Can mREITs Live Happily Ever After?

Includes: AGNC, CYS, MORL, NLY
by: Lance Brofman


There are various scenarios where highly-leverage mREITs could continue to deliver very high returns over an extended period.

Even if interest rates were to return to what many consider normal levels, highly-leverage mREITs could still do well.

There are many reasons why the Federal Reserve could be hesitant to raise interest rates or only do so in a very gradual manner.

Many consider investing in mREITs to be somewhat like "picking nickels off of the subway tracks." That is, you will get easy high returns for a while, but eventually be run over by a train. The basis for this view is that when interest rates eventually rise from their very low levels, highly leveraged mREITs will be crushed.

Investors with that view are content to allow others to collect double-digit yields form mREITs such as Annaly Capital (NYSE:NLY) and American Capital Agency Corp. (NASDAQ:AGNC) and they surely shun even more highly leveraged securities such as ETRACS Monthly Pay 2x Leveraged Mortgage REIT ETN (NYSEARCA:MORL).

The naysayers on highly leveraged mREITs consider it just a matter of time until higher interest rates bring grief to those who invest in them. They point to the "taper tantrum" in the Summer of 2013, where just the thought that the Federal Reserve would reduce their purchases of treasuries and agency securities caused a sharp spike in bond yields, which resulted in losses of more than 30% for the highly leveraged mREITs. They point out that all of this happened before the Federal Reserve has even begun to raise short-term rates.

A bad ending for highly leveraged mREITs is not necessarily preordained. There are definitely some scenarios where highly leveraged mREITs can go on delivering high returns for extended periods of time. The obvious winning case for mREITs would be a Japan-like situation where extremely low interest rates have existed for more than 20 years now. Some observers think that Europe may be entering a Japan-like situation. The possibility that the US might have a Japan-like extended period of low interest rates was discussed in my article, A Depression With Benefits: The Macro Case For mREITs.

Even those who are bearish on highly leveraged mREITs would agree that an extended period of very subdued economic activity would make highly leveraged mREITs a very good investment. They just do not see such a long period of below normal growth as likely. Another view held by some who are bearish on highly leveraged mREITs is that even if economic growth does not return to normal, inflation will soon (or in the minds of some conspiracy theorists already has) reach levels that will force the Federal Reserve and/or the markets or both, to raise interest rates. In most cases, the basis for the belief that inflation will soon or is already (official government inflation statistics not withstanding) be at unacceptable levels is that the Federal Reserve has greatly expanded the money supply.

If one believes, as Milton Freidman espoused, that inflation is at all times a monetary phenomena, then the expansion of the traditional measures of money such as M1 since 2008 should result in substantial inflation. Those who think that the huge increase in M1 should have resulted in more inflation are somewhat perplexed that it has not occurred already. The conspiracy theorists think high inflation has already occurred, but that the government figures are inaccurate.

My view that the traditional fiat money measurements like M1 are not useful today because we are no longer on a fiat money system but rather on a credit money system even though some fiat money still exists, is explained in my article: Federal Reserve Actually Propping Up Interest Rates: What This Means For mREITs.

Separate from my view that fiat money measurements like M1 are not useful today because we are no longer on a fiat money system but rather on a credit money system, is my view that inflation is usually not a monetary phenomenon, at least in developed countries with independent and well run central banks.

I have a different view of what causes inflation in developed countries with independent and well-run central banks. I believe inflation is mostly caused by government policies that allow rent-seeking behavior by powerful special interests.

The effective money supply is the sum of fiat money and credit money. Credit money cannot be precisely measured. A reasonable ballpark estimate of the credit money supply is that it was $70 trillion in 2007 compared to $50 trillion today. Adding in the increase in fiat money as measured by M1, which increased from $1.4 trillion in 2007 to twice that today, that makes the effective money supply still lower now that in 2007.

A potentially bullish case for highly leveraged mREITs can be made based on the scenario that there will be a prolonged period of low growth and very low interest rates, as has been the case in Japan for more than twenty years. Another potentially bullish case for highly leveraged mREITs could be made on the basis that inflation is much less a monetary phenomenon and much more a function of government and/or union power. Various factors such as the repeal of some of the worst of the government inflation causing policies, globalization, the internet and the decline of unions in the private sector have combined to keep inflation low even as the M1 money supply has more than doubled since 2007. Even those most bearish on highly leveraged mREITs would have to concede that without a significant increase in inflation from present levels, the prospects of much higher interest rates are not very likely.

The potentially bullish cases for highly leveraged mREITs based on the scenarios that there will be a Japan-like prolonged period of low growth or that inflation is much less a monetary phenomenon and much more a function government and/or union power, are not what I am focusing on now. Rather, there is a different argument as to why highly leveraged mREITs can continue to provide high returns even if interest rates return to "normal," as Janet Yellen promises will happen. This does not require someone to accept any "this time it will be different" arguments and still allows one to accept the premise that interest rates will return to normal.

Clearly, today's interest rates are below what is normal if we consider normal to be the averages of the last 30 years or 20 years or 10 years. The table below shows the average treasury bond, bill and note interest rates for the last 30, 20 and 10 years periods and the most current July 2014 figures. The spreads between 30-year bonds and three-month treasury bills and 10-year notes and three-month treasury bills are also shown. It is the spreads that are most significant for highly leveraged mREITs that make money on the difference between yield on their longer-term interest earning assets and their cost of funds.

