Author's Note: Due to the overall length of this particular article, I feel it is necessary to break this article into two separate parts. The two parts of this article will be broken down as follows:
PART 1 - Summary of Fed Chairman's Recent Testimony + FOMC Minutes and its Impact on the General mREIT Sector
PART 2 - Summary of Fed Chairman's Recent Testimony + FOMC Minutes and its Impact on American Capital Agency Corp. + American Capital Mortgage Investment Corp.
Focus of Article - PART 1:
The focus of PART 1 of this article is to provide a brief discussion on what occurred during the recent Fed chairman's testimony followed by the Federal Open Market Committee (FOMC) minutes that were both released on May 22, 2013. After this summarization, the article will focus on the how the data obtained from both pieces of information has affected the mortgage real estate investment trust (mREIT) sector as a whole. This general discussion will be broken down into two discussion points with supporting tables as evidence to prove the points the article makes.
I am writing this particular article due to the high demand that such an analysis be discussed. Understanding the points mentioned, in regards to both the Fed chairman's testimony and FOMC minutes from April/May, will provide readers with an overall better understanding of the pitfalls that can occur within the mREIT sector as a whole. Due to the recent market turbulence within the entire mREIT sector, including a particularly negative price movement for both American Capital Agency Corp. (AGNC) and American Capital Mortgage Investment Corp. (MTGE), I feel such a discussion should be written. From reading the first part of this article, investors will better understand how certain interest rate movements and existing fixed mortgage backed security (MBS) prices affect the current and future portfolio valuations of most companies within the mREIT sector. This would include companies such as ARMOUR Residential REIT Inc. (ARR), Invesco Mortgage Capital Inc. (IVR), Annaly Capital Management Inc. (NLY), and Western Asset Mortgage Capital Corp. (WMC).
Summary of Fed Chairman's Testimony + FOMC Minutes Released on May 22, 2013:
The Fed chairman's (Mr. Bernanke) opening remarks were quite positive for the mREIT sector. Despite recent economic indicators stating the economy seems to be heading in the right direction, Mr. Bernanke stated it was still premature to "taper" off the stimulus provided by the Fed's quantitative easing (QE3) program. He stated that "tapering" the Fed's QE3 program could cause the economy to weaken once more. In particular, he stated a further upswing in the overall job market and a continued decline in the employment rate were necessarily before lowering the Fed's QE3 stimulus program. The Fed's QE3 program purchases approximately $85 billion of fixed income securities per month. $40 billion of this amount is in the form of MBSs and $45 billion consists of U.S. Treasuries. In general, this specific piece of information was a positive indicator for the mREIT sector.
However, Mr. Bernanke also "hinted" if continued positive economic trends persist, the cutting back on Treasury and MBS purchases could occur in the near future. This statement was made because some FOMC members voiced concerns over the continued stimulus from the Fed via the QE3 program. Within the released FOMC meeting minutes, there was no clear consensus on how to proceed in the future. Some members voiced the same opinion as Mr. Bernanke of a more delayed, cautionary removal from the QE3 program. However, more "hawkish" members stated the Fed's QE3 program could begin tapering off its stimulus support as soon as the next FOMC meeting in June. The FOMC members appeared divided over key issues that seemed to sway in various directions. These statements led to the confirmation of some market participants that the end of the Fed's QE3 program was upon the markets. In general, these comments were deemed negative/cautionary for the current state of the mREIT sector.
Also, certain statements revealed if economic indicators turned negative after the Fed began tapering its QE3 program, it could once again purchase additional Treasuries/MBSs to stabilize the economy. Therefore, the recent speculative nature of the market that began occurring in early May 2013 was somewhat confirmed when this information was released. Due to the data just mentioning the possibility of the reduction of the Fed's QE3 purchases (no specific plan was established), the market seemed even more confused. However, the mere possibility of a reduction of the Fed's QE3 program resulted in the extremely volatile interest rate increases on fixed mortgage interest rates and existing MBS price declines. Fixed mortgage interest rates (15 and 30 year mortgages) spiked 7 and 9 basis points in just one day. Furthermore, existing MBS prices sank to their lowest valuations in nearly a year. The intraday changes on existing MBS prices were at an approximate two year high. Basically, a broad market panic ensued from the mere possibility of a reduction to the Fed's QE3 program in the near future.
Since no definitive answers were provided by the Fed chairman's testimony and minutes of the latest FOMC meeting, volatility in both fixed mortgage interest rates and existing MBS prices may continue in the coming months ahead. Market participants have already begun to realize the overall negative consequences that could occur if such a scenario came to fruition.
Brief Discussion of Topics to be Covered:
PART 1 of this article will now focus on how the lack of a direct answer/strategy provided by the Fed (including a possibility of a sooner than anticipated QE3 program exit) has affected the mREIT sector as a whole.
The following topics will be discussed (at the mREIT sector level):
1) General Impact on Fixed Mortgage Interest Rates
2) General Impact on Existing MBS Prices
1) General Impact on Fixed Mortgage Interest Rates (at the mREIT Sector Level)
In April 2013, after fear of this very same discussion (Fed's QE3 premature exit) subsided, fixed mortgage interest rates modestly dropped. However, as overall economic indicators turned more positive in May 2013, speculation once again entered the market that the exit of the Fed's QE3 program will occur sooner rather than later. This market speculation caused interest rates on both fixed 15 + 30 year mortgages to increase dramatically in May (even prior to the May 22 testimony/information). After the Fed chairman's testimony and release of the FOMC minutes, 15 + 30 fixed mortgage interest rates climbed further. Once again, rates were now at the same levels they were during the first quarter of 2013. Table 1 shows the fixed 15 + 30 year mortgage rates (on a weekly basis) for 2013 through the week of May 24, 2013.
