Why Is The mREIT Industry Getting Annihilated?

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

Summary

Prepayment expectations are creating problems for asset yields.

The sector occasionally suffers from particularly fierce selling due to poor liquidity showing up for some mREITs.

The way brokerages display the gain/loss information may encourage investors to misunderstand their losses.

Dividend cuts may be common throughout the industry in 2016.

I’m putting in a couple sentences to a paragraph on most individual mREITs in this piece.

This has been a crazy time for mREITs, and I'm sure my fellow mREIT investors may be struggling to process some of the huge price movements we've seen lately. This kind of hammering can easily leave investors feeling rattled. The problem may be further complicated by looking at their brokerage accounts and seeing the enormous losses pile up. This is a critical time for sanity, and this is when it is in the shortest supply. This is when I am wondering if we have seen the great capitulation, or if there is still another collapse remaining.

Since I'm going to be using several mREIT terms without including definitions, I suggest readers check out my guide to terminology if they see a term they don't know.

What We All Need to Know

The mREIT industry is selling at a substantial discount to book value despite an interest rate environment that still supports fairly significant yields from net interest income. Asset yields will still get hammered by prepayments and the repo rates are moving higher thanks to the Federal Reserve's mishandling of the economy. The situation is bleak, but the difference between asset yields and the short-term cost of funds is still high enough to generate some material levels of income. The enormous discount reflects market expectations for the possibility of a flattening yield curve that would further hammer away at book values. The mREITs are in the challenging environment of wanting hedges to protect from an increase in short-term rates while struggling with weaker asset yields due to high volumes of prepayments wiping out their MBS at par value.

Breaking Out the mREITs

I'm going to talk about factors influencing several of the mREITs. I will also break out several of the individual names for further analysis.

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

Ugly Brokerage Statements

One thing that annoys me is the way cost basis is used in demonstrating the gain or loss on a portfolio. My position in Dynex Capital demonstrates a huge loss. However, the position hasn't actually been destroying my wealth at that rate. The simple formula used for assessing my loss simply looks at the fair value of all shares I own and the amount of cash paid to acquire those shares. This would be useful if I was interested in assessing tax implications, but it is not useful for assessing the performance.

The real performance requires including the dividends. My first buy on Dynex Capital was too early. They were a best-of-breed mREIT that was finally dipping materially below book value. They were significantly above comparable mREITs. The second buy came on much more thorough analysis. That purchase was August 7th right before trading ended. If I track the performance of the position using the dividend adjusted close, then as of the 19th, it was only down 5.3%. However, there is no reduction in cost basis for a dividend that is obtained. That is the case regardless of whether the dividend is reinvested or not.

Imagine if you bought shares in a company for $10. This company pays out a special dividend of $5. The share price falls to $5, and then it recovers to $6 over the following month. You started with $10 and have either $11 or $12, depending on if the dividend was reinvested. Unfortunately the cost basis for holding one share would still show $10 relative to a market value of $6. If the investor reinvested his dividend, he would see a cost basis of $15 ($10 from his original cash and $5 from investing the dividend) and a market value of $12.

Investors may believe that the way this data is displayed has no impact on their returns, but I wonder about that. The returns are influenced by fair market prices and I wonder how many retail investors throw in the towel because they see a large loss listed on the account.

Efficient or Not

The huge decline on Wednesday morning for many mREITs appears to be linked to poor liquidity, among other things. Few buyers were lining up to take on mREIT risks since the mREIT is damaged by interest rate volatility (due to prepayments). After the sector sold off fiercely in the morning, it rallied hard going into the afternoon. That reinforces the idea that poor liquidity was a driving factor. Another factor encouraging the sector to move higher may be speculation about the potential value from liquidations, which I will touch on later in the piece.

