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Mortgage REIT Two Harbors Investment Corp. (TWO) has an interesting new business plan designed to take advantage of America's new economic reality. It has entered the housing business by buying single family residential properties - in other words, houses.

In its May 2 earnings release, the Two Rivers management team admitted that they had bought up $6.1 million worth of houses in various American cities. The release included a piece of doublespeak, called a "New Frontier" statement, which included this little gem:

As of March 31, 2012, the company had purchased $6.1 million in properties which are classified as investment in real estate on the consolidated balance sheet. The company intends to hold these properties for investment and rent them for income.

Yes, you read it correctly. Two Rivers intends to become a landlord as well as a buyer of mortgage derivatives. The problem here is that this investment could quickly increase expenses and eat into Two Rivers' bottom line and its profits.

The problem here is all about the additional expenses attached to the houses. The insurance, the property taxes, the maintenance, the utility bills, the homeowners' association fees, the repairs. Beyond that, somebody is going to have to manage those houses, somebody will need to screen the tenants, fix the plumbing, and mow the lawns. Obviously, that means management companies, which are also an expense.

Every house that Two Rivers buys is a potential expense that could drag down its earnings per share. Even if the housing market recovers, there's no guarantee Two Rivers will profit. The company has not revealed which housing markets it has bought into or the expenses on each house.

The added risk Two Rivers has taken could quickly sink its stock. After all, it just coupled its stock to the real estate market. The housing market is notoriously volatile and there is no sign that a significant house market recovery is imminent. There have been increases in selling prices in some markets, but these have hardly been robust.

In Las Vegas, where home values have fallen by half since the collapse of the housing bubble, Reuters reports that they are up 2.9%. That's hardly a tremendous increase and it certainly does not justify the kind of risks or potential expenses that Two Rivers is taking on. This course of action looks foolish and it will probably sink Two Rivers' stock price sooner or later.

Could ReScap Bankruptcy Hurt Mortgage REITS?

The bankruptcy of Ally Financial's mortgage unit Residential Capital LLC (also known as ResCap) could hurt mortgage REIT stock prices. Residential Capital's business model is close to that of some mortgage REITs, including Two Rivers, Chimera (CIM) and Capstead Mortgage (CMO).

This similarity could scare some investors away and cause some mortgage REITs to fall, particularly those that make riskier investments, such as sub-prime mortgages. Capstead might be very vulnerable here because its business model seems to devoted to subprime. Some investors might sell all of their mortgage stock, including fairly stable companies such as Annaly (NLY) and Armour Residential (ARR).

The biggest danger to mortgage REIT stock prices from the ResCap bankruptcy could be a new round of mortgage reform. There are sure to be more calls to reform the mortgage industry from both Republicans, who would like to abolish subprime, and Democrats, who that want some sort of bail out for underwater home owners.

Any attempt at reform would increase the industry's volatility, especially if the reform is designed at eliminating certain classes of mortgages. Another reform discussed could be the abolition of mortgage derivatives, a possibility that has been raised from time to time.

Derivatives are politically unpopular and they do make a popular political whipping boy. Witness the publicity over the recent losses at JPMorgan Chase (JPM), which have been blamed on derivatives. There is liable to be pressure for something like a Volcker Rule for REITs.

Nobody has proposed the abolition of mortgage derivatives yet, but some politician or pundit is sure to raise the possibility. Even talk of such a move would send mortgage REIT stock prices tumbling. The hardest hit would, of course, be those most exposed to subprime and other high-risk paper.

This could be why Two Rivers is looking at residential housing as an investment area. It is trying to refashion itself as a real REIT, or at least trying to present the illusion of one. How this is supposed to protect the company's stock price is beyond me.

Could ResCap Bankruptcy Strengthen Mortgage REITs?

One interesting side effect of the ResCap debacle could be to strengthen mortgage REITs and increase their stock value. Some analysts already believe that REITS, such as American Capital Agency (AGNC) and CYS Investments (CYS), are now the biggest and strongest players in the mortgage sector.

Media reports indicate that ResCap's parent Ally Financial is seriously considering getting out of the mortgage business entirely. Major banks might try to do the same, particularly with all the negative publicity over the derivative losses at Chase. Obviously, people will still need refinancing, so they will have to go somewhere else, namely to REITs.

The market share for mortgage REITs could actually grow because of ResCap, if. If banks and others attempt to follow Ally's lead and distances themselves from mortgages or at least refinancing. One possibility is that these companies will sell off a lot of their mortgage assets. Some of them may give up derivatives completely, particularly with the Volcker rule coming.

Companies like Annaly, which have a proven ability to quickly raise large amounts of financing and leverage, it would be well- placed to profit from this shift in the mortgage market. The only things that would put a damper on such moves would be government regulation or a fast increase in interest rates.

Given the realities of politics and bureaucracy, any sort of regulatory action or legal reform would take a minimum of one year. That means REITs would have plenty of time to build up the new market share and protect it. They would also be able to position themselves to survive regulation.

Interest rates are likely to remain low for the foreseeable future, so the basic REIT business model is fairly safe for now. Companies like Annaly will still be able to leverage paper into huge sums of cash.

One strong possibility in the mortgage REIT sector is a short -term drop in stock prices, followed by a long -term increase. Investors spooked by the ResCap news will get out, which will cause a drop. Then when they see that the sector is still healthy and the companies are still making money, they will back in.

It goes without saying that the fallout from ResCap could be a great opportunity for value investors. The mortgage REITs are associated with negative news in a related business, which may have little or nothing to do with their core expertise, yet. Yet they are also in an excellent position to take advantage of the opportunities created by the changes in the industry. This will cause many investors to get out of the area and drop stock prices at a time when the industry's potential could be increasing.

Therefore, some people may pick up some nice bargains because of this news. The dividends and earnings per share on some of the REITs are still pretty good. More importantly, their market share could be about to increase, which should lead to higher profits.

Source: 7 REITs To Consider For A Highly Volatile Market