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In light of the 2013 sell-off in mortgage real estate investment trusts (mREITs), as well as writing articles on my top mREIT holdings, I have been asked about my opinion regarding the movement to wind down Fannie Mae (the Federal National Mortgage Association) and Freddie Mac (the Federal Home Loan Mortgage Corporation) and the move to get these government sponsored enterprises (GSEs) out of the mortgage business. Truthfully, I had not considered the impact, although I was aware of this potential phasing out of Fannie and Freddie.

For those who are unaware, Fannie and Freddie are the two largest GSEs. A GSE is essentially a financial services corporation created by the United States Congress. Their intended function is to enhance the flow of credit to targeted sectors of the economy, to make those segments of the capital market more efficient and transparent, and to reduce the risk to investors and other suppliers of capital. The desired effect of GSEs is to enhance the availability of and reduce the cost of credit to the targeted borrowing sectors primarily by reducing the risk of capital losses to investors.

Without getting too technical, these have been privately owned and publicly chartered, as well as publicly traded companies over the years. Their history is long and complex. Explaining their history and their impact on mortgage lending in the United States is beyond the scope of this article. However, owners of mREITs should be aware that the call for getting Fannie and Freddie out of the mortgage business entirely is gaining momentum. Currently, there are varying forms of legislation that have been going through the legal process in Congress.

The key issue at hand here is that without the federal backing that Fannie and Freddie currently provide for home loans, the 30-year fixed-rate mortgage -- a staple of the American home buying process -- could be phased out in favor of other loans (e.g., 15-year, 20-year, 30-year adjustable rate mortgages, etc.). The purpose of this article is to discuss potential implications of this possibility for the mREITs and how to think about this important issue going forward.

Many mREITs Could Be Impacted

I cannot say for certain what will happen to the many companies that invest in the type of mortgage-backed securities that feature 30-year fixed-rate loans, but I can tell you that my personal investments in the sector could be impacted. Of central concern is the impact on fixed-rate agency investing companies such as American Capital Agency (NASDAQ:AGNC). As I write this article, I have AGNC in mind given that it is my largest position in the mREIT space. However, this analysis is applicable to my second-largest holding as well, Annaly Capital (NYSE:NLY), and will have an impact on those that invest in both agency and non-agency backed securities, such as Western Mortgage Assets (NYSE:WMC), Armour Residential REIT (NYSE:ARR). A hybrid REIT such as Two Harbors (NYSE:TWO) has less exposure, but investors need to be concerned there as well.

Many more companies beyond my investments, which concentrate their holdings in agency-backed paper mortgages, have cause for concern and people should start to do research on what could happen. My recommendation is that everyone reading this article dive deep into their respective mREIT 10-Ks, 10-Qs, and other SEC filings, as well as review conference call transcripts to assess what kind of exposure the stock may have to the potential Fannie and Freddie exit. To start, I looked into the concerns I would have for AGNC. Again, the concern is common to all mREITs with agency-backed security exposure.

Many of the agency mREITs have the same business model, so it is safe to discuss general themes right now that my investigation into AGNC reveals. While there has always been concern regarding the stability and long-term sustainability of Fannie and Freddie, we as mREIT investors must be concerned with the effects on the availability of agency-backed mortgages if the two agencies are eliminated. Of primary concern is the impact of a lack of agency-backed securities in the marketplace. Such a lack will easily affect pricing and volatility of mortgage-backed security values, which could impact the all-important interest rate spread through which the mREITs rely on to generate their revenues and profits.

The resulting volatility that the elimination of Fannie and Freddie will bring to the markets could call into question the value of the existing assets of these trusts. It would not be illogical to assume that if they are grandfathered in, but no longer newly available, that their value will almost certainly deteriorate. Anyone paying attention to my articles over the last few months will know that deterioration of mortgage-backed security values has an immediate and severe impact on a company's book value. Furthermore, book value is the ultimate driver of share price. The decline in the share price of the mREITs over the last few quarters has been driven by the decline in book value, which is a consequence of the deterioration in value of their mortgage-backed security holdings. This has been especially true for the case of AGNC and its main competitor NLY. Certainly, we must consider the consequences to book value if the elimination of Fannie and Freddie will crush the value of mortgage-backed securities currently being held.

Plan Your Exposure Accordingly

Over the last few quarters there has been extreme volatility in response to the belief that the Federal Reserve ceasing asset purchases could hurt the value of mREIT holdings. In turn, we saw spikes in interest rates, declining mortgage-backed security values, and extreme book value erosion. It is my belief that more market fear could ensue among investors in AGNC and similar companies surrounding this issue of Fannie and Freddie. This fear could begin to percolate once there is clearer guidance on the details of a potential exit, as well as a wind down of mortgage issuance and mortgage guarantees. Certainly, this will not happen overnight, but is something that investors should be aware of that could pressure share prices in coming months.

It certainly appears as if Fannie and Freddie will be phased out in time, and mREITs should plan accordingly. This is where management and the overall mREITs business model kicks in. I recommend first that if you are investing in this space you don't over extend your exposure; stay diversified. Second, I recommend picking a few companies to balance some of the intra-company volatility. A $10,000 investment in three mREITs with varying portfolios is stronger than a single investment in one company. That's my opinion. Rather than invest my whole stake in mREITs in AGNC, I also have exposure to NLY, WMC, TWO, and other hybrid and commercial mREITs. Breaking up exposure to several management teams and business models helps balance risk in the space.

Think Ahead

Perhaps most importantly, investors should look to see what their company is doing to plan ahead. I think the stronger companies will be the ones that are successfully diversifying their own portfolios. Right now AGNC concerns me. We really want to see companies mixing up their exposure to agency as well as non-agency backed securities. Also, is the company picking up any commercial exposure? Commercial real estate has yet to pick up real steam, and thus this is where the growth potential really could be. Having some diversified exposure also protects a company's interests. They could look to merge with Gary Kain's other company, American Captial Mortgage Investment Trust (NASDAQ:MTGE), which would provide commercial exposure. This is what NLY did with their CreXus takeover.

Another issue to examine is how hedged a company is, how successful these hedges have been, and what kind leverage the company has right now. Companies that are overextended could be in trouble if they are not successfully rebalancing their portfolios in the aftermath of the last two quarters. Finally, any company that is talking about the agency-backed mortgages potentially being phased out in a few years is probably one to take a serious look at. This means that they are cognizant of any potential issues and likely planning ahead for the possible elimination of Fannie and Freddie.

Source: Is Your Mortgage REIT In Serious Trouble If Fannie Mae And Freddie Mac Are Phased Out?