The book value of mREITs for Wednesday should be a mixed bag. The 30YR FNMA 3.5 is up about .28% (or 28 basis points) since yesterday. The 30YR FNMA 4.0 is up .16% since yesterday. However the 5-year treasury is up .30% and the 7 year treasury is up .47%. In short, treasury prices are rallying materially harder than MBS values. The live data for LIBOR swaps is not available, but if the LIBOR swap market is roughly tracking the treasury market, then the mREIT book values should be mixed. My guess is that book values moving down would be more common than up. Due to credit fears with the selling, I would expect book value on non-agency mREITs to get hammered from declining asset values.

On Thursday, book values should be slightly up with a little less credit fear and relatively flat MBS price performance compared to moderate treasury movements suggesting moderate swap movements. The gains on hedges would be more favorable because the 2-year rate was only up by 40% of a single basis point, while the 10-year rate was up by 4 basis points.

Dividend Cuts From Refinancing

This could be a year of dividend cuts for most mREITs. The weak price performance of MBS is a direct result of extensive refinancing activity. The entire economic model around refinancing is terrible and creates a substantial loss. I'm not saying refinancing should be completely removed from the economy, but I'd love to see very strict provisions against it. The cost of employing people to process refinancing applications and to provide marketing services to bring in homeowners must be covered. The uncertainty created from refinancing options means the buyers of MBS demand higher yields, which in turn means higher costs for the home owners. Risk demands return.

This is fundamental to any analysis of economics. Real wealth is not measured in any fiat currency. Real wealth is measured in the physical goods and the services produced by an economy. The government can print currency, but producing real wealth is much more difficult. When highly educated labor is employed to refinance an existing mortgage into a new mortgage, then the labor was wasted. Assuming the mortgage was for the same amount and similar terms at a lower interest rate, then everything gained by the borrower was lost by the bond holder. However, the total value must be negative because a company had to exist, have offices, and employ someone to handle the refinancing. These costs combine to take a zero sum game and make it a negative sum game.

The impact on the mREITs is showing up as weaker price appreciation on MBS and will be demonstrated in the income statement as weaker yields on existing MBS due to prepayment expectations. Note that I don't see the financing aspect of writing mortgages as an economic problem. I see the refinancing aspect as a problem. At the simplest level, it would be akin to saying that mowing your lawn once makes sense. Going out that same evening to mow again is not a good use of time.

Short Rates

The Federal Reserve lifted short rates in December. I covered it extensively leading up to the increase and suggested that they were intentionally painting themselves into a corner to provide justification for raising rates.

Keep Your Head On Straight

When the markets get really turbulent, I like to do some reading. Before coming to my desk to write, I was reading through "Security Analysis." I believe the lessons remain entirely relevant today. The lesson I want to remind readers about is the importance of being willing to disagree with the market. Investors should be very wary about losing money, but they should also be focused on the prospects of the company they are buying. Calling the precise bottom would be great, but it is also inherently problematic. The dangers facing the sector are very real. In my opinion, they are substantially more real than the dangers facing the S&P 500. However, the sector trades at a huge discount to book value and I believe it may be time to start discussing the potential for a wave of liquidations.

Liquidations Would Be Great

Some investors are going to argue that liquidation wouldn't really work because the mREITs are leveraged and would get a poor price for their MBS as they would flood the market or have to race to sell. This is not a scenario where mREITs need to liquidate overnight. There is no fire sale necessary. The prices on MBS have been rising substantially rather than declining. What does that tell you about supply and demand?

The mREIT sector as a whole represents a very tiny portion of the total market for agency MBS. The smaller ones could liquidate their portfolio in a day without the market even noticing. Back in 2013 the New York Federal Reserve had an interesting piece on TBA (to be announced) trading and the liquidity of the MBS market. They found that the daily trading volume for agency MBS was regularly over $300 billion. Even Annaly Capital Management only has about $65 billion, or about a fifth, of the average daily volume. If they were to try to liquidate in a couple days, it would push the markets, but the mREITs that only have a couple billion could close down operations pretty fast.

For additional perspective, treasury securities had an average daily trading volume of around $500 billion at the time.

