Don't Be Greedy: mREITs Still Have Room To Fall

 |  Includes: AGNC, ARR, CYS, HTS, IVR
by: Thomas Bradshaw

On Monday, August 12th, an article was published on Seeking Alpha titled "mREITs: An Opportunity To Be Greedy When Others Are Fearful". The article presented a table showing the difference between book value and share prices of several mREITs and the author ultimately recommended buying several mREITs.

I am on the other hand very skeptical of the mREIT market right now. Everyone that has been following mREITs knows that share prices have been hit hard since the Federal Reserve's May 22nd statements about possible future tapering of asset purchases. Of course the statement was vague, and had no particular timing or volume details, but nevertheless Treasury rates took dramatic swings and so did agency backed mortgage securities. I compiled a graph showing the change in mREIT share prices [the indexed average of the share prices of ARMOUR Residential (NYSE:ARR), American Capital Agency (NASDAQ:AGNC), CYS Investments (NYSE:CYS), Invesco (NYSE:IVR), and Hatteras (NYSE:HTS)] compared to the change in the 10 and 30 year Treasury rates (reverse indexed so an increase in rate shows up as a decreased index value on the graph).

mREIT ratesClick to enlarge
(Click to enlarge)

It is quite clear that mREITs follow interest rates closely, being particularly drawn to the 30 year maturity since that is the common base interest rate in residential mortgages. I notice however that mREITs decline almost identically with 30 year rates in June, yet in the following months don't quite see the dramatic decline that the 30 year index sees. Is this perhaps because of successful hedging? I am not quite sure.

Regardless of the separation between mREIT share prices and interest rates in the last month or so, I still see a clear declining pattern in both bond values and mREIT share prices. As the Federal Reserve releases more information on what the taper will look like, interest rates will take another big bump. After the Fed tapers, they will eventually bring their asset purchases to a close and interest rates will take another jump and mREITs will take another hit. After the Fed has closed their asset purchase program and when the economy begins to look like it can support itself sufficiently, the Fed will begin to bring the targeted Federal Funds Rate back up to normal levels, and rates will most likely see another hit and mREITs will get hit as well.

The other thing that we all don't know about the Federal Reserve's taper plans is how exactly they plan to taper. Suppose the Fed announces that they are going to taper by continuing to purchase $45 billion a month in Treasuries and completely stopping their $40 billion a month in agency MBS purchases. If that were to happen mREITs would be hit hard, much harder than Treasuries, and interest rate hedges wouldn't properly hedge against the hit to asset values in the MBS market. I could see this as a real possibility because the Federal Reserve may have concern over the interest rate burden of public debt.

The other aspect that worries me about the mREIT market is that lots of them use repo financing, meaning that they sell some securities to an investment bank with the promise to repurchase them at a set price in the near future. Suppose I give $100 worth of securities to an investment bank with the promise to repurchase them in a month for $110. If during that month the value of those securities falls by 10%, I still have to repurchase them for way over market value. To make problems worse, when I need to rollover my debt I will only have $90 worth of securities to borrow with and in a downward market I will quickly lose my ability to finance my operations if I continue to use repo.

There is a reason that mREIT dividends are at unbelievable prices right now, and I personally am not going to be greedy, I am going to play it safe.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within 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.