The shellacking agency mREITs such as Annaly (NYSE:NLY), American Capital Agency (NASDAQ:AGNC), Armour Residential (NYSE:ARR), and Hatteras (NYSE:HTS) have received is almost entirely explained by four factors:
1) The rapid increase in interest rates
2) Management's reaction to this event
3) The belief that rates will continue to rise rapidly in the future
4) The belief that mREIT book values will be equally impacted by future rate increases as with past increases
Through this article, I will show that these four factors are truly the fundamental reasons for mREIT stock price declines and that each of them will no longer be true going forward.
Rapidly Increasing Rates Cause a Downward Spiral
Agency mREITs were performing swimmingly until early May 2013 when earnings releases showed chinks in their armor. Their book values were shown to have suffered from Q1's interest rate volatility, even though rates were only a ¼ percentage point higher at the end of the quarter than at the start. Management at mREITs such as AGNC had made the classic mistake of extrapolating the past indefinitely into the future. Management was entirely positioned for continued extremely low rates and their primary concern was guarding against pre-payments.
While rates had settled down by early May 2013, Q1's volatility was just the prelude. Treasury rates climbed higher rapidly over the next four months, putting in an intermediate-term peak in early September 2013. While slowly increasing long rates coupled with stable short-term rates help mREIT earnings power by increasing spreads, a rapid rise wreaks havoc with their business model.
A rapid rise decreases the value of an mREITs' assets quickly, increasing their leverage ratios, making management very nervous and potentially putting mREITs in violation of agreements to maintain leverage ratios within prescribed bands. When rates rose, the only way to bring leverage ratios back into norms was to sell assets (namely, Mortgage Backed Securities or MBS) into the teeth of a vicious decline. This unfortunately timed selling caused a downward spiral in prices as MBS values fell further, prompting further selling, causing further price declines.
The downward spiral and panic-selling of MBS caused Dislocation #1. The spread between Treasury rates and their credit-risk-free agency MBS equivalents widened beyond historic norms. Folks wanted out of MBS at any price.
Management Panics, Possibly Out of Self-Preservation
While some selling was forced, management exacerbated the issue by panicking. They once again extrapolated the past into the indefinite future and prepared for a world in which rates climb ever upward at a rapid rate. They sold even more assets than was required by their need to bring leverage ratios within bounds. Additionally, they put on maximum protection (hedges) against further rate increases - turtling at the precise moment when it pays to take on risk. The pain was too great to bear and management wanted out of interest rate risk at any price. As a result, mREIT book values dropped farther and faster than the rise in interest rates alone would dictate. Treasury rates ended Q3 pretty much in the same place as the end of Q2 but mREIT book values dropped farther.
Management's moves had a basis in rationality. Remaining exposed when blood is running in the streets is risky and could put the entire business in jeopardy. If the rise in rates continued at their historic speed, losses could be so severe that the patient bleeds to death before there's a chance of recovery. Perhaps, it's better to stage a retreat and live to fight another day. Management's incentives have far greater alignment with the goal of self-preservation than the goal of maximizing alpha and expected shareholder value.
Quite simply, zero is an absorbing state - while diversified investors can accept the risk of not backing down when their opponent goes all-in if the potential reward is commensurate with the risk, management only enjoys fat fees so long as the business is standing. Management's downside is life-changing but their upside is more limited. They get paid well even if the stock price declines.
Mortgage REIT Stocks on the Discount Rack
Agency mREITs now trade at significant discounts to their book values, often exceeding the 10% discount that historically signaled the lower bound of the book-to-stock price ratio (mREITs historically trade between 90% and 110% of their book value). This is Dislocation #2 and this discount is caused by two factors:
1) A belief that rates will continue to rise, further decreasing book values. Based on this theory, the gap between book prices and stock prices will be eliminated by declines in book values
2) The elimination of any premium ascribed to the value added by management. In fact, some would argue that management's recent missteps mean that they subtract value from the underlying assets, thus partly explaining mREIT stocks' discounts.
The Way Forward for Rates: Part I - The Surprising Anti-Climactic End of QE
The million dollar question for mREITs is - "what happens to treasury rates?", since rates are correlated with MBS prices, which are correlated with mREIT book values, which are correlated with mREIT stock prices. Conventional wisdom is predicting that the current trading range for rates will be broken to the upside as rates shoot higher, causing book values to plunge. The rationale for higher rates seems clear - while there has been a delay in the Fed's tapering of asset purchases, that delay is only temporary. Tapering will happen in early Spring, or by the latest, early summer and whenever that happens - lookout below! The experts are predicting a "bond market hell" next year. As bond prices plummet, conventional wisdom says we'll see mREIT book values decline again, partly explaining the mREIT stocks' discount.
