Agency-Backed Mortgage REITs at a Crossroads

There is no doubt after the third quarter's earnings reports that the agency-backed mortgage REIT sector is beginning to splinter into markedly different strategic approaches. FOMC minutes confirm the high demand for agency MBS, noting that:

To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of $1.25 trillion of agency mortgage-backed securities and about $175 billion of agency debt. The amount of agency debt purchases, while somewhat less than the previously announced maximum of $200 billion, is consistent with the recent path of purchases and reflects the limited availability of agency debt.

Several of the amREITs I follow noted on their conference calls that the prices for hybrid ARMs had gotten absurdly high, into the 105s, with effective yields (net of expected premium amortization) falling below 4%. With seasoned fixed-rate MBS already overpriced, the sector appears to be at a crossroads for strategic direction going forward.

The major players appear to have divided themselves into three camps:

1) Focus on cost of funds through liability management: Annaly Capital (NLY) and Hatteras Financial (HTS)

2) Focus on cost-basis control and prepayment risk: Anworth Mortgage (ANH), American Capital Agency (AGNC), and Capstead Mortgage (CMO)

3) Focus on improving yield through credit risk assumption: MFA Financial (MFA) and New York Mortgage Trust (NYMT)

Rundown of Camp #1 Tactics

Both Annaly and Hatteras appear to remain as active purchasers in the MBS market, with Annaly leaning more toward fixed-rate MBS and Hatteras purchasing hybrid ARMs, both to replace portfolio runoff. These two have focused their strategic efforts on their swap books, attempting to lower their cost of funds through active liability management versus managing the asset side of the book.

Rundown of Camp #2 Tactics

This group has largely sold out of the richly-priced hybrid ARMs, instead seeking current reset ARMs in a bet that the Fed exit from the MBS market in early 2010 will remove the artifical downward pressure on long-term rates. All three companies hope to see a boost in asset yields during 2010 as the current to reset ARMs react to the upwards movement on the long-end of the curve.

Rundown of Camp #3 Tactics

Perhaps the boldest of the three groups, both MFA Financial and New York Mortgage Trust have chosen to diversify away from agency-backed MBS and chase after the non-agency AAA RMBS, which have rallied strongly this year, but they still believe non-agency RMBS provide more upside than the highly-priced agency debt. Both companies have lowered leverage dramatically as a result, but believe that the unlevered returns will still be greater than levering up against agency debt.

Whichever group turns out to be the most correct remains to be seen, but the bets have been placed. I would expect divergence in the stock prices among the sector members as we move through the fourth quarter and gain more clarity on whose strategy is working the best.

Disclosure: Author has no positions in any of stocks mentioned in this article.

Comments

[Crocodilian:]

Thank you for the post. I'd be curious to hear more. I've listened to the NLY and AGNC conference calls, and they've both been profitable investments for me, but I confess to being fuzzy on the differences in strategies.

Can you point to the way you look at reports to discern strategy? These are not the most transparent of entities.

Nov 07 12:26 AM

[Alan Young:]

Thank you for trying to clarify a very lucrative but mysterious sector. I've been puzzled by seeing different REITs, which I thought did roughly the same thing, going marked up and down in price on the same day. Now I begin to understand.

Agreeing with Croc, above, on everything... need more study of annual reports and quarterly conference calls, I guess, but even then, would I understand them without even more background study? I hope you will publish more analysis like this.

Nov 07 03:39 PM

[maryanne:]

thanks for insight into all of them as I own all of them. spreads are not going to remain this juicy forever, the challence is when to get out.

Nov 07 05:24 PM

[6343escortsr:]

MFA has done nothing but go down; however it still pays a good dividend. Hold or sell. Any ideas?

Nov 08 09:16 AM

[beaux:]

Given that NLY is a buyer of fixed rate MBS their risk stems net interest margin compression that results from the repricing of liabilities. NLY's proactive approach to managing/heding this risk is therefore sensible and stratgeic. Also, their running lower leverage while awaiting assets to become available at lower prices/higher yields addresses the asset risk.

In a way I do not see Strategy 1 and 2 as being mutually exclusive -- Strategy 2 simply may just have less duration mismatch risk stemming from shorter duration assets that does Strategy 1. Thus less of a need for liability management.

As for Strategy 3 which is based on stretching for yield -- that one seems most like picking in front of a bulldozer. I say, in the words of Monte Python, "run away".

Disclosure: long NLY.

Nov 08 10:41 AM

[Taymere:]

Actually I think MFA's strategy (3), like IVR's, is more conservative than the others. Some day years from now, when the Fed has printed enough money to make it possible from a capital ratio perspective to do so, the banks will stop extending and pretending and start foreclosing. When they do, agency MBS prepayments and yields will spike leaving the agency only mREITS with an underfunded dividend. That would be the right time for MFA to load up on agency MBS and by staying relatively unlevered now they retain the ability to buy heavily later.


On Nov 08 10:41 AM beaux wrote:

> Given that NLY is a buyer of fixed rate MBS their risk stems net
> interest margin compression that results from the repricing of liabilities.
> NLY's proactive approach to managing/heding this risk is therefore
> sensible and stratgeic. Also, their running lower leverage while
> awaiting assets to become available at lower prices/higher yields
> addresses the asset risk.
>
> In a way I do not see Strategy 1 and 2 as being mutually exclusive
> -- Strategy 2 simply may just have less duration mismatch risk stemming
> from shorter duration assets that does Strategy 1. Thus less of
> a need for liability management.
>
> As for Strategy 3 which is based on stretching for yield -- that
> one seems most like picking in front of a bulldozer. I say, in the
> words of Monte Python, "run away".
>
> Disclosure: long NLY.

Nov 11 03:52 AM