While it may have seemed like yesterday's Fed news conference with Ben Bernanke largely confirmed what many already suspected - the Fed will taper late this year if the economy continues to do well - there was one new piece of information in that came out of the meeting. The Fed will NOT sell their mortgage securities portfolio.
Specifically Bernanke said "While participants continue to think that in the long run the Federal Reserve portfolio should consist predominantly of Treasury securities, a strong majority now expects that the committee will not sell agency mortgage-backed securities during the process of normalizing monetary policy." Bernanke also said (and this I think was widely expected) that the Fed will continue to purchase MBS securities for the time being in the amount of $40 billion monthly along with $45 billion in Treasury securities.
This first statement of course implies that the Fed will hold onto its MBS portfolio until the securities mature which has important ramifications for mREIT stocks including Annaly (NYSE:NLY), Armour (NYSE:ARR), American Capital Agency (NASDAQ:AGNC), Invesco (NYSE:IVR), New York Mortgage Trust (NASDAQ:NYMT), Hatteras (NYSE:HTS), Two Harbors, and Chimera (NYSE:CIM), as well as ETFs like (NYSEARCA:MORT) and others. In particular, this will significantly affect future prices (and therefore presumably current prices) for MBS securities and thus will affect both the book value of the firms' existing securities pools and the yields the firms can achieve when buying future securities.
Financial commentators seem to have mixed views on the effect of Fed tapering on mREITs and mortgage prices with some seeing it as a positive for rates, and others seeing it as more of a negative for rates. Given this divergence in views, I think the best thing for investors to do is tune out the short term noise and focus on what the Fed's statements mean for long term supply and demand.
So let's start by looking at a basic representation of supply and demand for mortgage securities, which after all are what drive the dividends and prices (mostly) on mREITs. The graph below shows supply and demand as we might think about it today.
The graph shows that the Fed's entering of the mortgage market increased demand which drove up prices (drove down yields) for newly market mortgage securities. While this was good for the portfolios of companies like NLY, AGNC, etc., because it led to rising portfolio values, it was bad for the companies' yields and returns on new securities purchases. The result was the rapid fall in mREIT stocks initially followed by increased prices earlier this year as many mREIT companies reported much higher book values to the market. This is clearly illustrated in the mREIT income ETF chart shown below
Thus Fed purchases of mortgage backed securities were a mixed bag for mREITs - good in the short term because of the boost to portfolio book values, but bad in the long run as older securities matured and new ones had to be purchased at lower yields. This is likely an important reason for many mREITs efforts to diversify their portfolio over the last few months.
That takes us to yesterday. Now going into yesterday or for that matter last week or last month, all rational investors knew that at some point the Fed would stop buying mREIT securities. Maybe that point would be at the end of this month, or the end of this year, or in five years. But at some point the purchases were going to stop. What was much less clear is what was going to happen to the Fed's existing portfolio of mortgage securities. Would they be sold en masse? Sold over some period of time? Held to maturity?
Investors got answers to both questions this week.
First, Bernanke made it fairly clear that purchases will almost certainly slow down in the next 12 months (possibly within 3 months), and that purchases are likely to stop altogether in the next 12-18 months. This should not have been unexpected as I said. Presumably this expectation was priced into the market and was the reason for the dramatic fall in almost all mREITs over the last few months.
What was news and should have a major impact on these firms is the willingness of the Fed to hold onto their portfolio of MBS. The supply and demand graph below illustrates why this matters.
The graph shows that while prices on MBS will fall as the $40B in monthly Fed demand is slowly withdrawn, they could have fallen even more if the Fed had chosen to dump their MBS portfolio back onto the market (and hence dramatically increased supply).
The result of the Fed withdrawing demand will be a fall in the value of MBS securities and the portfolios of all of the mREITs. This will hurt these firm's stock prices in the short run. However, over time, as the firm's securities mature and the firms are able to buy new securities at lower prices (higher yields), this should enable the mREITs to increase their dividends and allow their stock prices to rise.
If the Fed had chosen to dump their mREIT portfolio onto the market, that would have deeply depressed MBS prices and resulted in a huge fall in book value for the mREIT firms without much of a boost to their yields over the medium term (since the price spike would have been transitory). Thus as the graph above shows, the Fed's decision to hold their mREIT portfolio should be a good thing for investors.
Wait though - the standard mREIT bear argument is not predicated on expectations for MBS yields, its built around the spread between long term and short term rates. Specifically, since mREITs generally are highly levered and borrow short to lend long, we need to also be concerned with the relationship between short and long term rates. Specifically, rising short term rates will hurt mREIT firms, while rising long term rates will have a mixed impact (hurting the portfolio values of these firms, but helping their reinvestment opportunities).
As rates have risen over the last month, not surprisingly, long term rates have far outperformed short term rates. This will hurt the mREITs making funding more expensive - again however, this should largely be reflected in the stock price already, but it may hurt the firm's ability to pay out dividends until their portfolios' sufficiently adjust to the new long term rates opportunities that will be available for investment. In particular, since short term rates are rising much more slowly than long run rates, the mREITs should only face a small increase in overall funding costs compared with the increased yields they can garner on future investments.
Overview: In summary, the Fed decision to hold onto their MBS portfolio should keep prices on MBS securities from falling too far which in turn will help cushion the book value of these firms going forward. While mREITs will be hurt by the increasing short term funding costs, over time the increase in long term rates should more than offset this. The Fed's decision to slow purchases over time will hurt MBS prices, but this should already be baked into the stock price for most of the mREITs.