A Couple Final Thoughts on Individual mREITs

JMI is down quite substantially and should remain a candidate for liquidation. Risk of substantial negative price movements on non-agency MBS would negatively influence the potential liquidation value.

I put a short rating on ORC a while back. I have not removed the rating because I still think CYS offers materially superior performance at the latest prices. Some could argue that it would have been perfect to pull the rating in the middle of trading on Wednesday. It also wouldn't be practical to try to time price spikes (up or down) to the hour. I'm looking at the long-term fundamentals of comparable securities.

I have been getting more reader requests to go take another look at NYMT. I put it on my "to-do" list, but there are quite a few things on the list and many are less challenging than evaluating an exceptionally complex portfolio that is handled by multiple external managers.

Those excess MSRs for NRZ are starting to look more dangerous with heavy refinancing volumes. I think I still like the excess MSR structure better than the regular MSR structure.

Two Harbors Investment Corp. has a huge position in non-agency MBS. Fair values should be falling substantially, but I don't agree with the market about the amount of credit risk. Their non-agency MBS assets generally have very respectable loan to value ratios, and I do not believe that the government will permit house values to plummet. This is a complicated area for macroeconomics because plummeting house values encourages defaults which, like refinancing, are a huge drain on the economy and create a negative sum game.

Around the end of the year, I was saying AGNC was underpriced relative to peers like NLY by about 2%. Since the end of 2015 they outperformed NLY by about 2%. My latest book value estimates were around January 15th and indicated that comparative discounts at the time were less than 1% apart.

ARR was actively buying back shares before this collapse. I hope they continue during the collapse. The massive buyback program was a huge positive in an otherwise challenging period.

I'm concerned about dividend sustainability for CMO. Their low cost structure is great and their focus on adjustable rate mortgages is one way to avoid having more swap exposure, but prepayments are nasty.

Dynex Capital also has quite a bit of adjustable rate mortgages, but that goes with positions in CMBS and derivatives on CMBS. The provisions against prepayments on the CMBS should be a nice benefit.

ZAIS Financial previously indicated they were considering liquidation to combat their persistent discount to book value. That problem still exists and is substantial. I'd love to see them go through with this.

MTGE deserves a larger discount to book than peers because their book includes MSR positions, which produce nothing but operating losses. The fair value gains and losses are irrelevant when the operating performance is always a loss.

BXMT stands to benefit from an increase in the USD LIBOR rate. That sounds positive when investors are concerned about rate increases, but I'm still wondering if we will actually see short-term rates get shoved higher by the Federal Reserve despite all the evidence suggesting it is the single stupidest thing they could do. The rates would need to increase quite a bit for this to have a material impact on income, but the presence of potential benefits from a rate increase can be a positive for share price. I'm concerned about credit risk here, but I haven't gone deep into BXMT in quite a few months.

I'm still working on researching RSO. I went over their latest presentation to get my first opinions ready. The first thing I see is that their sector reporting is carrying most G&A costs through residential mortgage lending. If those costs are actually a function of that department and not simply being allocated there, they might want to reconsider the segment.

CIM broke off the external management agreement with NLY, but so far the cost savings haven't been there. When a huge hedge fund manager challenged them about it on the earnings call, they refused to make estimates about the savings.

ANH is at a huge discount to last reported book value. It would be a great target for liquidation. Of course, there are those pesky real estate properties that would have to be sold. Why does an mREIT have a portfolio of single family homes? My best guess is that it is discourage activists from trying to liquidate the portfolio.

Conclusion

The sector took a harsh beating and there are legitimate concerns about high prepayments slamming asset yields while the Federal Reserve has yet to admit they made a stupid mistake. If the curve continues to flatten, liquidations would make sense. Activists may start appearing and would have a very solid case that the best thing for shareholders would be liquidation. If the curve returns to a steeper level, then it would make sense for new mREITs to be created. Otherwise, a return of the curve to the steeper level would crush book values.

I might add shares in any of the mREITs listed here over the next few days based on price movements.

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.