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I am not different from other investors invested in the agency-mREIT space. When I invest, however, I want to know the worst case scenarios. I own mREITs because I remain confident on select agency-mREITs. If I know the specific industry risks, then I can try and formulate a "worst case" loss-avoidance strategy.

Here are the worst case scenarios I can envision. If I were the Fed Chairman, I would realize draconian measures have to be enacted to address the entire country. The Fed, announced the essentially zero Fed Fund rate, which clearly benefits only banks and entities with access to the Fed Fund rate. Now is the time to offer meaningful benefits for the average American.

Fed Chairman Ben Bernanke will provide a crucial speech on this Friday, August 26th. In the below 4-topics, I address potential benefits to U.S. individual mortgage owners. The benefits would:

  • Reduce the number of individuals who are walking away from their underwater mortgage.
  • Revise mortgage terms to reflect current home valuations. This would provide a discretionary increase in the consumer's pocket.
  • Directly reach the consumer versus assuming the big banks will offer any value added agency-mortgage revision. Those who need to borrow can not borrow.

I want to state that I don't think any of these 4-options will be used. I have stated my "guess" on each event actually occurring. I believe, however, since Ben can't reduce rates any more, that a new approach to benefit the general population should be considered. Economic times are difficult as job losses widen, and housing values decrease. These scenarios all would, potentially, have negative consequences on the valuation of agency-mREITs.

1. Nationwide Refinancing Options for Home Owners

My Probability Guess: 5%.

I don't envision this happening as the Fed has focused exclusively upon benefits to big banks such as Bank of America (NYSE:BAC).

I want to be clear, in my opinion, the Federal Reserve has not directly focused upon the average American. My article, "Has Prudent Income Investing Become Extinct?", addresses my concern about the current Federal Reserve policy. Ben S. Bernanke, has clearly focused upon the success of big banks, foreign banks, and entities with access to the Fed Funds rate.

Based upon this view, I don't rule anything out from the Federal Chairman proposing, this Friday, a nationwide refinancing option for all agency Government Sponsored Entities (GSE) mortgages. The "white elephant in the room" is the reason home valuations continue to drop. If home owners are underwater on their mortgage by an increasing amount, there is an increased rationale for the home owner to walk away from the mortgage.

Providing a Federal nationwide refinancing option would address the increasing number of GSE mortgages which are under water. Who wants to buy a home when they read headlines that 2nd quarter home values dropped by 5.9%?

Potential Federal refinancing programs could include the following aspects:

  • An easy to obtain restructured GSE mortgage. Interest rates could be capped at 2-3%.
  • A plan to revise the home GSE mortgage loan to current market values. This would reduce the number of "mail in my keys" and walk away from the house and mortgage.
  • Home owners who leave their underwater GSE mortgage homes create a financial burden on the financial institutions who have to repossess, monitor the home's upkeep, and provide an incentive for a new home owner to move into the residence.

Such a plan would address the unemployment issue and lack of job opportunities. A significant percentage of Americans are unemployed and one out of six U.S. citizens are on food stamps. If this is not a time for drastic action, I am not sure what is. Employees, whom are forced to chang jobs, often receive a decreased income.

Potential negative GSE agency-mREIT impacts could include:

  • prepayment risk of an outstanding GSE mortgage with a new Federal mortgage. The new mortgage would possess a lower interest rate yield and mortgage terms. Agency mREITs would suffer a yield spread risk.
  • GSE mREIT mortgage reduction in loan principle. Agency mREITs would suffer hits to their book value per share.

2. Revisit the World War II Change to Maximum Mortgage Rates

My Probability Guess: 5%

The following reference refers to the issuance of 29-year non-marketable bonds. The war created a scenario for unique war time bonds. As stated, the goal was designed to address longer-term issues and reduce debt-to-GDP:

History has some basis of how to reduce the debt-to-GDP ratios. This would require restructuring of GSE debt:

3. Operation Twist

My Probability Guess: less than 1%

I was not aware of Operation Twist until the media discussed the idea on August 18th. This would have a material negative impact upon agency mREITs. BVPS would be impaired if short-term interest rates increased, and the 30-year decreased. Agency mREITs borrow short-term, at a low cost, and lend GSE securities at a dear price. The yield curve would be in dramatic contrast to an agency mREIT's business model. In addition, the agency mREIT is leveraged so the losses would be magnified minus any internal agency mREIT hedging strategies.

On August 9th, the Fed Chairman announced the Fed Fund rate would remain low for two-years. I have to take the Chairman at face value. The chances of Operation Twist occuring are slim. The net impact, if done, is startling:

"....So a new Operation Twist could help bring short-term rates up and the 30-year down....".

4. Yield Curve Flattens and agnecy mREITs Reduce Leverage

My Probability Guess: 10%

Agency mREITS thrive upon a strong yield curve. If the yield curve flattened, the yield curve percentage would decrease and agency mREITs profits would decrease. The agency-MBS interest rates lending rates could decrease, but the GSE MBS increase in value. This would drive the bvps higher. These changes all reflect secondary trading of the agency-MBS based upon the original coupon-rate remaining the same, and the original per value remaining the same.

In addition, there is speculation that the agency-mREITs will decrease their leverage levels which could decrease the extent of net profits, assuming all factors remained the same. If the agency-MBS terms were reduced by the repurchase agreements, this could also force a deleveraging by agency mREITs.

Here is a table with key data for the agency-mREITs. The dividend announcement dates and anticipated amounts are listed on the far right. I obtained the information from the company's websites, and SEC filings.

Source: mREITs' 4 Worst Case Scenarios From Ben Bernanke's Speech