mREITs Trading At Steep Discounts To Book Value Violates Efficient Market Theory

by: Lance Brofman

Many mREITs are trading at steep discounts to book value. American Capital Agency Corp. (NASDAQ:AGNC) has stated that its latest book value is $25.27 and the stock last traded at $19.59. The generally accepted explanation for the discount to book value is that most investors think that interest rates are headed higher. However, this would appear to be a violation of Modern Portfolio Theory, the Capital Asset Pricing Model and the Efficient Market Hypothesis. See: 30% Yielding MORL, MORT And The mREITs: A Real World Application And Test Of Modern Portfolio Theory for an explanation of Modern Portfolio Theory.

Clearly, if investors thought the stock market was headed lower, one would not expect to see the SPDR S&P 500 Trust ETF (NYSEARCA:SPY) or even the Direxion Daily S&P 500 Bull 3X Shares ETF (NYSEARCA:SPXL), which is leveraged 3X, to trade at any significant discount to book value. Thus, if investors were negative on the prospects for common stock, both the ETFs and the underlying shares would be equally depressed.

The reason why ETFs comprised of common stocks can never trade at prices that deviate much from book value is that in some cases holders can create or redeem new shares, and even where that is not possible investors can undertake arbitrage whereby they either own the underlying shares and short the ETF or vice versa. The same is true for closed end bond funds for the most part.

The possibility of arbitrage is also why mREITs do not trade at very large premiums to book value. Investors could short the overpriced mREITs and go long mortgage securities that emulate the portfolio. The mREITs themselves are more than happy to issue new shares in secondary offerings when the market price of their shares is above book value. Additionally, investment bankers tend to create new mREITs when existing ones are trading for more than book value. This is all consistent with efficient markets. Even if investors were overwhelmingly convinced that the underlying portfolios of mREITs were going to increase sharply, arbitrage opportunities would prevent the mREITs from trading much above book value for an extended period of time.

The question is why arbitrage opportunities have not prevented mREITs from trading at significant discounts to book value recently. There has been some arbitrage by the mREITs themselves. See mREIT Stock Buy Backs: The Impact On Dividends. However, unlike most public companies, the incentives are skewed against the management of mREITs doing share buybacks.

With regular public companies the management has various incentives to buy back shares, including boosting the share price and thus their stock options and/or share appreciation rights and increasing earnings that could affect their bonuses. Not to mention possible free super-bowl tickets from the brokerage firms that execute the buybacks.

With mREITs, especially externally managed ones, there are many disincentives to buybacks in that their compensation depends on the size of the net asset under management and buybacks reduce that aggregate amount even if they increase the net asset value per share.

Thus, I am a little surprised at the amount of buybacks we have seen so far. This suggests that when discounts to book value are as steep as they are now, management may put the shareholders' interests ahead of their own.

The more interesting question is why other market participants have not as of yet undertaken arbitrage opportunities to take advantage of the sharp discrepancy between the share prices and book values of mREITs, by purchasing the shares and simultaneously shorting the underlying positions.

For individual investors, shorting mortgage securities is problematic. However, for many institutional market participants, shorting a portfolio that mirrors the holdings of a relatively straightforward mREIT such as AGNC or Cypress Sharpridge (NYSE:CYS) would not be too difficult. Goldman Sachs Group Inc. (NYSE:GS), Citigroup Inc.(NYSE:C), Bank of America Corporation (NYSE:BAC) and Morgan Stanley (NYSE:MS) and others most likely hold and make markets in every type of mortgage securities and derivatives such as swaps, swaptions and futures that AGNC and CYS hold in their portfolios. Even participants such as PIMCO and Berkshire Hathaway Inc. (NYSE:BRK.B) could easily engage in that sort of arbitrage. Dealing with the repo positions of the mREITs would be particularly easy since the large banks are now major counterparties to the mREITs repo borrowing.

Creating a mirror image short portfolio for mREITs such as Annaly Capital (NYSE:NLY) and Armour Residential REIT Inc. (NYSE:ARR) which hold some non-agency mortgages would be more difficult but it could be done. For mREITs like RAIT Financial Trust (NYSE:RAS), which own some actual physical real estate, an exact mirror image short portfolio would be difficult to create.

There might be some regulatory impediments to emulating a mREIT's portfolio from the short side and buying the shares to lock in arbitrage opportunities. BAC might have some of the mortgage securities in their bank operations while the derivatives might be in their Merrill Lynch brokerage division. In most cases, the large institutions would not have to borrow the securities to create short positions. Instead of shorting a particular mortgage security, they could simply reduce the size of the position in that security they already own.

There may be some reluctance to engage in this type of arbitrage because of mark-to-market regulations that would apply to long positions in the mREIT shares as well as some of the other positions that would be established to do the arbitrage. The statement, "Markets can remain irrational longer than you can remain solvent" attributed to John Maynard Keynes holds powerful sway on Wall Street.

My conclusion is that steep deviations between market prices and book values cannot long endure where some type of arbitrage is feasible. If one wanted to take advantage of the potential appreciation that could result from a convergence of book values and market prices, one could use the pure agency mREITs such as AGNC and CYS or baskets of mREITs such as ETRACS Monthly Pay 2xLeveraged Mortgage REIT ETN (NYSEARCA:MORL) and Market Vectors Mortgage REIT ETF (NYSEARCA:MORT) and iShares Mortgage Real Estate Capped ETF (NYSEARCA:REM). There are distinct advantages to diversifying as opposed to buying individual mREITs.

Even if the market believes long-term interest rates are headed higher, that is not a rational reason for the mREITs to trade at steep discounts to book value. According to Modern Portfolio Theory, if that was investors' belief, then the prices of the securities and derivatives that comprise the mREITs portfolio should be equally depressed and the book values and market values of the shares should be close. As I indicated in: Federal Reserve Actually Propping Up Interest Rates: What This Means For mREITs an increase in long-term rates while short-term rates remain unchanged would result in higher spreads and yields for the leveraged mREITs.

Disclosure: I am long MORL, AGNC, RAS, CYS, ARR. 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.