We are long-term holders of Annaly Capital Management (NLY) and we continue to believe that the current market environment is ideal for mortgage REITs.
If you haven't done so already, we encourage you to read Annaly's Q4 Market Commentary that was published earlier this week.
Below are some highlights from the commentary that we feel back up our conviction that Annaly is a "Buy" for 2012.
Macro Picture: Policy and Economy
As we have stated before, the structural issues in the U.S. will continue to be a significant headwind for the overall health of the U.S. economy. Annaly echoed this point:
In short, prior to the crisis, the future could be counted on to generally follow the same path as the past, with governments and institutions playing their familiar roles. The uncertainty in the marketplace seems to reflect a perception that this belief no longer holds. Part of the problem is policymakers’ penchant for kicking the can down the road (what Nouriel Roubini has called the “infuriating euphemism”). European policymakers have yet to fully confront the possibility that at least one and maybe more of their eurozone member nations are insolvent and that their union (and currency) lacks some critical mechanisms such as fiscal union and joint and several liability. The United States, no better, has let its crisis moment pass without taking serious steps towards fixing its structural fiscal deficits and unwieldy entitlement systems. Many suspect that China, with its social imbalances and mercantilist policies, will have its own day of reckoning in the future. The gloom of the market as we head into 2012 is that the can, so to speak, may not be kickable much longer. As if this weren’t enough, policymakers have made headway in at least one respect — regulation. The looming catalysts of the enactment of the various pieces of the Dodd-Frank Act and Basel III are about to do nothing less than change the way in which our financial system operates.
Due to these structural headwinds, interest rates are likely to remain low for the foreseeable future and income investors will continue to scramble to find good risk-adjusted yield.
The importance of income from assets rose through the early 1980s and has been in decline ever since. Why? Lower interest rates and lower dividend yields, compounded most recently by a general decline in net worth. The owners of financial assets are clearly starved for income, and the Fed has promised that it will stay this way for some time to come, all along the yield curve. Chart 1 (see below) represents a worrisome headwind for the economy, as is the fact that the “growth” segment of personal income is dependent on government social programs (and our continued ability to fund them). Hopefully consumers have learned their lesson and won’t resort to excessive borrowing to keep their consumption levels up.
HARP 2.0 and Prepayment Risk
Prepayment rates remain stable despite the fear that government refinance programs will adversely affect the agency MBS market. Even amid the volatility induced by European solvency and contagion fears, on a spread basis agency mortgaged-backed securities ended the quarter roughly where they began as investors sought the relative safety of high-quality, liquid fixed income assets. In addition, the fourth quarter of 2011 brought with it details of the re-vamped Homeowner Affordable Refinance Program, or “HARP 2.0.”
HARP 2.0, announced on October 24, 2011, sought to ease the frictions associated with the original program. There were five key revisions to the original program: 1) eliminate mandatory Fannie/Freddie borrower risk-based fees for borrowers who refinanced into a shorter-term mortgage, 2) remove the 125% LTV cap, 3) waive certain lender representations and warranties, 4) eliminate the need for a new appraisal, and 5) extend the end date for HARP until December 31, 2013 for loans originated on or before May 31, 2009. While these revisions should certainly marginally help refinancing activity, it is important to note that these revisions are far from any kind of “blanket” government refinance program. In fact, the Federal Housing Finance Authority (FHFA) estimated that roughly 800,000 borrowers per year through 2013 may potentially refinance as a result of the changes, a far cry from the 14.7 million homeowners estimated to be underwater on their mortgages.
Despite the above mentioned revisions, there continue to be major frictions to refinance even the official target amount. First, as illustrated by Chart 2, provided by Nomura Securities, employment in the mortgage origination industry is off about 20% from January 2010, which in and of itself creates capacity constraints.
Conclusion: Agency REITs Are the Place To Be in 2012
We continue to believe that the current interest rate environment is ideal for mortgage REITs and that agency-focused REITs (like NLY) are a a suitable investment for investors seeking good risk-adjusted yield in 2012.
Agency mortgages are guaranteed by government sponsored entities (implying limited credit risk). Conversely, non-agency securities do not carry a similar implied guarantee, making them inherently more risky due to the higher relative credit risk.
Agency Mortgage REITs provide yield hungry investors access to strong dividend yields. These securities typically perform well in low-interest-rate environments with steep yield curves. We think they provide investors a hedge against heavy cash and short-term bond portfolios in the event interest rates stay low for an exceptionally long period of time.
Below is a list of agency-focused mortgage REITs:
Agency REITs with bias toward Fixed Rate Mix
- Annaly Capital Management
- American Capital Agency (AGNC)
Agency REITs with bias toward Floating Rate Mix
We are long-time holders of NLY and AGNC, which continue to be our two favorite mREITs in the space. Please see the links below for further details.