitative easing or QE3. They experienced compression in their spreads and the resultant dividend cuts, particularly during the fourth quarter of 2012. The aforementioned slow down in refinancing and a hike in mortgage rates make me all the more bullish on mREITs.
The hike in rates would mean higher MBS yields, while the slowdown in refinancing activity would translate into slower prepayments and the resultant lower amortization costs. Therefore, I believe American Capital Agency, Armour Residential, and Annaly Capital Management are all set to report higher spreads for the first quarter of the current year.
All three mREITs are exclusively invested in MBS guaranteed by government agencies. However, the structures of their investment portfolios differ. While American Capital and Annaly Capital have large chunks of the fixed rate Agency paper in their portfolio, Armour includes adjustable-rate MBS alongside fixed-rate securities in its holdings.
The leverage ratios of American, Armour, and Annaly of 7 times, 8 times and 6.6 times, respectively, reflect the fact that Armour is the most leveraged among them. Therefore, it is bound to benefit the most when it magnifies the positive results. American, Annally, and Armour reported prepayment speeds of 10%, 19%, and 14% at the end of the fourth quarter of 2012. These prepayments will come down further, benefitting the companies under consideration. Therefore, investors can expect a definite spread expansion and some price appreciation and increase in dividends.
While the Fed’s best efforts might not be working for the US housing sector, the lender shortage will undoubtedly assist the US mortgage REITs by bringing down their prepayments, amortization costs and expanding their spreads. In particular, American Capital Agency, Annaly Capital Management and Armour Residential are my favored picks.
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!