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One popular investment option offering dividends that are significantly above average is the agency mortgage REIT. Agency mortgage REITs possess very interesting advantages and risks that make them, in many ways, different from most other REITs or equities. This often stable business has been hit hard by the recent debt ceiling issue.

What Is an Agency Mortgage REIT?

Most REITs are equity REITs that own office buildings, shopping centers, apartment buildings, hospitals and other properties. Mortgage REITs, to the contrary, own mortgages on real estate assets rather than the assets themselves. Some mortgage REITs concentrate on commercial property mortgages, while others concentrate on residential property mortgages.

Within the world of residential mortgage REITs, there are two primary subdivisions: those that own mortgages insured by federal agencies and those that own mortgages without agency insurance. Agency mortgage REITs are supposed to have portfolios made up principally of mortgages insured by the federal agencies Fannie Mae (FNMA.OB), Freddie Mac (FNMA.OB) and/or Ginnie Mae.

These government agencies make mortgages and then issue a mortgage backed security (MBS). An agency MBS, as opposed to an MBS issued by a non-agency lender, comes with an agency guarantee and an implied U.S. government guarantee. These federal agencies’ implied or quasi-government guarantees have, so far, been proven virtually as solid as any paper issued directly by the Treasury.

The U.S. government has preferred to bail-out the agencies that are now effectively bankrupt. As borrowers default on these agency loans, the agencies continue to either pay on their behalf or buy out the defaulted loan from the owner(s). Now, here is a concern that this government policy may no longer continue, by choice or due to an inability to continue. Additionally, any downgrade of U.S. debt will lower the rating of debt backed by it.

Examples of Agency REITs

Below are seven companies that own agency-backed paper along with their performance over the last week, with each spiking far further down, intraday, on Friday morning:

  1. Annaly Capital Management, Inc. (NYSE:NLY)
    • 1 week performance: -6.87%
  2. American Capital Agency Corp. (NASDAQ:AGNC)
    • 1 week performance: -5.92%
  3. Anworth Mortgage Asset Corporation (NYSE:ANH)
    • 1 week performance: -5.58%
  4. Capstead Mortgage Corp (NYSE:CMO)
    • 1 week performance: -7.12%
  5. Cypress Sharpridge Investments (NYSE:CYS)
    • 1 week performance: -5.74%
  6. Hatteras Financial Corp (NYSE:HTS)
    • 1 week performance: -7.20%
  7. Invesco Mortgage Capital (NYSE:IVR)
    • 1 week performance: -7.63%

Agency Paper Risks

The current risk, here, is that the U.S. government will implement a policy change that hurts the value of this agency-backed paper. The change could come by an interest rate move, a removal of the agency backing or payout, or through downgrading its quality.

Agency mortgage REITs will certainly react to changing interest rates. These REITs obtain their lofty yields through high leverage. These companies all have far more debt than their market value, as indicated above, and make money off the spread between their borrowing costs and the MBS interest payment. Each company has a proprietary allocation of fixed and adjustable rate securities. Changes in rates will affect the value of these securities and the spreads these REITs can make off of them. In short, rising interest rates will largely reduce spreads and book values.

REITs must distribute at least 90% of their taxable income in order to eliminate the need to pay income tax at the corporate level. Under the current tax laws, REIT dividends are taxed as ordinary income, and not at the lower corporate dividend rate. Because these REITs must give away so much income, they cannot grow through retaining and re-deploying earnings. As a result, these REITs often choose to place secondary offerings in order to raise capital and increase market valuation. Such actions can be either dilutive or accretive to actual share value depending on how productive the REIT is at using the acquired funds. This can also make the quarterly payout volatile.

Source: Agency mREITs Spike Down on Government Uncertainty