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The selloff in mortgage real estate investment trusts (mREITs) that began in May has continued into June. One of my long-time favorite mREITs, American Capital Agency (NASDAQ:AGNC) has suffered double-digit losses in just a few short weeks, and is currently trading under $25.00 at $24.83, after being over $30.00 to start May. However, on a day where most of the mREITs were deep in the red, my second largest mREIT holding, Annaly Capital Management (NYSE:NLY) was in the green, up half a percent to $13.55. What has caused this huge decline in mREITs?

It is primarily the belief that the Federal Reserve will be slowing its bond buying program. It's kind of funny if it weren't so sad, because when the purchasing was announced, these stocks got crushed. Not that the buying may end, and they get crushed. In fact, has the pain has been so great that these dividend paying machines will likely lose money in Q2 and cut dividends down the road? The primary driver of this action were rising interest rates. But its wasn't just the rising interest rates, but the pain felt in the mortgage backed security values.

Recall that these publicly traded trusts buy mortgage bonds with borrowed money, thus, as interest rates rise, it costs more to borrow. If the long-term rates don't keep pace, or exceed the rate of growth in shorter-term yields, we will have a narrowing of the interest rate spread due to a flattening of the yield curve. In fact this yield spread is key to mREIT profits, because these companies borrow capital at very low short-term rates, and then invest in potentially higher yielding real estate mortgage assets. But here is the kicker. The long-term interest rate has expanded faster than the short-term rates. This means that companies like NLY should make more money, not less. While I have warned of a flattening of the yield curve in the past, it seems the curve is actually widening right now.

To really maximize returns, NLY also magnifies its risk because it uses leverage to make money off of the spread differential in rates while still paying out gargantuan yields to investors on a regular basis. The fear that these interest rate spreads will narrow and diminish profits, coupled with a move in the last few weeks higher in yields, has resulted in the selling. While much attention has been paid to the interest rates, and they are partly to blame for the selling, my analysis indicates that these spreads are widening. The selling is due in part to headline news of "30 year mortgage rates exceed 4% for the first time in a year" and "the 10 year treasury soars 10 basis points". When you open up the hood and look underneath, it seems that this fear is only partially justified.

Interest Rate Spread And Leverage; Key to NLY's Success.

As pointed out above, the interest rate spread is a key driver of profitability. Besides a narrowing of the spread, there are other issues that can arise (which you might not be cognizant of) which hurt NLY's business model. First, the companies often leverage their risk. As we know, the mREITs borrow in the short term to buy longer-term mortgage securities, earning the spread between the two. But what some may not realize is many companies also use repurchase agreements to leverage their holdings, in some cases up to 6, 7 even 8 times. NLY is currently leveraged 6.6 times (at the end of Q1 2013), which is up slightly from a 6.5 times leverage at the end of Q4 2012.

Still, this leverage magnifies risk substantially (while also increasing potential reward). Returning to the fear that the interest rate spread is potentially narrowing, I see this actually expanding if long-term rates continue to increase more rapidly than short-term. This number will be a key metric when the company reports its Q2 results this summer. At the end of Q1 2013, it was at a multi-year low of 0.91%. If it drops below 0.8%, it will pressure earnings dramatically and guarantee a dividend cut. However, the interest rate trend is on our side, for now.

Interest rates in the last month

Lets look at the action in mortgage rates so far during the quarter. The higher the longer-term rates go, the better the spread, so long as short-term rates stay low. However, if long-term debt rises too fast, it could seriously dampen demand for mortgages as consumers may not be able to afford additional monthly payments on a home, and in turn, can hurt NLY's business.

As of the time of this writing, the current interest rate for a 30-year fixed rate mortgage in the United States is 4.08%, whereas the shorter 15-year fixed rate mortgage is 3.17%. At the start of the quarter, these rates were 3.5% and 2.8%, respectively. Thus, the absolute spread was 3.5%-2.8%=0.7% at the start of the quarter and is now 4.08%-3.17%=0.91%. On a relative scale, the 30 year to 15 year ratio was 3.5%/2.8%=1.25 at the start of the quarter. This ratio measure too has widened, and is now 4.08%/3.17%=1.29. This exercise can be utilized for any short-term and long-term interest rate comparison.

