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There is no doubt that the mortgage-backed real estate investment trusts are among the top income sources for their shareholder. These companies offer investors a unique opportunity to participate in the market for securitized mortgage loans. When residents or commercial entities acquire new properties, they usually borrow from retail financial institutions. These institutions securitize these loans into debt instruments, which, in turn, are transferred to other intermediate institutions. mREITs are the final destinations for these loans. They hold mortgage-backed debt instruments, which pays interest for the long-term. mREITs finance these instruments by short-term borrowing -- mostly through repurchase agreements. Due to their unique structure, mREITs are subject to several risks. In this article, I discuss several risks faced by mREIT, ranging from general to specific risks. Based on my perception of the risk, I think leveraged mREITs are riskier than others:

Institutional Risks

The first risk faced by these companies is a possible change in the current regulatory atmosphere. Under the current rules, mREITs are not subject corporate taxes, as long as they distribute at least 90% of their distributable income. The distributions are taxed according to individual tax rates. Naturally, mREITs are best suited for tax-free or tax-deferred accounts. A change in the mREITs' current tax-free status is very likely to hit both agency and hybrid mREITs' in a negative way.

Market Risk

Another risk is the market risk. Investing in the equity markets is risky. The long-term trend is upward, but one can suffer from severe losses in the short-run. If the things get worse in the Eurozone, that will surely have its toll in the U.S. markets, which might push several risk-averse investors out of the equity markets. While most mREITs have lower correlation with the overall markets, they are still traded in the same market with other equities. Therefore, they are also subject to the market risk.

Mortgage-Default Risk

This is a risk type that is unique to mREITs. mREITs' entire business model is based on the cash-flow from the long-term debt instruments in the portfolio. A default on the loan will not only initiate into a loss on the balance sheet, but it will also cause a deep cut in the future cash-flow. From this perspective, investing in agency-backed securities such as Annaly Capital (NYSE:NLY), American Capital Agency (NASDAQ:AGNC), or Armour Residential (NYSE:ARR) looks like relatively safer investments. These companies invest in only agency-backed securities, where both the principal and interest payments are under the implicit guarantee of the Federal Government Agencies such as Fannie Mae (OTCQB:FNMA) or Freddy Mac (OTCQB:FMCC).

As these securities are backed by these agencies, they are known to be less risky. As such, agency mREITs use a higher level of leverage to boost their returns on capital.

Consider American Capital Agency, which is run by a majority-owned subsidiary of American Capital (NASDAQ:ACAS). The yield on the mortgage-bond is 3.06%, which is financed at a short-term borrowing cost of 1.16%. The difference of 1.9% simply gives us the return on invested capital [ROIC]. Using a leverage ratio of 7.9, the ROIC becomes 15%. Once we deduct the company's management expenses, the return on equity can be found as 14.9%.

According to the company fact sheet, almost 95% of its portfolio consists of fixed-rate agency securities. That sounds like a safe investment, but it hosts another risk, which I call as the "spread squeeze risk".

Spread Squeeze Risk

There are some misconceptions regarding the mREITs' correlation with the interest-rates. mREITs entire business model is based on the interest rate spread, but a higher or lower interest rate does not necessarily translate into lower profit margins. What matters for the mREITs is the yield curve, which explains the trend of interest rates over time.

The above graph shows the yield curve based on the treasury's current yield. While it is not the exact yield curve faced by individual mREITs, it is a very good general proxy. What we care is the slope of this curve. A steeper yield curve is a good thing for the future profits, whereas a flatter yield curve can crush the future distributions.

Now, given the record-low yields, the future interest rates have nowhere to go, but up. If the short-term interest rates stay constant, with long-term interest rates going up, that is an admirable thing for the future distributions. If it is just the short-term interest rates going up, while the long-term interest rates stay constant, that is a dreadful thing for the future distributions.

A higher long-term interest rate also has a significantly destructive affect on the mREITs' balance sheet. A higher interest on bonds will instantly be reflected as lower bond prices. As these companies' entire asset base is centered on a portfolio of long-term debt instruments, higher interest rates can crush their book value. That is a significant risk --particularly for the highly leveraged mREITs such as Annaly, American Capital and Armour Residential. These companies are highly leveraged with debt/equity ratios of 5.41, 7.82, and 8.52, respectively.

A spread squeeze will also affect the hybrid mREITs in a negative way, but this effect would be minimal compared to the leveraged mREITs. Consider Chimera (NYSE:CIM), which has a leverage of 1.85. 74.5% of Chimera's portfolio consists of non-agency residential mortgage-backed loans. As these loans offer relatively higher interests, the company does not need that much leverage. Using a backward logic, we can come up with Chimera's interest spread as follows:

The company has a return on investment of 10.05%. It was able to generate this return, by using a relatively low leverage of 1.85. Thus, the interest spread faced by the company should be around 5% - 6%.

Summary

There are two types of mREITs. The first one invests in only agency-backed securities, whereas the other one invests in other types of mortgage-related securities, as well. Both mREITs are subject to institutional and market-related risks. While the default risk is higher in hybrid mREITs, I do not see such risk in the near future. Most defaults have already occurred during the sub-prime crises, and there is not much left for the future.

Given the ultra-low interest rates, an interest spread squeeze risk seems like a higher possibility. Since the agency-backed mREITs are already exploiting this spread with a significantly high leverage, they are more likely to be hit by the realization of this risk. Therefore, I think low-leveraged mREITs offer more safety than the highly leveraged ones. Let me know what you think as I will be ready to discuss this issue further.

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

Source: Are Agency-Backed mREITs Riskier Than Hybrid mREITs?