Agency Mortgage REITs Follow Non-Agency REITs Down on Credit Rating Risk

 |  Includes: AGNC, CIM, HTS, MFA, NLY, REM, RWT
by: Zvi Bar
Mortgage REITs manage portfolios of securitized mortgages (MBSs). These companies buy the mortgage paper as an investment, or in order to re-securitize it and sell MBSs to another REIT or investor. 2010 was a fairly stable year for the group, which offers some of the highest yields one can find in the market, but significant risks and fears overshadow these mortgage REITs. Currently, the debt ceiling debate is fueling fears within mREITs, including within agency mREITs.

One concern in the real estate market is that another large wave of adjustable rate mortgages (ARMs) are scheduled to reset in 2012, 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.

Non-agency mortgages have many risks. 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 often hold large positions in agency paper. Without an agency backing, defaulting mortgages mean no payments and a considerably reduced collateral for the loans. Some non-agency paper is already priced to assume a significant default likelihood upon a rate increase and/or continued depreciating prices.

Another risk is borne by the agency mortgage market directly, with the broader borrowing market as a consequence. 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 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).
This current debt ceiling debate causes a potential regulatory change in the system that allows for agency mREITs to exist. Additionally, any downgrading of U.S. debt will also downgrade these agency-backed MBSs, and should also affect the ratings of some subordinate paper.
Recent Market Activity Shows Reduced Appetite for Agency Paper
2010 was a relatively stable year for both non-agency and agency mREITs. Most paid double digit dividends while maintaining share price while increasing the number of shares through secondary offerings. 2011 started off relatively stable, but agency mREITs began to outperform non-agency mREITs near the start of the second quarter. Over the past month, or around the start of the third quarter, both agency and non-agency mREITs began to perform poorly, with five of the six above-mentioned mREITs’ shares down over the last month, as was the iShatres NAREIT ETF (NYSEARCA:REM), holding all of these equities in its top 10 holdings.
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The concern over coming defaults and foreclosures, as well as downgrading of the U.S. debt backing, have also pushed this whole group down over the last two weeks, with all down between 2% and 7%, and most trading in a fairly tight formation.
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Much of the initial downturn in non-agency mREITs appeared due to mortgage default risk, while the more recent and broad move down appears due to credit rating risk, concerning even the normally fortressed agency mREITs. These mREITs offer significant yield and some real and understandable U.S. credit rating and property-related risks. Exposure to either agency or non-agency mREITs should be limited to a reasonable percentage of a portfolio. Continued negative pressure could push some agency mREITs near or below book value, where several non-agency mREITs presently trade,
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.