Mortgage REIT Risk Appetite Unlikely to Increase Until Debt Ceiling Does

by: Zvi Bar
There are many REITs that manage portfolios of securitized mortgages. These companies buy the mortgage paper as an investment, or in order to re-securitize them and sell them to another mortgage REIT or another entity investing in real estate loans. Last year was a generally good year for these mREITs, which offer some of the highest yields one can find in the market. But significant risks and fears now overshadow these mortgage REITs.
Mortgage REIT Risks
Agency mortgages are considered virtually risk free. 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 a risk that the agency market may become altered by future regulations regarding agency interaction with mortgages. U.S. downgrades will also hurt this paper. Most agency mREITs presently hold agency paper at a high leverage rate. The present debt ceiling discussions place this agency risk as a growing concern, while the market usually deems this risk to be incalculably small. Any significant change to the present backing of agency paper could hurt these agency mREITs, or possibly make them obsolete.
Another concern is that another large wave of adjustable rate mortgages (ARMs) are scheduled to reset in 2012, and that higher interest rates, underlying real estate valuations and debtor quality will further push down real estate values and that foreclosures shall riddle these securitized products with holes. Mortgage REITs are generally expected to have lower spreads as rates increase, and increased rates are anticipated. If the agency backing holds, this is less of a concern to the agency paper holders, at the government's expense.
Presently, non-agency mortgages have a more specific concern. 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 (and several recently have). Without an agency backing, defaulting mortgages mean no payments and a considerably reduced value. Some non-agency paper is priced to assume significant default likelihood upon a rate increase and/or continued depreciating prices. This non-agency paper has, as a consequence, lost significant value so far in 2011, as the market continues to attempt to price the potential for a potential future mass-default period.
The believed inevitability of interest rate increases is also affecting these mREITs, which make money off their spreads, or the difference between borrowing costs and investment returns multiplied by the leverage used by the mREITs. Risking rates could reduce these spreads. Many of these mREITs are now attempting to lessen this risk through holding ARM mortgages which have rates that change with the market rate. While non-agency paper is generally depreciating, ARM paper has been in greater demand lately and often appreciating, or at least going down less.
Other risks certainly affect these businesses, such as tax law as applied to REIT dividends and personal income tax rates, among others. But these above-mentioned risks are what now are primarily dictating mREIT market activity.

The recent market volatility is likely to continue so long as politicians grapple with the debt ceiling. Many now presume that the agency backing could be in jeopardy and that U.S. property values will continue to depreciate, making future defaults and foreclosures inevitable. Some of this risk appears already priced into non-agency paper, and several non-agency mREITS are now trading below book value. This discount highlights a significant expectation that real estate will sustain a second move downward in the near-term.

These mREITs offer significant yield but presently exhibit several real political, interest-rate and property-related risks. We now appear near a precipice, where several of these risks may either prove actual or slowly fade away. Until greater certainty is known, and Washington resolves the present debt ceiling debate, exposure to both agency or non-agency mREITs should be limited to a reasonably prudent percentage of a portfolio.

Disclaimer: This article is intended to be informative and should not be construed as personalized advice as it does not take into account your specific situation or objectives.

Disclosure: I am long NLY, CIM.