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The second quarter saw a sharp rise in interest rates which caught most of the mortgage real estate investment trusts (mREITs) unsuspecting and under-hedged. The market sold mREITs off as rates rose, anticipating a sharp decline in book values. In general Mr. Market was correct, 20%+ book declines were seen in many prominent names.

But not all mREITs were caught with their pants down. A few - AI, EFC, NRZ - managed to continue to add economic value (= change in book + dividend) despite the challenging times. So it is possible for an mREIT to make money even when interest rates climb! The question however remains, are mREITs a falling knife or an opportunity to be greedy when others are fearful? If the latter, just who is who?

This article will attempt a risk benefit analysis of 9 mREITs with a companion article by Dividend Living covering 10 additional equities.

Below are 3 charts outlining the risk, benefit, and dividend sustainability analysis at the end of Q2 for 19 mREITs:

Reward Potential

Symbol

Discount to Q2 book

Yield

Potential Economic Value

Reward Rating*

WMC

11%

23%

34%

B

JMI

21%

21%

42%

A

ARR

19%

19%

38%

A

AGNC

11%

19%

30%

B

MITT

12%

18%

30%

B

AMTG

20%

19%

39%

A

CYS

24%

17%

41%

A

IVR

14%

17%

31%

B

MTGE

13%

16%

29%

B

HTS

14%

15%

29%

B

NLY

9%

13%

22%

C

AI

26%

14%

40%

A

EFC

8%

14%

22%

C

DX

7%

14%

20%

C

ANH

22%

13%

35%

B

TWO

6%

13%

19%

C

MFA

7%

11%

18%

C

CMO

8%

10%

18%

C

NRZ

-40%

4%

-36%

B

Book Risk

Symbol

% of Portfolio NOT Hedged

Duration Gap

Leverage

Book Risk*

WMC

11%

0.7

8.2

B

JMI

43%

1.61

6.21

D

ARR

23%

1.34

6.14

D

AGNC

-1%

0.6

8

A

MITT

5%

-0.05

4.8

A

AMTG

21%

no info

3.9

B

CYS

6%

no info

7.5

B

IVR

18%

1 to 1.5 target duration

7.6

C

MTGE

-6%

0.2

6.4

A

HTS

52%

1

9.3

D

NLY

48%

no info

6.2

D

AI

29%

no info

3

A-

EFC

40%

no info

2

A-

DX

53%

no info

6.8

C

ANH

59%

no info

8.7

C

TWO

-17%

no info

3.6

B

MFA

82%

no info

3.1

B

CMO

51%

no info

8.4

B+

NRZ

0%

negative

2.2

B

Dividend Risk

Symbol

Q2 Taxable income / Q2 dividend

UTI (Q1 + Q2 undistributed income)

Q1 Net Spread

Q2 Net Spread

Spread % change in Q2

Dividend Risk*

WMC

104%

-37¢ a share or -41% of dividend

2.17

2.18

0.5%

B

JMI

82%

24¢ or 34% of dividend

1.96

1.75

-10.7%

C

ARR

86%

36¢ or 170% of dividend

1.35

1.38

2.2%

B

AGNC

99%

$1.07 or 102% of dividend

1.71

1.59

-7.0%

C

MITT

103%

$1.78 or 225% of dividend

2.25

1.96

-12.9%

B

AMTG

84%

-60¢ or -85% of dividend

2.8

2.1

-25.0%

D

CYS

108%

-$2.58 or -758% of dividend

1.16

1.36

17.2%

B

IVR

91%

11¢ or 17% of dividend

1.64

1.59

-3.0%

C

MTGE

95%

43¢ or 54% of dividend

2.09

1.96

-6.2%

B

HTS

94%

25¢ or 35% of dividend

1.11

0.93

-16.2%

C

NLY

118%

14¢ or 35% of dividend

0.91

0.98

7.7%

B

AI

128%

41¢ or 47% of dividend

1.9

1.45

-23.7%

B+

EFC

64%

89¢ or 116% of dividend

4.66

4.72

1.3%

B+

DX

117%

10¢ or 34% of dividend

1.89

1.75

-7.4%

A

ANH

100%

0 cents

0.89

1

12.4%

A

TWO

68%

39¢ or 125% of dividend (does not include $1.01 Silver Bay special dividend)

