Mortgage REITs: Real Value in a Chaotic Market

Is there a financial group that may actually benefit from all of the chaos that is present in our financial markets today? I’ve been looking a lot at Mortgage REITS and surprisingly, I like what I see.

The players:

• Annaly Capital (NLY) $13.68 14.6%
• Capstead Mtg (CMO) $10.21 14.1%
• MFA Financial (MFA) $5.57 15.1%
• Anworth Mtg (ANH) $5.60 18.6%
• American Capital Agency (AGNC) $15.91 21.0%
• Hatteras Financial (HTS) $23.35 17.1%

You can think of these companies as virtual banks that play on the spread between the company’s borrowing costs vs. MBS rates. It appears that the spreads that they earn will continue to be strong as the Fed aims to keep borrowing costs low. With short-term rates as low as ever and set to stay there for the foreseeable future, now could be one of the best times ever to give this group a look.

Part of the reason that these companies’ shares are so undervalued can be attributed to the fact that they are REITs (scary), and deal with MBS (mortgage back securities), which are even scarier. One thing that we all know is that MBS are inherently evil (didn’t you just watch House Of Cards) and should be avoided at all costs. These things are helping to destroy financial companies, so why would you want to go anywhere near them?

This is where the opportunity lies. I have singled out HTS, as it is one of the companies I’m starting to buy right now. HTS only buys its MBS products from Ginnie Mae, Fannie Mae (FNM) and Freddie Mac (FRE), and just like T-bills, Ginnie Mae's MBS are now backed in full by the U.S.

The risk lies with Fannie and Freddie, which are still “Government-sponsored” entities but lack the guarantee of being backed by the full faith and credit of the U.S. government. This is how you get to the 16% yield HTS is currently sporting. (Note: Some of the other risks include rising interest rates, a wave of prepayments and further government intervention that negatively affects the value of the MBS.)

So why don’t I think that these MBS securities are as risky as the majority seem to believe? For one you can look at the government policy regarding Fannie and Freddie MBS securities, here. Also, the Fed recently updated the 500 billion to 900 billion and Geithner was quoted as saying:

Fannie Mae and Freddie Mac are critical to the functioning of the housing finance system in this country and play a key role in making mortgage rates affordable and maintaining the stability and liquidity of our mortgage market.

In the fiscal third quarter call given when all the turmoil was beginning to explode and Fannie and Freddie had already been taken over the CEO stated:

However, as you know, many market events that were completely unprecedented happened during the quarter, especially toward the end of it. Perhaps fortunately for us, none of which was more important to what we did than the fact that our assets effectively became government securities…

If you think about it in these terms, both sides of our balance sheet, assets and liabilities have been directly supported by US and Global Central Banks and Treasuries…

We think that the government recognizes this and is giving significant priority to maintaining the viability of the MBS markets for housing finance. And more so, since the MBS market is now comprised mostly of agency issuance.

This only serves to reinforce my conviction that Fannie and Freddie-issued MBS products will continue to be supported.

On Bloomberg today, there is a story of Asian investors demanding that Fannie Mae (FNM) and Freddie Mac (FRE) be given the full faith and credit guarantee.

Recently, HTS made a secondary offering at $22 per share in order to capitalize on the current market environment (which is immediately accretive to earnings). The company now has one of the lowest leverage ratios in the group, which gives it the ability to increase its leverage significantly (around 40-50% from current levels) in order to take advantage of opportunities that present themselves in this environment.

People are truly afraid of high yielding financial stocks these days and I think that is a reason that these stocks present a real value in a market where value seems increasing difficult to measure.

Position: Long HTS

Note: Click here for the link the MBS index.

Comments

[Mad Hedge F...:]

