How to Capitalize on the Mortgage Market

Mohsin is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

To stimulate growth in the sluggish US economy, the Fed announced the launch of QE3. QE3 was aimed at particularly supporting the US housing and labor markets. However, the US labor market is still not close to the kind of improvement imagined by the Fed. I believe QE3 will stay even if the financial cliff is averted. Given the situation, I recommend investors stay away from pure play Agency Mortgage REITs with high prepayment risk. This does not apply to American Capital (NASDAQ: AGNC) as it has the least prepayment risk amongst pure-play mREITs. PennyMac Mortgage (NYSE: PMT) invests largely in distressed RMBS which makes it beneficiary accelerated prepayments. 

Business Mix

PennyMac Mortgage Investment is one of the mid-cap mREITs that operates as a residential mortgage REIT in the US financial sector. The company seeks to invest largely in distressed mortgage backed securities. Besides investing in mortgage loans, mortgage-backed securities, mortgage servicing rights and real estate acquired in the settlement of loans (REO), the company purchases originated mortgages for resale or further securitization. The company’s ‘Investing Activities’ business segment is involved in the regular REIT business, while the ‘Correspondent Lending’ business segment deals with originated loans to be resold or securitized. Around 60% of the revenues of the company for the third quarter came from the ‘Correspondent Lending’ business segment, while it contributed 63% to the bottom line. This diversified approach has caused the company to post solid results for the third quarter of the current year.

Recent Performance

The company reported net investment income of $99.2 million, a 54% appreciation Q-o-Q. Much of the improvement was a result of a 23% surge in interest income, partially offset by 6.9% lower net gains on investments. The surge in interest income was due to higher mortgage loans. The improvement in net investment income was helped by higher net gain on mortgage loans acquired for sale and higher loan origination fees, partially offset by a decline in results of real estate acquired in the settlement of loans.

Total expenses of $40.2 million, compared to the linked quarter remained 52% above largely on higher loan fulfillment fees. The company reported net income of $40.4 million at the end of the third quarter, against $29.6 million at the end of the linked quarter. Basic earnings per share edged up by 1.25% over the same time period.

Future Opportunities

The company will benefit from acceleration in prepayments as most of the distressed securities that the company purchases are acquired at a discount. Acceleration in prepayments will result in more cash inflows for the company, which can be invested in higher coupon securities.

Going forward, I believe the company will benefit from a steady flow of distressed home loans being offered for sale as a result of foreclosure settlements between the attorneys general and the large cap US banks.

The availability of distressed securities will also increase as a result of Basel III requirements on the money center banks. Previously, large cap banks have been the leading participants in this market. However, with the implementation of Basel III capital requirements these banks are exiting and reducing their volumes of such securities.

These loans have the potential to provide the company with attractive returns and will increase the spread that PennyMac will earn in the coming quarter. The prevailing ultra-low interest rate environment coupled with the restrictions faced by banks is also creating significant opportunity for PennyMac to fill the void in mortgage servicing rights.

Dividend Payout

The stock currently offers $0.57 per common share in quarterly dividends, up from $0.55 per share in August. This makes the dividend yield 9.34% compared to just 1.64% offered by 10-year treasuries.

The dividend hike in PennyMac comes at a point when most of the other residential Agency mortgage REITs are slashing their shareholder distributions. While American Capital Agency retained its quarterly dividend at $1.25, Annaly Capital (NYSE: NLY) was forced to announce a 9% cut in its quarterly dividend for September, followed by Capstead Mortgage (NYSE: CMO) with a 10% cut and MFA Financials (NYSE: MFA) with an 8.7% cut in its quarterly dividend. Armour Residential pays dividends on a monthly basis and was forced to cut its monthly dividend by 10%.

Attractive Valuations

The stock that has seen around 50% appreciation since the beginning of the year is trading at a 21% premium to its book value. This is compared to a 46% premium for Newcastle Investment (NCT), another non-agency mortgage REIT. Therefore PMT is attractively valued compared to peers.

Using a price to book value multiple of 1.4 times, based on stable home prices, higher earnings estimates and faster than expected traction in correspondent lending, to the book value of PMT at the end of the third quarter of the current year, I arrive at my target price of $28.20. PennyMac currently trades at $24.40, which presents investors with 15.6% upside. The consensus bullish price target for the stock is $27.00 per share.


Given the current situation where the economy has not picked up much and the US labor markets are not showing signs of improvement as expected by the Fed, I believe QE3 is here to stay for long. Therefore, PennyMac Mortgage remains my top pick for investors seeking both an elevated dividend and stock price appreciation.

SmartEquity has no positions in the stocks mentioned above. 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!

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