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In general, there are some safe mortgage Real Estate Investment Trusts (mREITs) that generate solid dividend yields for investors and invest heavily in mortgage backed securities (MBS) from government-backed agencies, such as Fannie Mae and Freddie Mac.

MFA Financial (MFA) is a different story because it lies between the less safe, Non-Agency based mREIT such as Chimera (CIM), and the safer, Agency-based mREIT such as Annaly Capital Management (NLY). Since 2009, however, MFA has increased its portfolio risk by picking up an increasing number of Non-Agency MBS in exchange for its Agency MBS.

There are two more significant talking points here, and two more reasons why MFA may be a good short candidate in the near future. First, MFA has moved most of these riskier assets into Variable Interest Equities (VIEs), giving it the power to remove much of the asset coverage off MFA's balance sheet. Second, MFA is doing this for a reason: its ability to generate cash comes more from its ability to issue additional shares than it does from its ability to earn interest income after paying its dividends.

Overview

MFA Financial began operating as an mREIT in 1998. It makes money, through leverage, by collecting interest on its MBS and paying off the interest expenses elsewhere. Agency MBS are sponsored by government agencies such as Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC); they come with higher interest rates, but are seen as safer investments because they are government backed. There is also a typically lower default probability on these mortgages, and depreciation of assets is usually lower. Non-Agency MBS come with lower interest rates but are riskier, so defaults are higher and depreciation on assets tends to be higher.

Here's a ten year snapshot of MFA's Assets [click tables to enlarge]:

Picking Flowers, Watering Weeds

Because of the rise in Non-Agency Assets from 2009-2011, less leverage is needed for positions, as can be seen on the right hand side of the table above. Still, the build up of Non-Agency MBS is alarming. MFA has stated that they have sold off many of their Agency MBS and purchased Non-Agency MBS to take advantage of lower short term interest rates. Here's what they said about their 2007-2009 selloffs:

  • 2007: "We selectively sold $844.5 million of Agency and AAA rated MBS, realizing a net loss of $21.8 million."
  • 2008: "[W]e sold 36 of our longer-term Agency MBS with an amortized cost of $628.3 million for $650.9 million, realizing gross gains of $22.6 million."
  • 2009: "[W]e reduced our borrowings, by selling [Agency] MBS with an amortized cost of $1.876 billion, realizing aggregate net losses of $24.5 million, comprised of gross losses of $25.1 million and gross gains of $571,000."

This drastic fall in assets can also be seen in the table above, and in 2011, Non-Agency purchases increased MBS Assets by almost 40%. Short term interest rates certainly won't be low forever (and are likely to rise in 1-2 years), while legislation in motion by president will allow homeowners more room to refinance their mortgages--a move that will crush interest income for mREITs.

So what's the longer term incentive to sell off Agency MBS (at losses) to purchase riskier, Non-Agency MBS?

Digging Deeper

One possible reason for the MBS swap is that MFA has yet to show it can make money without an equity injection from investors. It has issued shares every year since 2000, and if we calculate the difference between net income and the common share dividends paid out since 2000, we find that there is a net loss of $140M for that entire ten year period--almost the entire life of MFA's existence.

The table below illustrates these issues:

The table illustrates the vast amount of common issue revenue MFA generates on a yearly basis. The one exception here is 2010, when the switch to lower interest rate-bearing Non-Agency MBS reduced interest expense (not in the table) by more than $100M, or roughly 1/3 of total interest expense. These two one-time deals are the reason for 2009's explosion in net income, as explained in MFA's financial 2010 financial report.

The only time when common share figures remained roughly the same, from 2004-2006, MFA still has a net income-dividend payout loss of over $65M, not including 2008's bust of over $110M.

So what happens when new common shares are no longer issued to fund additional MBS assets, Agency or Non-Agency? That's something we have yet to see. Additionally, if short term interest rates rise or if there is an increase in mortgage refinancing, then MFA will really be tested. As of September 30, 2011, MFA has over $421M in cash as a cushion, but that might not be enough to sustain the potential losses from its new investments or potential hits to its interest income.

Other Red Flags

  • Lack of Insider Ownership: MFA insiders own roughly 0.5% of MFA stock. Stewart Zimmerman, MFA's CEO, owns 0.2% while William Gorin, MFA's President and Director, owns an additional 0.2%. Without heavier insider ownership, there is much less incentive for MFA to perform well in the long term.
  • Poor Non-Agency MBS Ratings: although we probably can't trust the S&P ratings of MFA's Non-Agency MBS before 2008, we can probably assume they weren't too different from what they were in the last three years to date. Also, despite the fact that Non-Agency MBS only make up only 34% of MFA's investments, this is by far the largest growing sector of its portfolio. Reference the table below for the ratings breakdown over the years.

  • Use of Variable Interest Entities: the last red flag on MFA is its recent use of variable interest entities (VIEs), which essentially allow MFA to push off some of liabilities onto "another" obligator. MFA says that the VIEs "were created to facilitate [resecuritization] transactions and to which the underlying assets in connection with the resecuritizations were transferred." The underlying purpose of the VIEs is still unclear on the company's financials.

Conclusion

I would stay away from MFA and lower quality mREITs until the longer term situation becomes clearer. Given the basic business model flaws and aforementioned red flags, MFA is developing into a great short opportunity.

Source: MFA Financial: Short Candidate On The Rise