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In my last article, I looked at the sustainability of the high yields that mREITs offer to investors. In this article, I am going to look at the leverage and borrowing that each of these companies has in order to sustain these yields.

Firstly a quick run down of mREIT financing methods.

Read more here.

The most common method for mREIT financing is through the use of repurchase agreements. The company will sell a bundle of securities together with an agreement to buy back the securities at a certain date for a certain price. For these securities the mREIT will receive a lump of cash, which is the company's financing.

Effectively this means that the company is a borrower, using their security as collateral for a secured cash loan at a fixed rate of interest. The repo agreement is the company's financing, with which the mREIT will buy a collection of both agency and non-agency mortgage backed securities.

The reop is marked as debt and the MBS' are marked as assets. The difference between is the company's net asset position.

I have put together simplified balance sheets of five mREITs that I have already mentioned in my previous article.

Derivatives include interest rate hedging assets and securities are usually treasury bills/notes unless otherwise mentioned. I have listed the total value of derivatives only to highlight the total exposure to the market and they do not influence the debt to equity calculations or balance sheets. According to GAAP accounting, derivatives are marked at fair value through profit or loss on balance sheets.

Two Harbors (NYSE:TWO)

$US Billions

Total MBS

Derivatives

Cash

Securities

Re-purchase Agreements

Net Assets

TWO

$14.0

$19.0

$0.0

$1.0

$12.6

$1.4

TWO has $14 billion in MBS' financed with $12.6 billion of repo agreements. This gives a net asset value of $1.4 billion. Total hedging instruments amount to an aggregate exposure of $19 billion and the company has $1 billion of US government securities.

Total Shareholder Equity

Market Cap.

Debt to Equity

Debt to Market Cap

$3.5

$3.7

1:3.7

1:3.4

TWO has 3.7 times more debt (repo's) than shareholder equity and a debt to market cap ratio of 1:3.4 .

American Capital Agency Corp. (NASDAQ:AGNC)

$US Billions

Total MBS

Derivatives

Cash

Securities

Re-purchase Agreements

Net Assets

AGAC

$85.7

$58.0

$2.4

-$11.8

$79.2

$6.5

American Capital Agency Corporation has just under $80 billion in repo agreements that have been used to finance $85.7 billion in MBS giving a total net asset value of $6.5 billion.

AGNC has a aggregate position of $58 billion in derivatives hedging interest rates and $2.4 billion in cash (for potential margin calls). The company is also short US treasuries and has a short position with a total value of $11.8 billion (negative above to highlight the fact that the company is short).

Total Shareholder Equity

Market Cap.

Debt to Equity

Debt to Market Cap

$10.9

$10.8

1:7.3

1:7.3

American Capital has a total shareholder equity of nearly $11 billion ($89.5 billion of liabilities and $100.5 billion of assets) and a market capitalization of $10.8 billion. These figures give AGNC a debt to equity ratio of 1:7.3 and a debt to market cap ratio that is similar, which equates to a gearing level of 730%.

Hatteras Financial (NYSE:HTS)

$US Billions

Total MBS

Derivatives

Cash

Securities

Re-purchase Agreements

Net Assets

HATT

$24.4

$10.9

$0.4

$0.0

$22.5

$1.9

Hatteras Financial has borrowings of $22.5 billion under repo agreements, which fund its $24.4 billion in MBS'. The company has nearly $11 billion in derivatives hedging interest rates.

Hatteras has $400 million in cash to cushion against potential margin calls and a net asset value of $1.9 billion.

Total Shareholder Equity

Market Cap.

Debt to Equity

Debt to Market Cap

$3.1

$2.6

1:7.3

1:9

Hatteras total shareholder equity is $3.1 billion, which gives a debt to equity level similar to AGNC of 1:7.3. However, Hatteras only has a market capitalization of $2.6 billion, which results in a total debt to market cap ratio of 1:9 or a gearing level of 900%.