But, the herd is often wrong and investing with them is no way to generate alpha. What conventional wisdom is missing is that Quantitative Easing (QE) has been shown to be largely ineffective at influencing rates:
So by now it should be no surprise that more than one scholarly paper presented at the big central banker and academic shindig in Jackson Hole last month showed exactly that: QE doesn't actually do anything beyond "signaling" Fed intentions about the future path of Fed policy. Which is all a bit shocking, as the FOMC has clearly signaled that QE does operate through actual 'monetary channels' beyond the 'signaling' Fed hopes and prayers. In fact it's not wrong to call QE a placebo.
In fact, any impact on rates is caused by the placebo affect:
That is, when the Fed administered the QE placebo pill, portfolio managers investment decisions and 'indifference levels' (market prices) shifted accordingly, as did economic forecasts, including the Fed's own forecasts as more evidence they all believed in the QE Fairy.
We hear the talk continuously. The economy is on life support. It's all a sugar high that ends when the Fed takes away the punch bowl. The 'exit strategy' will be a critical, dangerous operation that could end in tears. All from a placebo!!! This is madness. History will not be kind to any of these people.
None of this should come as a surprise after the San Francisco Fed's groundbreaking research showing that an asset purchase program by the Fed of $600B (such as QE2) has only half the effect of a 0.25 interest rate cut:
Our model estimates that such a program [as QE] lowers the risk premium by a median of 0.12 percentage point… The 0.13 percentage point median impact on real GDP growth fades after two years. The median effect on inflation is a mere 0.03 percentage point… Figure 2 shows the effects of a standard 0.25 percentage point temporary federal funds rate cut. GDP growth increases about 0.26 percentage point and inflation rises about 0.04 percentage point. This suggests that a program like QE2 stimulates GDP growth only about half as much as a 0.25 percentage point interest rate cut… Research suggests that the key reason [QE] effects are limited is that bond market segmentation is small.
Bear in mind that a 0.25 interest rate move is considered such a small move that the Fed typically does not change rates in increments less than that. The effect of QE is a rounding error compared to the impact of the Fed's Zero Interest Rate Policy (ZIRP). QE will not end with a spike in rates and bondholders in tears. It will end with a whimper from the drama queens who are expecting fireworks.
The Way Forward for Rates: Part II - A Catalyst in the Form of Increased Forward Guidance
It's widely known that the next Fed Reserve Chair, Janet Yellen, is as dovish as they come at the Federal Open Market Committee (FOMC). As such, Mr. Market is discounting a delay to the Fed's tapering until March or April 2014. But, is that all we should expect from a dove who is widely known to favor low unemployment over price stability? Probably not. However, given the ineffectiveness of QE, what other tools are at Ms. Yellen's disposal to drive down unemployment? The New York and San Francisco Feds provide an answer:
New research from the Federal Reserve Bank of New York offers a strongly positive take on the central bank's efforts over recent years to provide ever more refined guidance about the longer run outlook for short-term interest rates. At issue is what central bankers call "forward guidance." That's their term of art for trying to describe the likely course of future Fed policies.
The effects [of QE] appear to depend greatly on the Fed's guidance that short-term interest rates would remain low for an extended period. Indeed, estimates from a macroeconomic model suggest that such interest rate forward guidance probably has greater effects than signals about the amount of assets purchased… This suggests that communication about the beginning of federal funds rate increases will have stronger effects than guidance about the end of asset purchases.
Put this all together - combining Ms. Yellen's propensity for policy accommodation with the ineffectiveness of QE and the strong effect of forward guidance - and it's easy to see that the base case scenario should be the replacement of QE with increased forward guidance. Specifically, Ms. Yellen could lower the threshold at which the Fed will start raising rates from 6.5% to 6% or 5.5%. Multiple sources confirm this as a strong possibility and recommended policy:
Separate papers that will be presented formally this week at an International Monetary Fund meeting suggest that the U.S. central bank should lower its target for the jobless rate before it hikes rates… Under current Fed thinking, the unemployment rate would have to drop to just 6.5%-with the inflation rate rising to 2.5%-before making changes in the present structure, which has the policy target rate near zero. But the research from a half-dozen Fed economists maintains the unemployment objective actually should be lowered to 6.0% or even 5.5% before it makes any moves.