Table 1 - 15 + 30 Year Fixed Mortgage Interest Rates for 2013 (Weekly Basis)
As you can see from Table 1, 15 year fixed mortgage interest rates for the week of 3/29/2013 were at an average of 2.76%. By the first week of May, this rate dropped down to 2.56%. This 20 basis point decrease was an indirect reaction to the Fed's Q3 program being intact and a higher probability of an exit would not occur in the near future. For the same time period, 30 year fixed mortgage interest rates fell by 22 basis points.
However, during the first of week of May, speculation once again crept into the market due to recent positive economic indications. As a result, the talk of the Fed's exit of the QE3 program was once again felt by the market. Rates began to reverse course in early May 2013 and increase rather rapidly up to the May 22 testimony/FOMC minutes. Since speculation proved to be correct (to an extent) in regards to the Fed considering the "tapering" of the QE3 program in the coming months, rates continued to rapidly increase for the week of May 24, 2013. As shown in Table 1, during the month of May 2013, 15 year fixed mortgage interest rates increased 21 basis points and 30 fixed mortgage interest rates climbed 24 basis points. For one month's worth of activity, this is considered to be a very rapid increase in interest rates.
As a result of the decreasing fixed mortgage interest rates in April 2013 and the subsequent reversal of these rates in May 2013, existing MBS prices have been impacted as well.
2) General Impact on Existing MBS Prices (at the mREIT Sector Level)
As a direct result of a decreasing fixed mortgage interest rate movement, existing MBS prices saw a modest increase during April 2013. However, due to the speculation of an early QE3 exit by the Fed, both fixed mortgage interest rates and existing MBS prices reversed course in May 2013. From the unclear conclusions drawn from the Fed chairman's testimony and FOMC minutes, there was an acceleration of the increase to fixed mortgage interest rates. As such, there was an acceleration of the decrease to existing MBS prices. This has caused existing MBS prices to be at year-lows. In addition, as the market is still currently divided on when the tapering of the Fed's QE3 program could begin, existing MBS prices have had wild fluctuations in the latter half of May.
The same scenario occurred, to a lesser degree, in the first quarter of 2013. In addition to the generic existing MBS price declines that occurred, price premiums (pay-ups over generic MBS prices) on specified pools of MBSs with favorable prepayment attributes also declined during that quarter. This was caused by the same speculation fears by the market. The market's fear shifted from concerns of prepayment risk (shortening the life of an existing MBS) to extension risk (extending the life of an existing MBS). This change in risk was the direct result of favorable economic data released during the first quarter of 2013 and the increased expectations of a potential early slowing or discontinuation of the Fed's QE3 program. As noted earlier, the same characteristics are occurring in May 2013.
Tables 2a and 2b show existing MBS price movements for the second quarter of 2013 (through the week of May 24, 2013). Table 2a represents existing MBS prices during the second quarter of 2013 for 15 year fixed MBSs for both Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC). It further breaks down these existing 15 year fixed MBSs into the various coupons offered ranging from 2.5% - 4.5%. Table 2b represents existing MBS prices during the second quarter of 2013 for 30 year fixed MBSs for both Fannie Mae and Freddie Mac. It further breaks down these existing 30 year fixed MBSs into the various coupons offered ranging from 3.0% - 5.5%.
Table 2a - Existing 15 Year Fixed MBS Prices - Q2 2013
Table 2b - Existing 30 Year Fixed MBS Prices - Q2 2013
As fixed mortgage interest rates dropped in April 2013 (discussed above), MBS prices inversely increased when compared to their 3/31/2013 values. This conclusion is shown in Tables 2a + 2b. Since existing MBS prices increased throughout various coupons, their overall valuation increased as well. This would lead to a higher overall fair market price ('FMV') for most MBSs in regards to valuation. This would ultimately have a positive impact on the overall valuation of companies within the mREIT sector.
However, as was the case for fixed mortgage interest rates, existing MBS prices reversed course in May 2013. Not only have existing MBS prices given up all prior gains made in April 2013, these investments have continued to decrease in price throughout the entire month. The hardest hit MBS prices are those with the lowest coupons. This is because the increase in current fixed mortgage interest rates have made currently higher coupon MBSs more attractive when compared to the lowered coupon MBSs created in the past several quarters. Therefore, the lower the specific existing MBS coupon is, the greater the loss in price. The attractiveness of these lower coupon MBSs greatly diminishes in a rising interest rate environment. This has had an extremely negative effect on the entire mREIT sector in regards to portfolio valuations. This has already been evidenced by the material declines of the entire mREIT sector in the past few weeks.
We have now covered what generally happens when an earlier than anticipated/eventual QE3 exit by the Fed occurs. PART 2 of this article will show how such an occurrence would specifically impact AGNC's/MTGE's existing and future portfolio.
Conclusion - PART 1:
No definitive answers were provided by the Fed chairman's testimony and minutes of the latest FOMC minutes. Many options for the Fed's QE3 program are "on the table" depending on future economic indicators. However, since the possibility of a reduction of the Fed's QE3 program in the near future (as early as this summer) exists, investors have realized the negative results that would occur if such a scenario came to realization. Specifically, the entire mREIT sector would be directly impacted when these events unfold.
When the Fed chooses to reduce or eliminate the QE3 program, overall market interest rates would increase. This includes a rise in the interest rates on 15 + 30 year fixed mortgages impacting the entire mREIT sector. As a direct result of these rising fixed mortgage interest rates, existing MBS price declines will ensue (inverse relationship). As such, most mREITs' investment portfolios will incur a valuation reduction until these companies can "roll" over its investment portfolio into higher yielding MBSs.
Final Author's Note: PART 2 of this article should be available later this week or early next week.