Mortgage Market Update
The Fed's efforts to support the US housing market seem not to be working as imagined. In order to support the recovering US housing markets, the Fed launched its third round of quantitative easing, known as QE3, where the Fed is purchasing $40 billion worth of long-term MBS in order to keep the long-term mortgage rates low and encourage refinancing. However, refinancing and new mortgage originations have dropped significantly in over a month's time.
The Mortgage Bankers Association reports the Market Composite Index, which is a measure of mortgage loan application volume, plunged 12.3% week over week. The Refinance Index plunged 14% over the same time to its lowest since the week ending November 2, 2012. The Purchase Index decreased 5% week over week. The share of refinancing to total applications plunged to 83% from the prior week's 84%, while refinancing under HARP fell 25%. The 30-year US mortgage rate increased from its lowest level of 3.31% to 3.37%, while the 15-year rate increased 2 basis points from 2.62% to 2.65%.
Annaly Capital's (NLY) net interest spread was hit hard by the flattening of the yield curve and acceleration in prepayments during the third quarter of this year. The company's net interest spread declined over 100 basis points year over year, while it declined 50 basis points quarter over quarter. Mortgage spreads have widened 20 basis points over the past 11 weeks. Besides overturning a third of the QE3's tightening, this widening will result in expansion of Annaly's interest rate spread.
The fact the Annaly Capital, among the Agency mortgage REITs in the US will benefit the most is because it invests in the high coupon longer-term MBS that the Fed is purchasing under QE3. Annaly Capital owns mortgage securities with an average coupon of 4.1% compared to a 3.54% average coupon for Armour Residential (ARR). American Capital owns an MBS portfolio with an average coupon of 3.86%.
American Capital (AGNC) Agency and Armour Residential are among other beneficiaries of the developing situation. Both invest exclusively in Agency MBS with low prepayment risk.
Annaly Capital's dividend yield of 12.2% seems to be more sustainable under the widening of mortgage spreads. American Capital Agency offers a dividend yield of 16%, while Armour Residential offers a dividend yield of 14.4%. The returns offered by these three mortgage REITs are significantly attractive given the 10-year treasuries offer 1.81%.
Annaly Capital has attractive valuations compared to most of its peers in the US Agency mortgage REITs sector. Annaly trades at a 11% discount to its third quarter book value, while Armour Residential and American Capital Agency trade at a 16% and 4% discount, respectively. In comparison, mortgage REITs on average are trading at an 8% discount relative to their book value. This makes Armour Residential and Annaly Capital attractive investment opportunities.