MREIT Sell-Offs Focus On Book Value Or Spread, Why Not Both?

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Includes: AGNC, NCT, NLY, NRZ
by: Dividend Living

News stories, the market and investors seem to only be able to focus on one aspect of mREIT investing at a time during a selloff. At the moment, it's on book value [BV] decreases. Last November, it was spread decreases. The two are actually in a balancing act, but the price action during these overactive selling periods seems to ignore that.

Book Value

Book Value relates to how much the Mortgage Backed Securities [MBS] (and whatever other assets are on the books) are worth. When supply is tight, like when the FED buys 40$billion of MBS a month, the value of MBS goes up. When mortgage rates are going down, you pay a premium for prepayment protected MBS and when mortgage rates are going up, you see that premium go away as prepayments slow. In today's environment, fear of an end to the FED's MBS buying has caused mortgage rates to jump, which has led to a lowering in value of lower yielding and prepayment protected MBS and downward shocks to BV of the major mREITs

Spread

This is the earnings percentage that mREITs earn between what rate they borrow at and what rate they receive on the MBS they own. When borrowing costs and rates on MBS spread out from each other, earnings increase for mREITs. We are currently in an environment with rising yields on MBS and stable or falling borrowing costs. This will eventually lead to an increase in earnings as mREITs replace lower yielding MBS with higher yielding MBS.

Repeating the Past

On October 15th 2012, I penned this in my investing journal: mREITs are diving hard, roughly 10% in a week of trading days. Reason: QE3, which was announced on Sept 13th, is finally thought to lower yields and increase prepayments while BV increases are realized to be offset by hedges. Although QE3 effects were known before, an overall downturn because of earnings season forecasts caused investors to stop believing in BV increases and start believing in yield compression and prepayment risk more. Mortgage rates on 30 year fixed are down .18%.

I could say roughly the same today, just switched around: mREITs are diving hard, down roughly 5-15% in a month. Reason: Fear of QE3 tapering is thought to lower book value while spread increases are thought to take some time to materialize. Although the end of QE3 in the near term is still in doubt, an overall panic has set into the long term bond market and it has tried to price in QE3 ending. Investors have stopped believing in spread increases and started to believe more in BV declines. Mortgage rates on the 30 year fixed are up .67% since May 1st. Discount to BV is in the 12-13% range for major mREITs Annaly (NYSE:NLY) and American Capital Agency (NASDAQ:AGNC).

In November of 2012, the fears of spread decreases causing decreases in dividends hit a crescendo on the 14th of November with price to BV reaching a 15% discount in many of these stocks before mREITs rebounded, as writers pointed out yields on long term debt were not falling off a cliff and BV increases were going to happen.

What to point out now

This time around, the change to the interest rates has been more significant (+.50 in May vs -.13 in Sept-Nov in the ten year treasury yields and +.43 in Q2 so far vs -.16 in Sept-Nov in the 30 year fixed mortgage rate), but the oversold status is still the same.

In AGNC, we are currently down more than twice the amount (in price to BV terms) of the 4.2% predicted decrease to BV that would occur with a +.50 rate change.Click to enlarge

In NLY, we are also down more than twice the amount (in price to BV terms) of the 3.76% predicted decrease to BV that would occur with a +.50 rate change.Click to enlarge

(the 3.76% decrease in BV is calculated from the .57% change in portfolio value multiplied by the leverage rate of 6.6.)

The markets are pricing in twice the interest rate change that has actually happened, and they are not pricing in any increase in spreads that will occur.

What Lies Ahead

The uncertainty from the Fed as to when it is going to taper or end QE3 and the quietness of these companies (lack of recent insider buying, no statements) could start to be resolved soon as dividend announcements should start to roll in around the 11th of June. Newcastle Investment Corp. (NCT) and New Residential Investment Corp. (NRZ) just announced what amounts to a dividend increase to .24 per share when it was .22 for the combined company last quarter) and unemployment numbers for May will come out Friday the 7th of June. They wont tell us what the BV decreases will be or exactly what month the QE3 tapering will begin, but it will give us something to beat away some of the uncertainty.

If you think dividends will be okay for Q2 and you think that unemployment numbers will cause a delay in the QE3 exit, this is a great buying opportunity for a rebound. The Fed has a roller coaster in store for these stocks with QE3 tapering on the horizon and then a decision as to what to do with all the MBS it owns. I personally think the Fed will hold onto its MBS for a long while. They don't want to take the loss they would incur if they sold all of them immediately, and they are concerned with keeping the mortgage rate low to help the economic recovery. Zero Interest Rate Policy [ZIRP] I believe will stay in place until 2015. That means in the long run, an end to QE3 and a rising long term mortgage rate will increase spreads and secure or raise dividends in these stocks. The best time to buy might be after the official QE3 tapering announcement has played out to a certain degree (when BV aren't going much lower and spreads are shown to be increasing, you have waited too long), or it could be right now.

Disclosure: I am long NCT, NRZ, MORL. MORL's major holdings are NLY, AGNC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.