Seeking Alpha
Profile| Send Message| ()  

The prices of most of the mortgage REITs have nosedived since the start of the speculations of QE unwinding. I believe the pressure on the sector will further increase as the Fed announces that it's close to tapering the QE3 as reported by the Financial Times. In my previous article, I noted that the recent economic data related to the upbeat retail sales and encouraging labor market figures might have negative consequences for the mREITs, and I was right. It's this data and improvements in the labor markets that will lead the Fed to halt its bond buying program. However, not all mREITs will be equally affected. Annaly Capital Management (NLY), American Capital Agency (AGNC) and Two Harbors (TWO) are among the mREITs that will outperform.

How mREITs make money?

Mortgage REITs are a corporate structure that is highly sensitive to interest rates. Agency mortgage REITs invest in residential mortgage backed securities which are backed by government guarantees. Short-term financing is used to purchase the MBS. The mREITs pay a cost on their financing, while the MBS generate yields linked to the long-term mortgage rates. Finally, the mREITs earn a spread between the yield they earn and the cost they pay. Therefore, the earnings are highly sensitive to changes in interest rates.

The catalyst

This Wednesday, the Fed's Open Market Committee will be meeting again to decide the fate of the third round of quantitative easing. The committee's minutes of the meeting released in mid-May resulted in speculations about the Fed's exit. This caused the mREITs to skydive.

American Capital Agency and Annaly Capital Management plunged 12.4% and 10%, respectively. ARMOUR Residential (ARR) and Two Harbors fell 19% and 10% respectively since then. The decision made during tomorrow's meeting will have a significant impact on the stock price and future profitability of the mREITs.

Why QE unwinding is likely?

The Financial Times reported that Ben Bernanke is likely to disclose that his central bank is close to tapering its bond buying programs. The substantial improvements in the U.S. labor markets and the release of the latest data on retail sales will probably be the reason why the Fed is getting closer to unwinding the QE.

The anticipated unemployment is down to 7.4% from 7.75%, while the average six months payrolls surged to 194,000 from 130,000 six months ago. Given the improvements, the QE tapering is likely.

What QE unwinding means for mREITs?

The much anticipated QE unwinding means a bloodbath for the mortgage REITs. In short, it will have two effects. One, it will cause the book value of mREITs to erode, in the near-term. Two, it will cause the spreads of mREITs to increase, but in the long-term.

During the first quarter of the current year, when speculations about the Fed's exit first erupted, the mortgage rate climbed higher giving a glimpse of what you should expect when the Fed finally exits. Mortgage REITs like American Capital Agency, Annaly Capital Management and ARMOUR Residential reported 9%, 4% and 8.2% respective declines in their book values.

Why some mREITs will outperform?

In short, the mREITs that will outperform their peers under the given situation will be the ones that were prepared for the QE unwinding.

Among them, Annaly Capital is at the top. It's a well managed Agency mREIT. There are several drivers and catalyst that will protect its book value and lead the company to report higher income. The presence of CRE loans and less leverage will provide a cushion to its book value and make it less sensitive to changes in interest rates, while its latest acquisition of CreXus and less compensation expense after the externalization of its management structure will provide support to its bottom line.

Two Harbors is another mREIT that is classified as hybrid as it has investments in both Agency and non-Agency MBS. The company is poised to benefit from MSR license, the company's exposure to credit sensitive assets and the abundance of non-Agency securities. Further, it's well positioned for non-Agency securitizations in the future. These factors will enable the company to withstand the rising interest rate environment. This is why it's also the top pick of Barclays and Credit Suisse.

American Capital Agency is the second largest mREIT that invests exclusively in Agency paper. The company was not prepared for the QE unwinding, which led to the massive book value depreciation. During a recent presentation, the management announced the rebalancing of its investment portfolio to better suit the rising interest rate environment. Among other actions, the management got rid of some of the 30-year fixed rate residential mortgage backed security. It is considered to be more sensitive to changes in interest rates. Besides, the management announced the active management of its hedges and assets in order to create attractive returns.

Conclusion

While the volatility in interest rates will hurt the mortgage REITs sector in general, some mREITs will outperform the rest of the sector because they were prepared for the unwinding of the QE. These include NLY, AGNC and TWO. Therefore, I am bullish on these stocks.

Source: Catalyst For American Capital And Annaly Capital

Additional disclosure: The article has been written by Equity Whisper's Financials Analyst. Equity Whisper is not receiving compensation for it (other than from Seeking Alpha). Equity Whisper has no business relationship with any company whose stock is mentioned in this article.