Prologis (PLD), the world’s largest developer of commercial warehouse space, and a leading manager of REIT’s, has seen its shares collapse 94% from $65 to a low of $3.62 by last November. It is effectively trading as if the company has already gone bankrupt. The Denver based company employs 1,500, managing 2,898 properties, totaling 548 million square feet in 115 countries. It had been a highly leveraged call on the growth of international trade, which is now imploding with unprecedented speed. PLD listed $40.8 billion in assets on its balance sheet, and until recently, was one of the largest listed REIT’s. CEO Jeffrey Schwartz, a 14 year veteran at the company who spearheaded its growth into China, where it now has 3.3 million square feet, resigned on November 12 and will be replaced by CFO Walter Rakowich. Thus, the keys to (PLD) have been handed over from the visionary risk taker to the bean counter. On November 4, the company announced a Q4 dividend of 52 cents, giving the shares now trading at $3.78/share an effective annualized yield of 55%! The company refused to issue a forecast for 2009, which didn’t exactly inspire shareholders. PLD’s 5 5/8% bonds due in 2016 are trading at just 43 cents on the dollar, giving it a low grade junk yield of 16.7% over Treasuries. PLD is now clearly in survival mode. It has suspended development of the $8.4 billion of projects in the pipeline. It is dependent on rolling over $353 million of company debt and $1.46 billion of fund debt in 2009 in credit markets, which are now effectively closed. It hopes to carry out distressed sales of $2 billion of assets by next year to deleverage its balance sheet. On November 13 it told shareholders it would save $290 million by slashing its future dividends, and another $100 million in cutting administrative costs. The stock has clearly been pulled down by the general distress in the sector in an environment where leverage has become a dirty word. The default rate on commercial properties is expected to soar from this year’s 1% to as high as 5% next year. 18 publicly traded REIT’s have cut or suspended dividends so far this year. PLD was badly hurt by a deal with Lehman Brothers struck in July, 2007, at the absolute peak of the market, where it bought a $1.85 billion national portfolio of warehouses from Dermody Properties and the California State Teachers Retirement System. Lehman was unable to repackage and resell the debt. There are dozens of stocks like this out there now where share prices have fallen to the level of an undated, highly leveraged call option. It is a bet that we have a “V” type recession, not a “U”, and that credit markets recover rapidly next year. I give it a 50:50 chance of survival. But the risk/reward ratio is good. If you are wrong, you lose $3.75. If you are right, the stock could very quickly make it back up to $20, giving you a return of 533%. If you were running a portfolio, you would be buying these all day long, where the mathematics of venture capital applies. If four out of five go bankrupt, you breakeven. If only three out of five go under, you double your money. You need to buy five PLD’s, not just one.

Feb 23 07:05 AM

[I need a ba...:]

Interesting article on Mortgage REITs. The yields are tempting. One way to spread the risk on purchasing any one of these is to purchase REM which holds a basket of these mortgage REITS and yields 26%. We are long REM.

Feb 23 11:24 AM

[tc1:]

Thank you for this article. What i can't figure out is why American Capital (AGNC) (disclosure: i'm long AGNC), which is considered such a "bullish" stock by so many analysts, tanked fully 25% in the days following its Feb 4 quarterly earnings conference. I haven't seen any negative appraisal of AGNC's earnings report-- so why the dive in its shareprice? Are its profitable finances just too arcane for most investors to understand, and the very idea of a mortgage REIT spooked investors to run? If so, why were they invested in it in the first place??

I'd love to have an answer here from anyone who can surmise what happened.....

Feb 23 11:42 AM

[Mitch Tuchman:]

Another M-REIT that invests in agency paper and that I own, along with MFA Financial (MFA) and Anworth Mtg (ANH), is Dynex (DX) which is run by an extremely accomplished CEO, Tom Akin, who also happens to own close to 20% of the company.

Feb 23 01:05 PM

[Leonard the...:]

Thanks Mitch I will have to give that one a look as I am not familiar.

I need a bailout - REM is my fav ETF right now!

tc1 - I'm not claiming to be the expert on AGNC but I believe it had to do with their spread being lower then the avg. and the use of options to make up a chunk of the earnings last qtr., if I remember correctly.

Feb 24 08:00 PM

[Thomas Wagner:]

Interesting article. What the author fais to understand is that most of these companies are not buying GNMA MBS which have always been a direct obligation of the US govt. They are super leveraging FNM and FRE backed MBS which still are not a direct obligation of the US Govt. The Japanese and Chinese are reevaluating there holdings in this area. I believe the ability of the companies to hedge there underlying portfolio is limited. Anyone familiar with hedging will tell you that if they were to fully hedge the portfolio of underlying MBS any spread or profit would be eliminated. If im right i expect to see a major increase in the spread of FNM, FRE over treasuries as the Chinese use the failure of this administration to clarify there support of these securites.

Mar 02 08:53 PM

[dave mckay:]

I'm pretty sure the drop in AGNC following the quarterly results had to do with their announcement that they are going to increase the leverage from 5x to 7x, which is where Annaly is at. To do this increase in leverage, AGNC will probably do a secondary stock offering. This is what caused the drop. If you read the conference call transcript, an analyst somewhat points this out.

Mar 04 01:56 PM

[Leonard the...:]

HI Thomas,

If you had actually read the article you would see I focused on the FNM and FRE issue.

Good day.

BTW: Yields have contracted as these securities are increasingly viewed as being safe.

Mar 13 05:00 PM

[drbob66:]

Thanks for the info on REM. I've owned NLY for quite a while, and bought a little ANH a few weeks ago...but I never knew there was an ETF for the MBS REITs.

On Feb 23 11:24 AM I need a bailout wrote:

> Interesting article on Mortgage REITs. The yields are tempting.
> One way to spread the risk on purchasing any one of these is to purchase
> REM which holds a basket of these mortgage REITS and yields 26%.
> We are long REM.

Mar 19 07:18 PM