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ARMOUR Residential REIT (ARR) purchases mortgage-backed securities from Fannie Mae (OTCQB:FNMA), Freddie Mac (OTCQB:FMCC), and Ginnie Mae, but differs from most of the competition in that it purchases all three 'flavors' of mortgages, fixed-, adjustable-, and hybrid-rate securities. The majority of its holdings are adjustable rates and hybrids, which make up 20.1% of its asset portfolio, with the rest spread between 10 to 20 year pass-throughs.

I do not believe that publicly-traded mortgage REITs are a long-term alternative for fixed income investments in current market conditions, due to interest rate uncertainty, variable investor confidence, and active regulatory changes. However, as a short-term investment, the mortgage REIT sector may be appropriate. That's because interest rates are likely to remain stable in the near-term, and these REITs are relying on the spread between interest rates to grow revenue and support rewarding dividends.

Regulatory Challenges

Mortgage REIT margins are threatened by the Obama administration's interest in continuing to assist underwater homeowners with refinancing opportunities. Such early payoffs could have a detrimental effect on Armour's revenue. Armour and its peers are also threatened by the continuing European banking crisis. Worries over a second period of contraction may mean good news for the interest rate spreads upon which the mortgage REITs depend, but these same worries also cause contraction in the lending markets. Armour, like most other REITs, depends on short-term borrowing to leverage its purchases of mortgage-backed securities. Without this funding, it cannot move on available transactions.

On average, the mortgage REIT industry does not suffer as many investor lawsuits and negative regulatory actions as other sectors. However, news that the Securities and Exchange Commission is debating whether mortgage REITs should continue to receive the special tax considerations for which they are currently eligible has some investors concerned. The first repercussion of losing tax protection would be the likelihood of substantially decreased dividends as companies would no longer be required to pay out at least 90% of taxable income. I believe this would most likely result in a decline in share prices across the board. The mortgage REITs, including Armour, would be less attractive without high dividends offsetting the risks.

Market Conditions

Mortgage REITs, including Armour, are continually purchasing new mortgage pools. Recent news of declining mortgage applications will be cause for worry if the decline is continued. Though fewer mortgages may mean those packaged into the pools are of higher quality, these 'pure' pools trade at a premium.

While highly-rated securities should be part of Armour's holdings, Armour depends on a mix of ratings, since premiums erode the dividend and also lead to increased risk of prepayment by well-qualified mortgagees. Prepayment rates are steadily rising, with Fannie Mae reporting a 10% rise in prepayment rates on 30-year mortgage-backed securities in March and Freddie Mac reporting a substantial 13.7% increase for February. To decrease its risk on this front, Armour does not participate in To Be Allocated pools, only specified pools where Armour can pick securities with its own desired characteristics. As a result, its constant prepayment rate has stayed steady at 9.9 since February.

Armour also hedges itself with non-mortgage derivatives, and has a stated goal of at least 40% hedge against assets and funding rate risk, which it mostly holds in interest rate swaps. A small portion of these derivatives are held in eurodollar futures. Currently Armour is holding a total of $5.5 billion in non-mortgage derivatives against assets of $12 billion, a healthy 45% hedge. I like Armour's relatively conservative focus on interest rate swaps, which for the time being remain fairly predictable. Since its exposure to eurodollar futures is relatively low, I am not particularly worried about the impact this could have on derivatives portfolio performance. However, given the uncertainty in Europe at this time, I would be very cautious if Armour were to increase its capital allocation in this area.

Outlook

Average earnings estimates show expectations for Armour's earnings per share to quadruple by December 2013. I believe these are slightly overinflated expectations considering the challenges Armour is facing in the markets. Although competitor American Capital did quadruple in the twelve-month period between December 2010 and December 2011, it was not contending with the SEC review on mortgage REITs' qualifications as REITs for most of that period. And from here, investor uncertainty on this front will be affecting Armour and its peers until a final determination is made.

Armour and its competitors could stand to benefit from the Consumer Financial Protection Bureau's recent suggestion that it would propose new rules for mortgage servicers that could potentially reduce foreclosure rates on a go-forward basis. The rule that would most help mortgage REITs' security pools is, however, the least likely to be adopted: The proposal suggests that servicers be required to dedicate staff to assist troubled borrowers with foreclosure avoidance.

Armour is currently trading around $7 with a forward P/E of 5.6, compared to Annaly Capital Management (NLY) at 7.6, CYS Investments (CYS) at 6.5, American Capital Agency (AGNC) at 6.1, and Chimera (CIM) at 6.4. This makes Armour one of the cheapest mortgage REITs currently trading.

Armour has an outstanding dividend of 17.5% to reflect the risk inherent in the mortgage REIT sector. Its dividend is higher than most of its competitors' which compensates for Armour's increased exposure in riskier mortgages like ARMs and hybrid-rates. American Capital has a dividend yield of 16.6%, Chimera has a dividend yield of 15.9%, CYS Investments has a dividend yield of 15.1%, and Annaly rounds out the bottom with a yield of 14%.

I believe that Armour has a good chance of significantly increasing its portfolio, as it is one of few mortgage REITs focusing on riskier mortgages, and its comparatively high dividend in a field of high yields goes a long way towards compensating for this. Additionally, its derivatives trading outside of mortgage-backed securities is fairly moderate compared to some of its competitors' aggressive strategies- which softens the potential of negative returns on growth. Armour is a good buy at its current price for those who can withstand the risk.

Source: Can Armour Residential REIT Sustain Its Monster Dividend?