The announcement and the launch of the much-awaited third round of quantitative easing (QE3) by the U.S. Federal Reserve (Fed) has had mixed effects on the U.S. mortgage industry. Mortgage REITs are put in a difficult position as the street and investors in general welcomed Fed's new initiative to stimulate the sluggish US economy. Though we believe the interest spreads at agency mortgage REITs will be hurt, mortgage REITs that invest primarily in non-agency REITs will benefit. Mortgage REITs, which have large proportions of adjustable-rate securities in their holdings, will be least hurt by the acceleration in prepayments. Therefore, we recommend long positions in non-agency mortgage REITs. The remaining of the investment thesis aims at discussing the effects of QE3 on agency mortgage REITs (Annaly Capital (NLY) and American Capital Agency (AGNC), mortgage REITs that invest exclusively in adjustable rate securities (CMO), non-agency mortgage REITs (Newcastle Investment (NCT) and PennyMac (PMT)), and mREITs that hold a combination of agency and non-agency mortgage-backed securities MFA Financials (MFA) and Invesco Mortgage (IVR).
mREITs Business Model:
Through QE3, the Fed intends to purchase agency mortgage-backed securities that are fixed rate in nature. This will have the effect of increasing the demand for these securities, which will ultimately increase their prices. Increased prices for MBS means lower yields for MBS holders. Mortgage REITs hold mortgage-backed securities in their assets portfolios, which are funded by short-term financing (repurchase agreements). Mortgage REITs earn a spread between what they earn on their interest yielding assets and what they pay on their interest bearing liabilities.
While, on the positive side, QE3 will result in an increase in the book value, and on the negative side, the third round of easing will lead to an obvious compression in the interest rate spread and the resultant decrease in interest income in the coming quarters. The acquisition of MBS by the Fed will result in a decline in their yields, while the cost of funds remains flat. This will compress their net interest spreads threatening their elevated shareholder distributions.
Another consequence of QE3 is a further decline in the mortgage rates. Thirty-year mortgage rates have already reached their low level of 3.39%. This will encourage borrowers to take out more mortgages and homeowners with underwater mortgages to refinance. The accelerated refinancing activity will hurt mortgage REITs' returns as it will increase prepayments on mortgages. A hike in prepayments will result in increased amortization expense on the mortgage-backed securities that agency mREITs have purchased on premium. mREITs that invest largely in non-agency MBS acquire securities at a discount to their par unlike agency mREITs. Therefore, accelerated prepayments actually help non-agency mREITs. Mortgage REITs that have large holdings of adjustable rate or hybrid mortgage-backed securities in their assets portfolio will be the ones least adversely affected by acceleration in prepayments.
Since the Fed is determined to buy only agency mortgage-backed securities, the aforementioned consequences on QE3 are visible in the third-quarter performances of agency mortgage REITs in general. We believe mortgage REITs that invest either exclusively or have significant holdings of non-agency mortgage-backed securities will outperform their agency mREITs counterparts.
The following chart displays the stock price performance of agency mREITs compared to mREITs with considerable holdings of non-agency MBS since the announcement of QE3. AGNC and NLY, the two mREITs that invest exclusively in fixed rate agency mortgage-backed securities have seen 12% and 14% decline in their share price, respectively.
Annaly Capital Management:
Annaly Capital invests exclusively in agency mortgage-backed securities and has witnessed the greatest plunge in its stock price among the mREITs being considered in the graph above. The company reported 14% decline in its interest income, while the net interest spread plunged over 100 basis points to 1.02% at the end of the third quarter. The effects of QE3 are visible in this significant drop. The prepayments rate increased from 19% at the end of the linked quarter to 20% at the end of the third quarter.
American Capital Agency:
American Capital seeks to invest exclusively in fixed rate agency mortgage-backed securities that the Fed intends to buy through QE3. The company reported 3% sequential increase in its bottom line of $520 million at the end of the third quarter of the current year. QE3 and other initiatives of the Fed resulted in a 23 basis-point decline in the company's net interest margin during the third quarter. The third quarter end reported conditional prepayment rate of 9% remained below the second quarter's 10% conditional prepayment rate.
At the end of the third quarter, MFA Financials reported a surge in the weight of their non-agency MBS holdings to 15.4% of the entire assets portfolio from 14.8% at the end of the second quarter. The company reported a 22 basis-point decline in its third quarter interest rate spread of 2.23%, while the interest income decline 4.3% compared to the linked quarter. The company also reported acceleration in prepayments at the end of the third quarter. The average portfolio conditional prepayment rate (CPR) was 19% compared to 18.2% at the end of the second quarter. While the agency securities are hurt by prepayments, non-agency securities benefited from this acceleration in prepayments as they were purchased below par value.
Invesco Mortgage Capital:
Non-agency mortgage-backed securities constitute 14.7% of the entire asset portfolio of the company at the end of the third quarter. The interest income of 140.5 million edged up from the linked quarter's interest income of 139 million on an increase in interest yielding assets during the same time period. The company reported a 24 basis- point decline in its net interest spread of 1.64%. Overall prepayments increase from 13.3% at the end of the second quarter to 14.3% at the end of the third quarter of the current year.
Capstead Mortgage Corp.:
The company has exclusive investments in adjustable rate mortgage-backed securities, which have a tendency to adjust to their coupon rates to the prevailing interest rates at the next reset date, reducing the risk of acceleration in prepayments. The company reported an 18 basis-point sequential decline in the third quarter earnings review. The conditional prepayment rate increased from 15.9% at the end of the second quarter to 18.7% at the end of the third quarter. Over $5 million of additional amortization costs were incurred as a result of increased prepayments.
PennyMac Mortgage Investment:
One business segment of the company (Investing Activities) invests in distressed mortgage-backed securities that are not guaranteed by any government-sponsored agency. The company reported earnings per share of $0.81 at the end of the third quarter, against $0.79 per share at the end of the linked quarter. The turnover increased 54% sequentially from $64 million to $99 million at the end of the most recent quarter.
Newcastle Investment Corp:
Newcastle owns a portfolio of originated home loans, mortgage-backed securities that are not guaranteed by any government-sponsored agency and CDO obligations. The non-agency mortgage-backed securities are 9% of the entire company's asset portfolio. The non-agency MBS were purchased at 65% of their par. The company posted earnings per share of $1.63 at the end of the third quarter, against $0.35 per share a year ago. While the weighted average prepayment rate for September was 9.5% against the projected rate of 20%.
We believe if the Fed accelerates its bond-buying program, the agency mortgage REITs will take a major hit as far as their net interest margins are concerned. In this scenario, we recommend investors buy mREITs that invest in non-agency mortgage- backed securities.