Is Refinance Uncertainty Bad For mREITs?

by: Parsimony Investment Research
Mortgage REITs have provided investors with stable income in a low interest rate environment. However, recent rumblings out of Washington have led to increased volatility in a low beta asset class. As Washington and the Federal Reserve desperately seek to revive a very weak economy, new proposals from the administration on bolstering the economy could have adverse impacts on mortgage REITs.
While we believe that the Federal Reserve will remain accommodative for quite some time, we think that monetary policy tools are experiencing diminishing returns. Based on the comments from Jackson Hole, we believe Bernanke is signaling to Congress and the administration that fiscal policy will be needed to bolster the economy.
The corporate sector has benefited the most with the Federal Reserve’s ultra-low interest rate policy. Large multi-nationals and middle-market borrowers have been able to refinance and issue new debt at very low rates. Despite the benefits to the corporate sector, the average household has not experienced a similar decline in borrowing costs.

Part of the problem that many homeowners face is that their mortgages are underwater and bank appraisals are becoming more stringent, thus requiring more equity to refinance. Mortgage REITs such as Annaly Capital Management (NYSE:NLY) and American Capital Agency (NASDAQ:AGNC), which invest heavily in fixed rate agency mortgages, have benefited the most from slower prepayment speeds.

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Prepayment Speeds
  • High prepayments (from lower mortgage rates): The faster the prepayment rate, the quicker cash flows are paid back to the bond investor, and therefore the shorter the life of the fixed income investment. The benefits to homeowners are clear: Lower mortgage rates translate to more cash flow for spending, saving, or investing. For a homeowner with a $400,000 mortgage, a rate reduction from 6% to 4% would translate to a reduction in his or her monthly payment to about $1900 from $2400, freeing up $500 a month that could be used elsewhere. Gains to homeowners will be offset by losses to some mortgage-backed securities investors. Many agency MBS are trading well in excess of par (100 cents on the dollar). A wave of refinancing would result in losses for these MBS investors.
  • Low prepayments fom higher mortgage rates: When prepay speeds slow down, the average life of the bond's cash flows are extended. This occurs because of the embedded call option in MBS. Only the borrower has the option to pay off the mortgage debt. If a borrower's mortgage rate is below current market yields, the borrower will be less likely to refinance. If an investor buys an MBS with cash flows supported by borrowers who have mortgage rates near current market, and rates unexpectedly rise, that investor will be holding an MBS that is unlikely to prepay because borrowers will have no incentive to refinance, because current market rates are higher.
mREIT Strategy for Investors
An investor's risk tolerance and view on future interest rates will dictate which mREIT investment is right for her .
High Agency and Fixed Rate Mix (best for investors who believe interest rates will remain low)
  • Annaly Capital Management
  • American Capital Agency
High Agency and Floating Rate Mix (best for investors concerned about rising interest rates)
  • Anworth Mortgage Asset Corp (ANH)
  • Capstead Mortgage Corp. (CMO)
  • Hatteras Financial Corp. (HTS)
High Non-Agency Mix (best for more aggressive investors that think the housing market is recovering)
  • MFA Financial, Inc. (MFA)
  • Chimera Investment Corporation (CIM)
In general, we think interest rates will remain low for the foreseeable future and we believe the risk from an orchestrated refinancing program by the administration is low. As such, we believe mREITs offer investors an extremely compelling risk/reward profile (especially REITs with a high mix of agency securities). However, we caution investors to watch interest rates and prepayment rates very closely if invested in the space. NLY, AGNC, and MFA remain our main REIT holdings and we continue to believe that the best strategy for investing in this space is to own a portfolio of mortgage REITs to diversify your risk.
Disclosure: I am long NLY, AGNC, MFA.