2.5

2.9

16.0%

B

MFA

86%

-6¢ however there is a lot of 2012 undistributed income

2.32

2.38

2.6%

B

CMO

68%

-4¢ or -13% of the dividend

1.15

1

-13.0%

B

NRZ

214%

8¢ or 114% of the dividend

no info

A

* Reward, Book Risk and Dividend Risk ratings are the subjective opinions of the author and factor in not only the data presented but prior history and confidence of the author in management. EARN, CIM, NYMT, NRF, NCT, PMT and RWT are additional names in the space which you may wish to consider but we were not able to incorporate this time around. The individual company write-ups on the first 10 names in the chart: WMC, JMI, ARR, AGNC, MITT, AMTG, CYS, IVR, MTGE, HTS and NLY can be found in the article linked above.

Arlington Asset Corp.

84% agency / 16% non-agency (non-agency is held at 64% of face value)

AI is actually a C corporation with large tax loss carry forwards, not a REIT. This is significant because it means its dividends qualify for the lower dividend tax rates and should continue to for years. It means in a taxable account with a 28% marginal tax rate their dividend is equivalent to an mREIT paying out roughly 19.6%. Thus, AI has one of the highest paying dividends out there. Despite this and a decline in spread from Q1 to Q2 (due to increased hedging expense), the dividend is not judged to be at significant risk. They were able to well cover it with taxable income in both Q1 and Q2 and have leftover unused taxable income of almost a half a dividend payment so far for 2013. I gave AI a dividend risk rating of B+. AI was one of the few mREITs to add economic value in Q2, +78¢ per share or 2% (= change in economic value / Q1 book). It predominately utilized Eurodollar hedges and proactively increased those hedges during the quarter. They seem to have worked well. For this reason, its stellar hedging and its low leverage, I gave AI an A on book risk. Last, in addition to its high dividend, AI currently trades at a significant (26%) discount to book. It has the highest economic potential of any of the mREITs reviewed and thus received a potential reward rating of A. With resilience to book value loss and dividend cuts as well as significant reward potential, if you were only going to buy one mREIT stock, AI is the one I would recommend.

Ellington Financial

52% agency 48% non-agency (held at 73% of face value)

EFC was another of the few mREITs to add economic value, +50¢ or 2% per share, in Q2. Again I was impressed and raised its book value risk rating accordingly. EFC is also unique in that it publishes its estimated book value monthly. Something other mREITs should consider. EFC is legally a partnership not a REIT which means it issues K-1s. I don't find K-1s an issue when you use turbo tax but others prefer to stay away. EFC utilizes TBA short positions and longer dated interest rate swaps to hedge. This worked well in Q2. Going forward, EFC believes prepayment protected agency are attractively priced and still have value, as well as non-agency paper. They are also looking to buy a small mortgage origination firm and grow it over time. Management owns 13% of EFC. The $2.35 per share in net income so far for 2013 well covers the $1.54 dividend despite low Q2 income.

Dynex Capital

86% Agency / 14% non-agency; 68% CMBS / 32% MBS; 15% of portfolio at fair value in IOs

DX maintains a low duration, adjustable heavy, and CMBS heavy, portfolio. They rely on this to help them limit interest rate risk. Unfortunately, it did not work in Q2. An unfavorable change in basis on their adjustable MBS caught both DX and the market by surprise. This resulted in a $1.27 (12%) loss in economic value for Q2. $430M of additional Eurodollar hedging has been added since then (see AI for how well this worked). DX has significant insider ownership and significant NOL carry forwards.

Anworth Mortgage Asset Corp.

