Mortgage REITs: Where Danger Lurks

by: Alan Brochstein, CFA

As a frequent blogger, I am often approached by the public about a variety of topics. One of the most common questions over the years has been regarding the Mortgage REITs. I usually answer that they are attractive most of the time and horrible some of the time. This is one of those times I fear could be horrible.

I began my career trading mortgages back in 1986, so I have some understanding of the nature of the underlying investments that are being made (agency mortgages). That asset itself has what the finance professionals call "negative convexity". In lay terms, that means they can go up just a little in price but can go down a lot. Why? If interest rates decline, the borrower can refinance. Therefore, the investor typically doesn't like to pay a big premium. On the other hand, if interest rates rise, they can sink like a stone as their perceived maturity extends.

The mortgage REITS, which I've included not only invest in this asset that is essentially "short volatility", but they layer on a lot of leverage. They then, as REITS, pay out the vast majority of the spread between their borrowing costs and the mortgage interest. That's how they produce the big dividends.

As I said in the introductory paragraph, this is a strategy that works more often that not. The problem is that when it fails, it really fails. The main issues are the value of the underlying assets and the difference between borrowing costs and the yield on underlying investment. The steeper the yield curve and the lower interest rates, the better it is for producing big fat dividends. More leverage will help too.

When interest rates rise, the value of the collateral declines (as does the NAV of the REIT). The borrowing costs can also rise, which can hurt the dividend. In a rapidly rising interest-rate environment, the NAV can plunge and the dividend can get chopped.

With the recent rally in the bond market, the underlying assets in which these M-REITS borrow to invest are already quite expensive. On top of that, volatility is very low presently, goosing up the value of the mortgages even more. When the economy accelerates again, which I believe could be very soon, rates are likely to rise, perhaps dramatically, even if the Fed doesn't tighten anytime soon. If we were to move into a higher short-term rate environment as well, the outcome would be terrible for the M-REITS, which could not only lose principal value but also see their dividends erode.

Annaly (NYSE:NLY) is considered one of the best in the business, and I concur with that assessment. Still, though, look at how erratic the dividend has been and how the NAV has moved sharply lower at times historically. Click to enlarge:

Click to enlarge

I have seen others address the risk by looking at the premium to book value, and that is certainly important. It makes little sense to pay any premium at all in my view. More important, though, is to make sure you understand "the trade", especially the amount of leverage that the manager employs. Here is how I look at it: Total Liabilities to Equity. The greater the number, the more the risk. Here they are for each of the REITs (as of 3/31):

  • American Capital (NASDAQ:AGNC): 7.7
  • Anworth (NYSE:ANH): 8.0
  • Chimera (NYSE:CIM): 1.9 (they take credit risk rather than leverage)
  • Capstead (NYSE:CMO): 8.8
  • Hatteras (NYSE:HTS): 6.3
  • MFA Financial (NYSE:MFA): 3.0
  • Annaly (NLY): 6.6

What these numbers represent is the amount of total borrowing and obligations of these trusts compared to their net asset value.

There are various tools the managers can use to mitigate some risk to principal, but, ultimately, higher rates and increased volatility will lead to lower NAVs potentially and likely lower dividends.

After years of low interest rates generally and particularly for mortgages (due to low supply as well as outright purchasing by the Fed), this is a foolish time to be engaged in this strategy. If you are at all constructive on the economy, you are better off investing in companies with growth opportunities, and with solid dividends that can increase over time.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.