With an almost 30% reduction in the monthly dividend for the 2013 fourth quarter compared to the third quarter rate, it appears that something may be seriously amiss with the portfolio management and interest rate hedging program of ARMOUR Residential REIT (ARR).
ARMOUR Residential is an agency mortgage-backed securities REIT. That means the company owns a portfolio of Fannie Mae (FNMA.OB, Freddie Mac (FMCC.OB) and Ginnie Mae guaranteed MBS leveraged with borrowed money to increase the net portfolio income. To make leverage work, an agency MBS REIT must borrow at lower, short-term rates to fund the ownership of the longer maturity, higher yield MBS. To protect against the numerous inherent dangers of the lend long, borrow short investment scheme, the REITs hedge against rising interest rates that could drive interest margins to zero or negative.
Interest Rate Hedges Failing to Function
The following thoughts are highly speculative on my part and you can decide if my logic makes sense concerning ARMOUR Residential as an investment. I envision two reasons why the interest rate hedges of a mortgage REIT would fail to protect the company's book value and ability to pay dividends.
The interest rates on MBS cannot be directly hedged. The mREITs are hedging with derivatives on Treasury rates, which have not changed with the magnitude of the changes in mortgage rates. Also, with the higher rates the effective maturities of the agency MBS have been extended by several years, throwing another factor into the hedging equation.
It seems natural to me that the interest rate hedges in a lend long-borrow short portfolio strategy would focus on rising short term rates that would wipe out the spread being earned on the portfolio. However, the short rates have stayed low, and the danger to the mREITs has been falling MBS values rather than a rate squeeze. Any hedges on rising short rates have not produced a profit to offset falling MBS prices.
After several months of this new mortgage rate environment, it has become apparent that successfully hedging the mREIT portfolios takes a bit of art and more than a dash of luck. The 33% share price drop for ARMOUR Residential over the last five months indicates the company came up short on both counts.
Some Bothersome Data Points
As I reviewed recent quarterly earnings press releases as research for this article, a couple of items caught my eye. These are the types that make me wonder if the company management is performing competitively.
I was surprised that the company included neither an income statement or balance sheet on the earnings press release. All of the data seems to be selected to show the company in the best possible light. Also, I could find no indication that the company has a quarterly earnings conference call. If it does, no ongoing record exists.
During the second quarter ARMOUR repurchased 3.4 million shares at an average price of $5.94 per share. The end of the quarter book value was $5.43 per share and now in the latter half of September ARR is trading for less than $4.50. Could have just thrown away $5 million with less effort.
The decline in the dividend rate has been dramatic, yet not a word on the earnings news release about expectations concerning the distribution. Maybe it was discussed during the conference call, if there was one.
Avoid This Falling Knife
The good news for the market about QE-infinity today - Sept. 18 - gave a nice boost to the mREIT stocks. I believe this will be a short term blip in the long-term trend to higher mortgage rates. Current ARMOUR Residential investors should use this mini-rally to cut losses and get out of the shares.
With a share price that has dropped by 40% in a year and a dividend that has been cut by over 50%, I do not see a bottom anywhere close yet for this REIT stock. If the company wasn't paying monthly dividends, the short would probably have the share price well into the $3's. What is now a 13.6% dividend - it was 20% yesterday - is not enough payment to hold shares of ARR.