Armour Residential REIT (NYSE:ARR) is an interesting REIT that was set up to invest in Agency residential mortgage backed securities. It seems like quite a simple model: buy mortgages that are primarily guaranteed by Fannie Mae (even throw in some Freddie Mac and Ginnie Mae) and hold those to maturity, collecting coupons on the way. Since the assets would be held to maturity, no need to worry about the market value of the securities because we know what the fixed income stream will be and the face value of the securities won't change over time.
ARR however adds more complexity to their REIT. ARR has a leverage target of 8-9 times the amount of "additional paid in capital," so in other words the debt-to-equity ratio is targeted at 8.0 or above. This sounds risky to me - my readings on the firms that lost significant amounts of money during the 2007 & 2008 financial crisis warn about these types of leveraged firms and the consequences they suffered.
ARR finances its activities through Repo - repurchase agreements. Basically how this works is a firm, like ARR, will go typically to an investment bank and sell them securities, in this case Agency RMBS. Typically the securities will be transferred to a third party clearinghouse, and the seller will now be given the cash. The catch is that the selling party has agreed to repurchase the securities at a set price that is higher than what they sold them for, usually the repurchase happens in 90 days or less. Essentially this is a shadow loan, where the interest paid is in the form of a higher repurchase price of the securities.
Since ARR is a leveraged firm, they have substantial exposure to declining asset values. I think about it this way: if I own $100 in securities and then value declines by 10%, then I lose $10, leaving me with $90 in equity. If I borrow 9 times my capital and purchase securities with it, then I will have $100 of my own money invested and $900 in securities that was financed. If the value of the leveraged fund declines by 10% then the fund loses $100, leaving no equity.
In this particular case, the variable that ARR is most impacted by is interest rates. Now, people have disagreed with me on this topic (see the comments in this article about ARR), but nevertheless here is what I understand to be the risk: interest rates go up, since interest rates go up, the yield on the Agency securities goes up, and the market value of the securities goes down. Since ARR is financed primarily through their securities, the amount they can borrow declines. Since they have a fairly substantial amount of dividends to be paid (common shares are over 18% annual at the moment), principle and interest payments from the securities will have to cover dividends and the remainder will roll into new securities purchased at the lower market price and higher yield. The point I am making here is that ARR's strategy doesn't allow for cash to roll into the higher yielding, lower priced securities at a rapid enough pace to truly reflect current market yields on Agency RMBS.
Apparently, ARR to some level agrees with my thinking that higher interest rates need to be hedged against and this is where the derivatives come into play. ARR invests in interest rate swaps, swaptions, and Eurodollars - all can be used to hedge against rising interest rates depending on what side of the transaction you are on.
In the below chart, I use ARR's monthly reports to show what has happened to the value of Agency securities, derivatives, and net Repo contracts since the end of February.
We can see that, as I suggested earlier, during the recent rise in interest rates, which started at the beginning of May, Agency securities have in fact declined in the portfolio holdings quite a bit. At the same time, Repo has declined. The value of the derivatives, however, have stayed relatively constant throughout the entire period. The graph below show the percent of derivatives to Agency securities.
As we can see in the graph, the amount of derivatives per Agency security is increasing. In February, ARR held around half of the total value of their Agency securities in derivatives. As of the most recent report in July, ARR holds over 70% of the value of their Agency securities in derivatives.
The real question I have with ARR is what is their real goal? Is it to hold good credit RMBS to maturity or is it to hedge against interest rates? Right now it looks like ARR is more into market speculation than solid coupon collections.
Perhaps the stock market agrees with me, ARR's stock has fallen 23% since February 25th, pushing their dividend rate to over 18.5% annually. For now, I am going to keep ARR on my watchlist. This REIT has too much risk for my liking and seems to be turning quickly into a market speculator rather than a solid coupon clipping investment.