Rapid Mortgage Rate Increase Raises Many Questions About Armour Residential REIT

Jun.17.13 | About: ARMOUR Residential (ARR)

Armour Residential REIT, Inc. (NYSE:ARR) is a mortgage real estate investment trust. It is managed externally by Armour Residential Management LLC. ARR pays a monthly dividend/distribution (Form K-1). For the three months of Q4 2012 that dividend was $0.09 per share per month. For the three months of Q1 2013 that dividend was $0.08 per share per month. For the three months of Q2 2013 that dividend has been $0.07 per share per month (about 17% at the closing stock price on June 13, 2013). Many were afraid that this dividend would be cut again soon. The dividend has been falling in a continuing trend since the beginning of 2011, along with the falling net interest margin. The net interest margin has fallen from 2.23% as of March 31, 2011, to 1.55% as of Dec. 31, 2012, to 1.35% as of March 31, 2013. These two trends had convinced nearly all of the "trend followers" that ARR was sure to cut its dividend again in Q3 2013.

As of the press release on June 13, 2013, which declared a $0.07 per share per month dividend/distribution for the months of Q3 2013, that fear has been erased. ARR also announced that undistributed REIT taxable income as of June 30, 2013, will exceed $15 million. In other words, a dividend cut is definitely not likely to occur in the near term. ARR rallied on the news, and that may be the signal to buy into ARR again -- especially with a new mini-rally perhaps in the offing for the overall stock market.

The table below gives a good approximate view of ARR's holdings as of May 8, 2013:

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Far from cutting the dividend, ARR seems likely to increase the dividend in the near future. The mortgage rates have gone up dramatically in the last month (see the Freddie Mac table below):

The current national average mortgage rate for June 2013 of 3.95% is far higher than the April 2013 average rate of 3.45% or the March 2013 average rate of 3.55%. It is also already out of date. The most recent 30-year fixed-rate mortgage rate as of June 13, 2013, is 4.16%; and the rate has been above 4.15% for the last week. This is 71 bps above the average April 2013 rate, and it is 61 bps above the average March 2013 rate. The cost of funds for ARR has certainly not gone up this much. At most it could have gone up 20 bps. This means the net interest spread has widened significantly in the last month. It means ARR is earning more net interest income. Far from cutting the dividend, ARR seems likely to increase the dividend, if the net interest spread stays retains this added width. Admittedly, ARR will only earn a higher net interest spread for the last few weeks of Q2, but even that should help.

The problem is that ARR as a rule loses book value as the mortgage rates increase. Without the exact data from ARR, it is hard to estimate exactly how much book value will be lost in Q2 2013, especially since the quarter isn't over yet.. However, it is possible to come up with a ballpark figure.

ARR's book value as of March 31, 2013, was $6.69. This had fallen from $7.29 per common share as of Dec. 31, 2013. In other words, ARR lost -$0.60 in book value as the average mortgage rate climbed from a 3.34% average rate in December 2013 to a 3.55% average rate in March 2013 (or up about 21 bps). This doesn't bode well for the Q2 2013 book value losses.

In April 2013, the 30-year fixed-rate mortgage averaged 3.45%, which was down from the 3.55% average of March 2013. In other words, ARR initially recovered some of its Q1 2013 book value losses. However, that didn't last long. During the recent mortgage rate run up, ARR has apparently lost a lot more book value in Q2 2013 than in Q1 2013.

One quick way of estimating the loss would be just to compare the 21 bps spread gain in Q1 to the conservative figure for June of 40 bps gained vs. the March average. By this estimate the book value loss should be roughly double (about -$1.14per share). This would put the book value at $5.55 per share. In this case ARR should be a relative bargain.

The Fed is unlikely to let mortgage rates go straight up. The housing market would collapse, and the Fed has been trying to help the housing market recover. If the mortgage rate rise took a breather here, ARR would be able to generate more dividend income due to a higher net interest spread. Plus ARR, which is selling at a stock price of $4.83 per share as of the June 14, 2013, close, would be selling at a large discount to the book value of $5.55 per share (using the above ballpark estimate).

Naturally, no calculation is ever that simple. Another item in the calculation is the hedging. In Q1 2013, the 30-year U.S. Treasury Bond yield was up on average about 20 bps from Q4 2012, although from Jan. 1 (2.95%) to March 29, 2013, (3.10%) the move was only 15 bps up. Yet the average mortgage rate in December 2012 was 3.34%, and the average mortgage rate in March 2013 was 3.55% (a 21 bps rise). This means that in Q1 2013 six bps were essentially uncovered by interest rate hedges. Let's ballpark estimate that the hedges are 50% effective against book value losses. Hence, the losses in Q1 may represent the effect of 13.5 bps of uncovered losses. The chart of the 30-year U.S. Treasury Bond yields is below.