79% adjustable agency / 21% fixed agency MBS

ANH is one of the mREITs who focus on adjustable rates. Unfortunately, that was no place to hide in Q2 as the adjustable MBS suffered a significant unfavorable basis change. ANH lost 88¢ per share in economic value in Q2 or 12.5%. Its adjustable rate concentration, however, has already resulted in an increase in spread which should allow it to maintain its dividend.

Two Harbors Investment Corp.

54% agency/ 46% non-agency and CSLs/ 0% Residential Real properties

(Silver Bay spun off and stock distributed. For those of you in CLNY and BX, it should be interesting that TWO chose to completely distribute the SBY shares.)

TWO is getting into MSRs, Securitization and Credit Sensitive Loans which should help hedge interest rate risk. TWO's hedging includes short TBAs which were not included in my leverage ratio. They lost 41¢ per share of economic value in Q2. TWO does publish a book value exposure estimate which I commend them for; going forward they estimate a 1% change in rates would result in a 9.9% loss to book. However, at the end of Q1 they estimated a 1% change in rates would lead to a slight increase in book value. This did not hold true. TWO is interesting but gets no love from me until they follow through.

MFA Financial

60% agency / 40% non-agency

Special Dividend of 28¢ declared 8/1. If hedging was only applied against agency assets then it would be 50% hedged. 64% of the portfolio is in ARMS and 43% of the total portfolio is in ARMS with less than 2 years to reset. So book and dividend risk isn't as high as it first appears by the data presented. MFA lost 43¢ or 4.9% in economic value in Q2.

Capstead Mortgage

100% agency ARMS

CMO lost 49¢ or 3.6% in economic value in Q2. Very low duration adjustable ARMs protected this portfolio from significant book losses in Q2 despite low hedging (-3.8% due to portfolio + another -2.1% due to preferred capital transactions). Overall, I was surprised by how well this mREIT came through Q2. I was expecting something more like HTS. Low duration adjustable ARMs also mean this portfolio should be quick to reset, improving the dividend risk rating.

New Residential Investment

34% agency ARMS / 19% non-agency ARMs / 26% consumer loans / 19% excess MSRs / 2% other.

In Q2 NRZ added 60% to book due to the increase in value of the MSRs and credit challenged consumer loans it holds. Because of these assets, at first I was hesitant to include NRZ in the mREIT overview. However, it is an mREIT with over half of its portfolio in MBS; and in the end I thought people would want to know. NRZ is one of the few equities with assets designed to increase in value as interest rates increase. It is also likely NRZ will increase its dividend before the year is out. I think of NRZ as a hedge for the interest rate risk in other mREIT holdings. Note however, that the market also values this aspect highly in today's environment. NRZ carries a P/B of 1.4.

Summary of Interest Rate Sensitivity

Likely to increase in value if rates rise: NRZ

Likely to be less effected by continued interest rate increases: AI, EFC, MITT, AGNC, MTGE, and CMO

Likely to lose further book value if interest rates rise again: JMI, ARR, IVR, NLY, HTS, DX, and ANH

Outlook

So, back to our original question, are mREITs a falling knife or a chance to be greedy where others are fearful? In general, I think the latter. The MBS market is one of the most liquid markets in the world, second only to Treasuries. As such, the price of MBS fully reflects the consensus estimate of risks such as Fed tapering. Since mREITs mark to market, their book values already reflect these MBS prices. The current discounts to book therefore represent an opportunity; particularly for those mREITs which have fully hedged their books.

I consider AI, NRZ, EFC, MITT, MTGE, AGNC, WMC and CYS to be buys. The first five are either very significantly hedged against rate increases, or in the case of NRZ, can actually benefit from them. WMC and CYS, while not fully hedged, offer significant reward combined with adequate hedging. JMI, NLY, and HTS in my opinion are sells. Their potential rewards do not overcome the losses they are likely to take if rates continue to rise. The rest I consider holds.

If one does want to hold one of the higher risk but also higher potential reward stocks such as AMTG, ARR or CYS, I would recommend also buying NRZ as an additional hedge against their higher interest rate risk.

Source: mREITs: An Opportunity To Be Greedy When Others Are Fearful

Additional disclosure: I am short NLY via puts.