Thoughts About A Handful Of mREITs And The State Of The Industry (Week 13)

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Includes: AGNC, AI, AMTG, ANH, ARR, BXMT, CHMI, CIM, CMO, CYS, DX, EARN, JMI, MFA, MTGE, NLY, NRZ, NSM, NYMT, ORC, RSO, STWD, TWO, WMC, ZFC
by: ColoradoWealthManagementFund

Summary

I’ve put together thoughts about most of the mREITs I would typically cover.

Book values should be up slightly for most mREITs so far in the first quarter, but not enough to cover losses and dividends paid in the fourth quarter.

The flatter yield curve is problematic for mREITs.

I've grabbed a group of mREITs that I intend to be providing a substantial amount of coverage on throughout the winter. Since this article may contain some industry jargon, I would encourage readers to check out the piece I did describing the terms if they feel any confusion. If something else is confusing, tell me in the comments and I will get it added to my list of terms and concepts.

I want to run through some of the latest data and share my thoughts on a long list of mREITs. I won't get to single every mREIT in the list out for attention, but I'll get several of them listed and the interest rate impacts should be useful for investors holding any of them. The table is demonstrated below:

Annaly Capital Management

(NYSE:NLY)

American Capital Agency Corp

(NASDAQ:AGNC)

ARMOUR Residential REIT

(NYSE:ARR)

Capstead Mortgage Corporation

(NYSE:CMO)

CYS Investments

(NYSE:CYS)

Dynex Capital

(NYSE:DX)

Long DX

Javelin Mortgage Investment

(NYSE:JMI)

New York Mortgage Trust

(NASDAQ:NYMT)

Orchid Island Capital

(NYSE:ORC)

Two Harbors Investment Corp

(NYSE:TWO)

Western Asset Mortgage Capital Corp.

(NYSE:WMC)

MFA Financial

(NYSE:MFA)

Ellington Residential Mortgage REIT

(NYSE:EARN)

Arlington Asset Investment Corporation

(NYSE:AI)

Technically Corporation

ZAIS Financial

(NYSE:ZFC)

Apollo Residential Mortgage

(NYSE:AMTG)

Anworth Mortgage Asset Corporation

(NYSE:ANH)

American Capital Mortgage Investment

(NASDAQ:MTGE)

Cherry Hill Mortgage Investment

(NYSE:CHMI)

Resource Capital Corporation

(NYSE:RSO)

Starwood Property Trust

(NYSE:STWD)

Blackstone Mortgage Trust

(NYSE:BXMT)

Chimera Investment Corporation

(NYSE:CIM)

New Residential Investment Corp.

(NYSE:NRZ)

Click to enlarge

Getting Up to Date on Rates

I found readers appreciate the discussion of interest rates, so I'm opening this piece up with quite a bit of comparisons regarding the interest rates. After posting the numbers, I'll be sharing my interpretation.

First I want to compare the end of Q3 rates with the rates from January 8th, which were made available on Monday shortly prior to my writing:

In this model I was estimating the change in the value of a bond, however, the mREITs are generally going to be shorting the bond by agreeing to pay the fixed rate. Therefore, the negative value change displayed for the short duration bonds actually represents an increase in book value for the mREITs. Let me know if that is confusing in the comments. I'm contemplating switching the presentation format for future weeks.

Relative to the end of the third quarter, the LIBOR rates moved substantially in general, however, the shorter rates substantially outperformed the longer rates. That would be beneficial to book value for mREITs that focus on hedging the short end of the curve, but I expect book value losses to be more prevalent than gains. From the end of the third quarter through the end of last week, it looks like the 3-year and 5-year swaps were the best swaps to hold. They had substantial valuation gains and lower fixed rates than the longer swaps. The lower fixed rate reduces the drag on earnings from the net interest paid on the swap.

Now I want to shift the discussion to the changes seen so far in the first quarter of 2016:

While book values for the end of the fourth quarter aren't available yet, I would expect the mREITs to be reporting losses on hedges so far in the first quarter. Those losses would offset a material portion of the gains from the previous quarter.

MBS

The following chart shows the starting and ending value for MBS prices using the end of the fourth quarter and the end of January 8th.

During the fourth quarter there would be substantial losses on the agency MBS. However, during the first week or so of 2016, a substantial portion of those losses in book value would have been regained.

So far during the first quarter (all of about a week), the gain on a 3.0 or 3.5 would be roughly offsetting the loss on a 5-year swap. The gains on the 4.0 and 4.5 would be roughly offsetting the loss on a 3-year swap. All things considered, I'd say the gains on MBS aren't keeping up with the losses on swaps assuming full hedging.

However, most mREITs won't be fully hedged on interest rate risk, and because the value of assets will materially exceed the value of swaps, the net impact over the first week or so should be positive for book values.

Flatter Yield Curve

A flatter yield curve is bad for mREITs. However, the material decline in the 3-year and 5-year rates suggest that the market is less convinced about the ability of the Federal Reserve to continue shoving rates higher. I think the Federal Reserve still has that ability, but it would be unwise to use it.

Thoughts on Individual mREITs -- Inefficient Market

ORC became materially too expensive relative to the sector.

Remarkably, that pretty much sums up my thoughts in that regard.

Efficient Market

NLY, AGNC, CYS, and TWO tend to be efficient. I believe CYS and AGNC are slightly more attractive than NLY at the present time, but only by 1% to 2%. I'm giving NLY a 3 (neutral/hold). Here are my ratings on a handful of mREITs based on their prices over the weekend.

Click to enlarge

JMI and ZFC occupy that more attractive space in the "4" rating on the basis of potential liquidations that I would expect to be very favorable to shareholders.

I was hoping to be able to assign a 4 for Two Harbors, but the market didn't sell off shares despite intense credit risk fears in the rest of the economy. If shares had declined materially, I would have been able to justify a 4 rating.

WMC falls under the category of future movements being unclear. I don't think shares provide attractive risk adjusted returns at this level, but there is not a clear catalyst to send the share prices lower in the short-term and the very high yield may bring in enough new buyers to support the mREIT trading at a premium. Note that the height of a company on the side of "Future Movement Unclear" means absolutely nothing.

MSRs and Excess MSR

This section primarily relates to NRZ, Nationstar Mortgage Holdings (NYSE:NSM), CHMI, and MTGE. There may be a few others also investing in similar securities that don't come to mind immediately.

The excess MSR sector is very interesting. The yields on these assets are solid and the negative duration is great. Unfortunately, there is some substantial risk in the model because it requires the company performing servicing to responsibly handle their role. I don't like that cross company risk, but otherwise the yields are great and cash flows are solid.

On the other hand regular MSRs are simply terrible, in my opinion. The gross yield on the MSR (fee income) is exceptional, but the combination of necessary amortization and servicing costs makes the net yield terrible and often it ends up being negative. I find the MSR business very unattractive in the current environment and see the separation of the excess MSR from the regular MSR as a poorly designed system because it reduces the incentive for the servicer of the mortgage to act responsibly.

I want to point out that TWO also has a material position in MSRs. I'm currently researching their performance with the segment to determine if the economies of scale are strong enough to make the MSR segment work for them when it is such a disappointment for other mREITs.

Disclosure: I am/we are long DX.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.