CYS Investments (NYSE:CYS)

$US Billions

Total MBS

Derivatives

Cash

Securities

Re-purchase Agreements

Net Assets

CYS

$16.0

$10.8

$0.1

$0.0

$14.0

$2.0

CYS has total borrowings of $14 billion through repo agreements. MBS total $16 billion, which gives a net asset value of $2 billion. The company owns derivative's with a total value of $10.8 billion hedging interest rates and a cash balance of $100 million for margin calls and additional costs.

Total Shareholder Equity

Market Cap.

Debt to Equity

Debt to Market Cap

$2.4

$2.1

1:5.8

1:6.7

CYS' total shareholder equity is $2.4 billion and market cap is $2.1 billion, which gives a debt to equity ratio of 1:5.8 and a debt to market cap ratio of just under 1:7.

ARMOUR Residential REIT (NYSE:ARR)

$US Billions

Total MBS

Derivatives

Cash

Securities

Re-purchase Agreements

Net Assets

ARR

$19.1

$10.0

$0.0

$0.0

$18.4

$0.7

Armour has just over $19 billion in MBS' funded by debt in the form of $18.4 billion in repo agreements. The company has a net assets of only $700 million, no cash or securities and derivatives totaling $10 billion hedging interest rates.

Total Shareholder Equity

Market Cap.

Debt to Equity

Debt to Market Cap

$0.6

$2.5

1:30

1:7.4

With a net asset value of only $700 million Armour only has a shareholder equity of $600 million, which gives the company a debt to equity level of 1:30 and a debt to market cap value of 1:7.4 or a gearing level of 740%.

Fed asset buying

It has been well publicized that the Federal Reserve has been buying mortgage backed assets to the tune of $40 billion a month as a form of QE3.

This asset purchase program has had a serious effect on all five companies listed in this article. The buying of MBS has driven up prices, which has forced down yields. In addition, with interest rates continuing at their low levels there is no scope for mortgage providers to raise the rate of interest on their mortgage products.

So, interest rates on mortgages remain low, Fed buying is driving the yield on mortgage based assets lower and repo borrowing rates are actually rising. All three of these factors are squeezing the income for the mREITs.

The interest rate spread is the difference between the rate that the company pays to borrow money and the money it receives in interest from its MBS'. TWO's interest rate spread is the highest as the company engages in the purchase of sub-prime type mortgage securities that have a much higher rate of return than the agency mortgages that the other mREITs purchase.

Nonetheless, the interest rate spread across all five companies has been consistently declining during 2012.

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The change in interest rate spreads across all three companies. CYS and AGNC have seen the biggest contraction in rate spreads across the group as detailed below.

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Cost of funds includes the cost of hedging instruments and overnight financing rates on derivatives.

Armour's average yield on assets has fallen from just above 3% to under 2.5% during 2012. Meanwhile its cost of funding has risen from 0.7% up to just under 1%, which has resulted in a net interest spread decline in 0.7%.

(click to enlarge)

CYS' spread has fallen the most in the group - almost 1%. The company's cost of funding has risen from just under 1% to just over 1%, while the average yield on its assets has fallen from 2.75% to 1.9%.

(click to enlarge)

TWO has faced the same fall in its net interest spread but the company has a much higher average yield form its assets. In addition, the company's funding costs have remained stagnant.

Average yields have declined from 4.9% to 4% - the reason for the decline in the net interest spread.

(click to enlarge)

Out of all five companies, HATT has experienced the smallest decline in its interest rate spread. The interest rate spread between HATT' assets only 0.5% during 2012. The yield on the company's assets has fallen but the cost of the company's borrowed funds has fallen marginally as well resulting in the small net spread decrease.

(click to enlarge)

Along with CYS, AGNC has suffered a 1% fall in its net interest spread. Surprisingly, even though AGNC is the biggest company in this piece, its borrowing costs are actually the highest and have risen the most during 2012 - up nearly 0.25%

When these rising financing costs are combined with falling yields from the company's assets the result is the rapidly declining net interest spread.

For how these declining interest spreads are effecting mREIT income and dividend potential further reading can be found here.

Source: mREIT Financing And Declining Interest Rate Spreads