So while folks are panicking over the 30 year rate rising (which in my opinion means people on the fence about home purchases will rush to buy before rates go up further), in reality, it has led to a widening of the interest rate curve, for now. However, as far as the mREIT investors were concerned, interest rates have risen, pressuring consumers, commercial borrowers and has increased fears the interest rate spread is diminishing and that the residential housing market could weaken. This is in addition to fears (whether rational or irrational) of a tapering of Fed asset purchases that could impact the mREITs' business operations and pressure margins. Figure one shows the rise in interest rates on the last month, which has widened the long-term to short-term ratio.

Figure 1. Interest Rate Changes For the 15 and 30 Year Fixed Rate Mortgages, Last 30 Days.

Should we buy this selloff?

Back in May, I believed the book value at the end of Q1 to be lower than where I thought it currently was in the beginning of May. At this time, the information is changing. Mortgage backed securities prices have been hit with the increase in interest rates, however, the interest rate spread is widening, which could benefit NLY.

With the rise in interest rates and the dropping value of mortgage backed securities, book value could easily now be lower. However, the stellar management led by Wellington Denahan could be making decisions as I write on whether to leverage up, taking advantage of decreased MBS prices. Alternatively, they may stay on the sidelines, or if they believe this is temporary, make some portfolio changes/additions.

I think this is a temporary spike that will level off. It could be an opportunity for NLY to lever up. The stock is far oversold in my opinion, mostly on unfounded fears of the Fed tapering. Remember, the stock got hit when the Fed started buying, now its getting hit when the Fed might exit. What I know is that NLY has been in business long before the Fed intervened in this economy. Given that I am a long-term investor, I will side with management on this one and trust that they will take the company in the correct direction. See my recent piece on NLY's purchase of Crexus as an example.

While the rise in the interest rates could help the mREITs in the short run, my only fear is that it could seriously jeopardize the fragile recovery we have seen. Housing has been very strong as of late, but this action could quickly change, given these rate hikes. I think the Federal Reserve absolutely does not want the interest rates to rise this quickly as it undermines their intervention into the bond market and asset purchasing program, which was designed to keep demand up. Thus, I think this may make it less likely that the Fed will taper, and they may try to influence rates further to turn them lower. So long as rates don't rise too rapidly, I think this extreme selling could be an opportunity for investors who are looking to get into the mREIT space. While dividends may be cut in the future, the yields are still north of 10%. For investors who pyramid down into stocks and reinvest dividends (which is the right thing to do), these kinds of return should be in your long-term portfolio.

NLY currently trades at $13.55. While the dividend will surely fluctuate over time, slowly building a position in your portfolio in increments on the way down is a key to long-term success. For those trading the stock, simply watch short-term interest rates. The higher they go, the more pressure on the stock in the short term. Right now folks are panic selling. I think this is an opportunity. However, you have to diversify. I plan to allocate 3% of my retirement portfolio to the mREIT space, but even within this space, I am long not just NLY and AGNC, but also Western Mortgage (NYSE:WMC) and American Capital Mortgage (NASDAQ:MTGE). This diversification can at least protect you in case one company has issues. With the recent selling, they are all good long-term buys for a small portion of your portfolio.

Finally, note that NLY was up on this down day (6/10/13). AGNC, WMC and MTGE were all down 1%-3%. This suggest to me that NLY is forming its bottom. It has bounced off the $13.40 mark several times. This is a very positive sign for a sustained rebound in the stock that could take it back over $14.00. I will be watching $13.40, $13.20 and $14.00 as key support and resistance levels moving forward. Further, I will be watching for the next dividend announcement as a catalyst to move the stock.

Disclosure: I am long NLY, AGNC, WMC, MTGE. 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.

Source: Annaly Capital Management And The Spread: One Widening Reason Not To Sell