Housing Double-Dip Fears Further Non-Agency Paper Weakness

by: Zvi Bar
I recently wrote an article discussing potential non-agency mortgage REIT risk on the horizon. Several non-agency mREITs have now continued to perform poorly, further diverging from agency mREITs. This difference appears to highlight a significant expectation that real estate will sustain a second move downward in the near-term.
The primary specific risk appears to be within non-agency mortgages. Without an agency backing, defaulting mortgages end up providing no payments and a considerably reduced value. Also, the underlying equity may not provide sufficient funds to satisfy the present value. Some non-agency paper is already priced to assume significant default likelihood upon a rate increase and/or continued depreciating prices.
Three well-known non-agency mREITs are Chimera Investment Management (NYSE:CIM), MFA Financial (NYSE:MFA) and Redwood Trust (NYSE:RWT), though these companies also can and do buy large positions in agency paper. These non-agency REITs have performed poorly in the short term on little to no news, and this performance appears to indicate increased market concern over this risk.
Their five-day chart:
[Click all to enlarge]

This poor performance appears over concerns that real estate will sustain a second move downward in the near-term. In contrast, agency paper has appreciated.
Agency mREITs & Spread Risk
Another risk is borne by the agency mortgage market. Agency mortgages are considered virtually risk-free, because U.S. agencies have guaranteed to step in and make payments to the lender on behalf of the non-paying borrower that they backed. These agencies can also choose to buy out the mortgage, and they often do exactly that after a borrower’s continued default for several months.
Three well-known agency mREITs are Annaly Capital Management, Inc (NYSE:NLY), American Capital Agency Corp (NASDAQ:AGNC) and Hatteras Financial Corp (NYSE:HTS). There is always a minor risk that this whole market may become altered by future regulations to and/or agency interaction in mortgages, but such would likely only apply to future paper and not alter already existing guarantees.
An issue to several of the mREITs is the risk that interest rate changes will reduce future spreads. The market anticipates interest rate increases in the coming quarters and/or years, and another large wave of adjustable rate mortgages (ARMs) are scheduled to reset in 2012. Higher rates are generally expected to lower mREIT spreads. The performance of agency mREITs, which presently use high leverage to multiply this spread, indicates little market concern over dramatic spread changes.
Recent Market Activity Shows Increased Preference for Agency Paper
The past year was a relatively stable year for most mREITS, with most paying high dividends and also showing mild appreciation. Over the past quarter, of those named above, agency mREITs’ shares notably outperformed non-agency mREITs.
A three-month chart:
This divergence in performance should not be terribly unexpected. U.S. property values continue to depreciate and coming defaults and foreclosures appear increasingly likely. At some point, long term buyers may find discounted mortgage paper an attractive investment. Some non-agency paper and mREITS now offer yields in the double digits, which is abnormally high even for junk bonds. Exposure to non-agency mREITs should be limited to a reasonable percentage of a portfolio.
Disclosure: I am long NLY, CIM.