Economists at Goldman Sachs have been monitoring the internal Fed analyses over what would constitute a safe unemployment rate, and said in a paper published Tuesday that the threshold is probably 5.5%. That analysis is influenced by two recent papers from Fed economists that concluded waiting for a lower rate would have greater economic benefits… "Although our analysis is subject to significant uncertainty, our results suggest that taking into account adverse supply side effects--by aiming to normalize both the unemployment and participation rates--strengthens the case for lowering the 6.5% unemployment threshold," Stehn said. "Our small model suggests that the most desirable unemployment threshold in this case would be around 5.5%."
"The FOMC, and especially a Yellen-led FOMC, will put a lot of weight on the employment side of its mandate and it's going to take a long time to get unemployment down to where the Fed wants it to be," said Goldman Sachs chief economist Jan Hatzius in a recent webcast. Hatzius said he expects the Fed to cut its threshold for unemployment to 6% from 6.5%. The U.S. unemployment rate currently stands at 7.3%.
The way forward for rates is that yields will remain low and even if they do rise, it will not be by much. This Treasury trader summarize my view well:
For the bond market, which suffered a number of doomsday predictions for 2013 that never materialized, that means yields could also remain low. Even if they do rise, it might not be by much, since benchmark 10-year yields have already had a 100-plus basis point increase from lows hit in May.
"The Fed under Janet Yellen will be committed to a very low federal funds rate for several more years," said Jake Lowery, Treasury trader and portfolio manager for global interest rates at ING U.S. Investment Management. "That commitment to low rates is much more important than the precise timing of tapering," Lowery said.
The Way Forward for mREIT Stocks
Clearly, there is a disconnect between the assumptions built into mREIT stock prices - a rapid rise in interest rates in reaction to the Fed taking away the punch bowl - and the likely course of interest rates. However, don't expect an immediate turnaround in mREIT stock prices as those assumptions unwind for the following reasons:
1) Damaged Investor Psychology - mREITs traditionally have heavy retail presence as their high dividends are appealing to retirees and folks not equipped to predict the direction of stock prices. As mREIT stock prices have plummeted, many of these retail shareholders realized that they don't understand what they own and in fact, mREITs are extremely complex trusts that are not suitable for ownership by most retail investors. These investors are in despair as they held onto the stocks too long since they relied on the dividends for living expenses but now that dividend cuts have caught up with stock price declines, they are throwing in the towel.
Furthermore, mREIT stock charts and price action are downright atrocious. There is heavy overhead resistance, and bagholders will bail on every uptick.
2) Tax Loss Selling - typically continues through the middle of December.
3) Loss of Confidence in mREIT Management - As noted above, mREIT management has been less than stellar through this period of volatility. It will take time for them to prove that they add value to mREIT assets.
4) Continued Drag From Asset Sales - As noted above, most mREITs have sold large amounts of agency MBS which means they will be earning less spread income for every dollar of equity.
Instead, the way forward for mREIT stock prices is a flat stock price for 2-4 months before an upward rise for the following reasons:
1) Conventional Wisdom Needs to be Unwound - It will take time for the naysayers to be proven wrong.
2) Management Needs to Regain Investor Trust - This probably won't happen until investors see the dividends and book values stabilize over the course of 1-2 quarters.
3) Management Needs to Re-Lever - Unfortunately, management bought into the conventional wisdom of higher rates but as they realize it's wrong, they will start increasing leverage. Or, at the very least, they will need to buy additional assets just to maintain their current leverage ratios as MBS prices (and book values) rise.
While it may be a few months before mREIT investors will see significant share price appreciation, in the meantime investors enjoy a double digit dividend yield that makes waiting a whole lot easier. That said, a significant catalyst is on the horizon that could speed up this timetable - the extension of forward guidance from the Fed by lowering the unemployment threshold for raising rates.
Note: This analysis is also largely applicable to hybrid mREITS with a large portion of their portfolio in Agency MBS such as American Capital Mortgage (NASDAQ:MTGE), Invesco (NYSE:IVR), CYS Investments (NYSE:CYS), and to a lesser extent, MFA Financial (NYSE:MFA).
Disclosure: I am long AGNC, NLY, MFA. 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.