The highly leveraged mREITs typically invest in mortgage-backed agency securities that pay about 50 basis points above treasury securities with similar maturities. Their cost of funds, before hedging, to finance those mortgage-backed agency securities is usually about 20 basis points above three-month treasury bills. However, recently the spread on their cost of funds has been somewhat higher as treasury bill rates have been so low. Recently some mREITs such as Cypress Sharpridge Investments (NYSE:CYS) have been buying some treasury bonds rather than mortgage-backed agency securities, citing favorable spreads on an historic basis, along with better financing and lower hedging costs.

Average Treasury Interest - Rates Periods Ending July 2014
Period 30 year Bonds treasury bills spread bonds-bills 10-year notes spread notes-bills
Last 30 years 6.17 3.79 2.38 5.72 1.93
Last 20 years 5.01 2.7 2.31 4.45 2.14
Last 10 years 4.1 1.47 2.63 3.37 1.9
Current July 2014 3.24 0.02 3.22 2.45 2.43

The key driver of earnings of the highly leveraged mREITs is the spread between the short-term rates they pay and the long-term rates received on their interest-earning assets. The table above shows that over the last 10, 20 or 30 year periods the treasury spreads have been close to, but lower than the July 2014 figure. However, that is not the entire story. The actual costs that are subtracted from the yield on the highly leveraged mREITs interest-earning assets used to compute the interest rate spread includes the cost of hedging. With interest rates at very low levels, the highly leveraged mREITs are spending much more on hedging. For example NLY reported that for the quarter ended March 31, 2014, the annualized yield on average interest-earning assets was 3.21% and the annualized cost of funds on average interest-bearing liabilities, including the net interest payments on interest rate swaps used for hedging interest rate risk, was 2.31%, which resulted in an average interest rate spread of 0.90%. The weighted average interest rate on the repurchase agreements that NLY used to finance its portfolio was only 0.65%, so the hedging cost was 1.66%

It is logical that highly leveraged mREITs will pay much more to hedge the risk of interest rates rising using swaps, futures and options when interest rates are historically very low as compared to when rates are normal. Thus, the net after-hedging cost net spread for the highly leveraged mREITs will likely be at least as high as current levels if and when interest rates return to normal. If the net after-hedging-cost interest rate spreads remain at least at current levels, the earning power of the highly leveraged mREITs would not be negatively impacted by a return to normal interest rates. Even if higher than normal interest rates, such as those that prevailed in July 1984 occurred, spreads could be maintained. The July 1984 rates of 30-year treasury bond rates at 12.87% and three-month treasury bills at 10.40% for a spread of 2.47%, would allow highly leveraged mREITs to earn amounts similar to what they do today. Furthermore, during periods of high interest rates, the spreads between mortgage-backed agency securities and treasury securities with similar maturities typically widen.

During the rare periods of inverted yield curves, when the Federal Reserve is raising short-term rates above long-term rates in a desperate effort to push up unemployment to control inflation, the highly leveraged mREITs would forgo the use of leverage. Under those circumstances, they would not have any cost of funds. Their yields would simply be the yields on their portfolio securities, which would certainly be double-digit under those high interest rate circumstances.

Even if highly leveraged mREITs can have double-digit yields at any level of interest rates, that does not mean that interest risks do not exist. The summer of 2013 certainly demonstrated that. The key is the perceived or actual path that an increase in rates takes. A very sharp actual or expected increase in interest rates will reduce the value of the highly leveraged mREITs' portfolio securities much faster than they can benefit from the increase in the yields on the portfolio securities. This can cause forced liquidation as the highly leveraged mREITs attempt to reduce their leverage.

The risk is not that interest rates rise, but rather that they do so rapidly. I would assert that, if over the next 30 years both long- and short-term interest rates were to return to levels that existed 30 years ago, when 30-year treasury bond rates were 12.87% and three-month treasury bills were 10.40%, but did so in a smooth gradual pace, highly leveraged mREITs would do just fine, if not great.

Those who may have shorted NLY under $10 or MORL under $17 are now probably aware that the markets can overreact to a fear that interest rates will rise sharply. However, if the Federal Reserve does not validate that fear by actually raising the short-term rates that they control, securities such as highly leveraged mREITs will usually eventually deliver good returns.

For various reasons I think that the Federal Reserve and in particular Janet Yellen believes that they have won the war against inflation and that any increase in interest rates engineered by the Federal Reserve will be a kind and gentle tightening over an extended period. Additional theories have been put forward as to why the Federal Reserve will be very hesitant to raise interest rates. One reason why the Federal Reserve might hesitate to raise interest rate is the consequences that higher interest rates would have on the Federal Budget deficit now that the amount of treasury debt held by the public has ballooned.

Even if the Federal Reserve was not concerned with the Federal Budget deficit, it might be concerned with its own balance sheet and income statements. Now that the Federal Reserve has adopted the despicable policy of paying banks interest on reserves deposited at the Federal Reserve, after not doing so over for almost 100 years, they may be concerned that the Federal Reserve will no longer earn an arbitrage between reserves on deposit, which previously had no cost, and the interest bearing assets on the Federal Reserve's balance sheet. I use the word "despicable" since the policy of paying interest on reserves is simply a transfer from the American taxpayers to the banks. Another concern that might motivate the Federal Reserve to think twice before increasing rates would be the possibility that the hundreds of billions in treasury securities and mortgage-backed agency securities on the Federal Reserve's balance sheet as a result of the quantitative easing, could experience losses were interest rates to rise. This could be embarrassing to the Federal Reserve were it forced by Congress to undergo a mark-to-market audit. Thus, for various reasons it is possible that investors in highly leveraged mREITs could live happily ever after, or at least for the foreseeable future.

Disclosure: The author is long AGNC, CYS, MORL. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.