If we take the recent average national mortgage rate of about 4.15%, then the average is up 60 bps from the March average of 3.55%. On March 29, 2013, the 30-year U.S. Treasury Bond yield was 3.10%. The peak so far in Q2 2013 was 3.37% (or 27 bps higher). This means 33 bps in mortgage rate increase were essentially uncovered by interest related hedges (i.e., represent a total loss). This means the Q2 book value losses may be due to approximately 33 bps + (27 bps * 0.5) = 46.5 bps of uncovered losses.

If you estimate that the effective 13.5 bps of uncovered losses in Q1 were typical, which they probably weren't, then the Q2 losses so far would amount to approximately $2.06 per share in book value. This is likely a worst case scenario, and I doubt it is accurate. However, some value between -$1.14 per share and -$2.06 per share seems likely, unless the mortgage rates fall between now and June 30, 2013. A recent survey of 250-plus professionals indicated that 72% think mortgage rates will be the same or up from current values over the next 30 days. Therefore, a dramatic fall by June 30, 2013, seems unlikely.

Another way to ballpark estimate the loss is to use the loss on the 30-year FNMA 3.5% RMBS over the Q2 period. The chart of the 30-year FNMA 3.5% RMBS is below:

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The value of this RMBS at the end of March 2013 was approximately 105-19. A recent reading was 103-15. This means the value has fallen approximately 2%. If you multiply this by ARR's approximate 9x leverage, you get an 18% loss. If you figure approximately 22.5% of the mortgage rates rise was compensated for by interest rate hedges (see the above interest rate vs. mortgage rates changes), then the losses in book value will amount to approximately 14% or $0.94.

Of course, the $0.94 book value loss figure is also an inaccurate measure. The amount on losses of the various kinds of RMBS were all different, and they have different weightings in ARR's portfolio. For instance, the losses on the 30-year FNMA 3.0% RMBS were significantly higher. Still, this estimate provides another data point on which to base an estimate of book value losses.

Now, I have come up with three ballpark estimates of book value losses for ARR in Q2 2013 so far. They are -$0.94, -$1.14, and -$2.06 per share. The average of these is -$1.28. The mean is -$1.14. I will be interested to see how close any of these ballpark estimates come. I do not have all of the data on ARR's holdings, so it is impossible for me to make an exact estimate. However, the above estimates should serve to ballpark for investors how much ARR is likely to lose in book value in Q2 (presuming the quarter ended June 14, 2013).

You should also consider that it is unlikely the cost of funds went up appreciably. A ballpark maximum amount is likely 15 bps. Consider that CPRs (constant prepayment rates) probably fell (or stayed nearly the same) during Q2. Fewer people want to refinance when mortgage rates are rising, although some may have felt pressured into refinancing immediately before rates rise too much. This means that the net interest rate spreads likely rose by 35 bps to 45 bps or more during Q2 2013. This will translate into higher net interest income per share, and it means the dividend is unlikely to be cut. In fact, the dividend, which is based largely on net interest income per share, seems likely to rise significantly in later quarters now that the mortgage rates have expanded again.

I don't foresee the U.S. economy improving noticeably in FY 2014. It may even go back into a double dip recession. Let's hope that doesn't happen, but the possibility does indicate that fast growth is probably not in the cards. This should mean that mortgage rates will not rise dramatically. With constant (or only very slowly rising) mortgage and interest rates, mortgage REITs should be good investments. With ARR trading likely below book value, it is a bargain with a 17% annual dividend, which may rise more with the recently higher net interest spread. ARR is a buy.

The two-year chart of ARR provides some technical direction to this trade:

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The slow stochastic sub chart shows that ARR is oversold. The main chart shows that ARR is in a downtrend. However, ARR looks far overextended downward beyond both its 50-day SMA and its 200-day SMA. It is due for a significant bounce upward. If the dividend is raised in Q4 2013 due to the improved net interest rate spread, the stock may recoup a huge part of its losses. It still has an average analysts' one-year target price of $6.58. I might lower this to $6.00 given the likely huge book value losses coming for Q2 2013. However, with the huge dividends it seems likely to pay in the near future, now does seem to be a good time to buy ARR.

ARR seems to be suffering from the typical market overreaction. Few investors really understand the mortgage REIT stocks. This makes those investors easier to scare. Taking advantage of this near-term fear seems likely to be a good investment. Remember Warren Buffet's adage: "Buy when there is blood in the streets." Too many will only see the losses. I am a bit unsure whether you want to invest now or after the Q2 earnings report. My inclination is now would be the better time. However, investors may experience less angst if they average in.

Notes: Some of the above fundamental financial data is from Yahoo Finance. Also, I understand that the swaps, swaptions, and other interest rate hedges are usually based on two-year, five-year, and 10-year U.S. Treasury Bond yield movements rather than 30-year U.S. Treasury Bond yield movements. However, the 30-year U.S. Treasury Bond yield movements cited were good enough for this article's ballpark estimates. There were many pieces of information that I did not have, and the 30-year agency fixed-rate mortgage rates are based on the 30-year U.S. Treasury Bond yields.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in ARR over the next 72 hours. 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.