Mortgage REITs Are on the Rebound

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Despite the speculation about the Fed's exit, some mREITs are poised to benefit from their management structures and the positioning of their investment portfolios. Let's see which mREITs fit the bill and how they will benefit under the prevailing challenges.  

The business model and its risks

Mortgage REITs are complicated and dependent on changes in interest rates. They loan money for mortgages or the acquisition of existing residential or commercial mortgage-backed securities. The revenues of mortgage REITs are the interest income they earn on the mortgage securities, and they pay a cost of funds on the short-term borrowings they have. The spread is the operating profit they earn, which is the difference between the asset yield and cost of funds. Theoretically, interest rates are inversely proportional to the book values of mortgage REITs. Increases in interest rates results in corrosion of book value. Besides, their income is highly sensitive to changes in interest rates.

Stimulus end to increase volatility

According to the Federal Reserve, Federal National Mortgage Association (FNMA) and Federal Home Loan Mortgage Corporation (FMCC) held a total of $7.5 trillion mortgage backed securities in the last year, and mortgage REITs represent less than 5% of the total. Some REITs are making long term financing arrangement and using hedging (financial contracts) to cope with rising interest rates. Before the financial crisis, the leverage ratio for mortgage REITs was above eight times, which came down to five times in 2009, and in the third quarter of 2012 industry average leverage surged to 6.3 times.

It is likely that the Federal Reserve could end its buying program in the second half of the year. The speculations about the exit have already hurt the sector a lot. The speculations turning into reality, coupled with relatively higher levels of leverage, will create havoc for the mortgage REITs.

A glimpse from the past

Fluctuations in interest rates and news regarding the Federal Reserve ending its bond buying program smashed mortgage REIT investors during the first quarter. The two industry leaders, Annaly Capital Management (NYSE: NLY) and American Capital Agency’s (NASDAQ: AGNC), have seen their share prices drop 19% and 29%, respectively, over the last three months. American Capital reported an 8% decline in its book value, while Annaly Capital announced around a 4% decline. ARMOUR Residential, which is down 29% over the past three months, reported an 8% decline in its first quarter book value.

I believe the current quarter’s results will resemble the first quarter’s results because the first quarter also saw climbing interest rates. However, some mREITs have taken actions to reverse the situation.

Corrective actions by these mREITs

Annaly is the largest mortgage REIT and had $124 billion of Fannie and Freddie mortgage-backed securities. The company will benefit from lower compensation expense due to the externalization of its management structure. It will also earn higher returns coming from the commercial MBS sector, resulting from its CreXus Investments’ acquisition. Further, it can benefit from a relatively lower level of leverage, which will cause less volatility in the results. 

American Capital is the second largest mortgage REIT that invests in Fannie and Freddie mortgage backed securities. It announced the repositioning of its assets recently. The company recognized that its book value has already plunged 8% since the start of the current quarter. However, now the management decided to get rid of the 30-year fixed rate residential MBS, which is the main cause of the book value depreciation under rising interest rates. Further, active management of its assets will cause more attractive investment opportunities for American Capital Agency to outperform its peers.

A safer option

Capstead Mortgage Corporation (NYSE: CMO) is another mortgage REIT that invests in Fannie and Freddie mortgage backed securities. However, its investment portfolio is different from that of Annaly Capital and American Capital. Capstead invests exclusively in adjustable-rate mortgage backed securities (ARMs). They adjust they interest payments to the more current interest rates on the next reset date. That way, their book value is less exposed to erosion, while they are prone to deliver higher yields under the rising interest rate environment. Therefore, the company’s investment portfolio is best suited for the current environment.

Final Words

This storm in the mortgage REIT industry might not end soon. However, Annaly Capital, American Capital and Capstead Mortgage have already secured their book values from further erosion. Besides, Annaly Capital and Capstead Mortgage can also expect higher asset yields. Therefore, I am bullish on the three stocks.

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