What Operation Twist Means For mREITs

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 |  Includes: AGNC, CIM, CMO, HTS, MFA, NLY, STWD, TWO
by: Efsinvestment

This past week has been one of the worst in the history of the stock markets. While the markets showed some green on Friday, investors made huge losses overall through out the third week of September. Commodity stocks took the most damage, losing 12%, followed by industrials (-10%) and financials (-7.7%). Even the defensive utilities and healthcare stocks lost 4% and 4.5%, respectively. During this chaotic environment, the Federal Open Market Committee held its September meeting. Here is a brief summary of the FOMC's press release:

Good News:

  • Business investment is strong.
  • Inflation is under control.

Bad News:

  • Growth is slow.
  • Unemployment is not improving.
  • Household spending is only modestly increasing.
  • Housing sector is still depressed.

Scary News for mREITs:

  • Fed will extend average maturity of its holdings of securities "to support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate..."

The last one is kind of scary for mREITs, since this action directly affects mREITs' business operations. The committee decided to replace its short-term Treasury securities with long-term Treasury securities. In application, Fed will buy $400 billion of long-term bonds (with maturities of 6+ years), and sell $400 billion of short-term securities (with maturities of less than 3 years).

The question is, how this will affect interest rates? Let me explain the effect of this action using two-step logic:

  1. Fed will buy long-term bonds, shifting the demand curve for the long-term bonds upward. If the demand for long-term bonds gets higher, the price of the long-term bonds will also get higher, driving down the long-term interests.
  2. Fed will sell short-term securities, shifting the demand curve for the short-term securities downward. If the demand for short-term securities gets lower, the price of these securities will also get lower, driving up the short-term interest rates.

Obviously the Fed's action will reduce the spread between long-term and short-term interest rates. How will this affect mREITS?

A reduction in the long-term rate is expected to have a booster affect on household's long-term expenditure. If that reduction is turns into lower and more affordable interest rates, more households will be inclined to purchase long-term assets. Therefore, there will be a positive effect on the housing market. Interest-induced demand will lead to more economic activity in the supply chain. From that perspective, it will have a good affect on the housing market as well as on mREITs' balance sheet.

Here comes the scary part for the mortgage REITs:

Mortgage REITs operate as a pseudo-bank, acquiring short-term loans to invest in long-term mortgage-backed securities. As SA contributor John Dalt suggests, these companies also use leverage in their balance sheets up to 8 times, to make the most out of the interest-rate spread. Consider Annaly Capital (NYSE:NLY) for example: As of June 30, Annaly's annualized yield on long-term assets was 4.04%, whereas its short-term interest cost was 1.59%. The interest spread was 2.45%. 89% of Annaly's portfolio consists of fixed-rate mortgage-backed securities and agency departures. 10% of the portfolio is invested in adjustable-rate securities and agency departures. 38% of the portfolio is insured through interest swap agreements. Thus, Annaly is already engaged in interest swap agreements to mitigate the interest risks, locking in the spread, but that portion is only 38% of its mortgage portfolio. Fed's plan is very likely to raise Annaly's short-term borrowing costs, and reduce its profits from long-term securities.

More bad news for investors: The Fed is planning to reinvest "principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities." What that means is that the Fed is becoming a stronger competitor to mREITS, which also invest in the agency mortgage-backed securities. Higher demand for agency securities will result in more competitive interest rates. Thus interest rates on mortgage-backed securities are expected to get lower, reducing the mREITs profit margins.

Any good news?

Yes of course, there are also good news for mREIT investors. As I stated above, a higher demand for long-term bonds means both lower interest rates and higher bond prices. Therefore, it is very likely that the long-term derivatives hold by the mREITs will appreciate in value. Also, the Fed's twisted plan is expected to have a booster effect similar to that of QE2. While, I have my own suspicions about the power of such plan, it can motivate the household's decision to become a homeowner, which will induce more economic activity.

What should investors do? Buy? Sell? Hold?

That is hardest question to answer. mREITs have been outperformers, and given the extreme volatility in the stock markets, their nifty dividends provide soft cushion against capital losses. The Fed's twisted plan might take several months, or even years, to show its full effect on the economy. Besides, while the plan can drastically reduce the interest spread, it is aimed at keeping the long-term interests at a low level. Thanks to that low interest environment, mREITs have been huge outperformers during the last decade.

It is my opinion that investors should keep mREITs in their portfolio as long as they fit into some safety criteria. A rule of thumb could be setting a maximum trailing P/E ratio, a minimum dividend yield, and a market cap. A 10% minimum yield and $1 billion market cap along with a maximum trailing P/E ratio of 15 can be set as a safety criteria. Here is a list of mREITs that fit into this criteria (ranked according to their market caps):

Company

Ticker

P/E Ratio

Yield

Market Cap

Annaly Capital

(NLY)

6.11

14.87%

$16.94 Billion

American Capital Agency

(NASDAQ:AGNC)

3.92

20.33%

$4.92 Billion

Chimera Investment

(NYSE:CIM)

5.17

17.33%

$3.08 Billion

MFA Financial

(NYSE:MFA)

7.1

14.66%

$2.43 Billion

Hatteras Financial

(NYSE:HTS)

6.23

15.63%

$1.92 Billion

Starwood Property Trust

(NYSE:STWD)

10.83

10.10%

$1.63 Billion

Two Harbors Investment

(NYSE:TWO)

6.05

18.64%

$1.23 Billion

Capstead Mortgage

(NYSE:CMO)

8.11

14.56%

$1.02 Billion

Click to enlarge

Do not expect huge capital gains from mortgage REITS. However, given their special tax code, these companies are required to distribute at least 90% of their profits back to their shareholders. Therefore, as long as they keep on making profits, their profits will turn into dividends.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.