Mortgage interest rates are headed into uncharted territory and could bode well for mortgage real estate investment trust (mREIT) stocks. The uncharted territory is below 3%; on May 31, a Freddie Mac survey found that the rate on 15-year fixed-rate mortgages had dropped to an eye-popping 2.97%. This is the lowest rate recorded since Uncle Sam began keeping records back in the 1950s.
This will benefit trusts that invest in short-term mortgages that are not federally-guaranteed because it is encouraging homeowners that can't get or don't want a traditional 30-year fixed rate mortgage to refinance. These companies include Chimera (CIM), Dynex Capital (DX), and Two Harbors Investment (TWO).
Such refinancing is becoming a bigger and bigger part of the mortgage industry. Freddie Mac estimates that 31% of refinancers in the first quarter of 2012 took out shorter-term loans. The low interest rates and the Obama Administration's Home Affordable Refinance Program (HARP) have convinced more homeowners to try for refinancing. Even though a lot of homeowners are not eligible for HARP, it is luring more people to the mortgage broker's office. Once there, many of them become aware of the lower interest rates and the options they have.
If this trend continues, market share and profits for REITS willing to risk this market, such as American Capital Mortgage Investment (MTGE), AG Mortgage Investment (MITT), Newcastle Investment (NCT), and PennyMac Mortgage Investment Trust (PMT), should increase. This should lead to higher stock prices and dividends if it continues.
Higher Short-Term Refinancing Rates Increase Risk to mREIT Stocks
There is a very nasty potential downside to this increase in short-term refinancing. The risks are much greater than with government-guaranteed 20- and 30-year mortgages. A lot of those refinancing are simply trying to get the balances on their mortgages down to $417,000, which is the maximum amount for the lower rate.
Those of us with long-term memories will see a similarity between this and the situation right before the start of the Great Mortgage Bubble. Back in 2002, the percentage of short-term mortgages was 35%, which is higher than it is now.
This means that mREITs are underwriting riskier mortgages and getting into bed with more underwater homeowners. That means that there is a greater risk of foreclosure and non-payment. It also means that mortgage issuers are willing to work with some of the people they would have turned away just a few months ago.
Obviously, this could lead to losses at mREITs, which would destroy their stock values. Even a hint of increased foreclosures or news stories about risky lending practices could send prices for stocks such as PennyMac, AG Mortgage, and Northstar falling. Even news stories that mention the similarities between this and the situation before the Bubble could cause mREIT stocks to fall.
Another potential risk is that mREITs that take on these kinds of risks will not be able to raise money. If that happens, those trusts will not be able to pay back the money they have leveraged and they could collapse. Even rumors of this could topple some high-flying mREITs.
The biggest risk though is a continued economic downturn and more unemployment, which could lead to a situation in which some of these borrowers could not make their mortgage payments. If that were to happen, rumors of a new foreclosure crisis will fly and mREIT investors could panic, and such a panic could lead to a selloff. The bad news is that such an economic downturn seems to be right around the corner.
In that situation, those conservative mREITs, such as American Capital Agency (AGNC), Hatteras Financial (HTS), and Annaly Capital Management (NLY) that invest in government-backed paper, will look very good. They could see their stock values go up because they'll look like safe havens in the economic storm.
Dismal Unemployment Figures Could Hit mREIT Stock Values
Only 69,000 jobs were added to the U.S. economy in May, according to the U.S. Bureau of Labor Statistics. That's fewer than almost every economist had predicted. To make matters worse, the U.S. Bureau found that the unemployment rate nationwide had actually increased from 8.1% in April to 8.2% in May.
These figures are not very good news for mREITs because people without jobs are not going to be taking out mortgages or refinancing their homes. To make matters worse, some of those who are losing their jobs will not be able to meet their mortgage payments. That means we could soon see the foreclosure rate going up again.
Such figures indicate that there could be little or no growth in the refinancing market in recent months. That could put a halt to mREIT stock value increases and lead to falls in value. It would hurt those REITS, such as AG and Newcastle, that buy the riskiest paper the most.
One worrisome trend for the mortgage industry mREIT stocks is that employment in the highest paying sector, such as manufacturing, government, and construction, is falling the fastest. Factory employment increased by 12,000 jobs in May, which was lower than the number forecast.
To make matters worse, the construction companies cut 28,000 jobs and government payrolls fell by 13,000. That means that there are less of the higher-paying positions, which would be more likely to help people meet mortgage payments out there. The biggest gains were in service sector jobs, which don't usually don't pay enough to help people meet mortgage payments.
Another trend that could hurt mREITs is the increase in the underemployment rate. That is the number of people who quit looking for better jobs and settle for whatever they can get. Those people usually end up in lower paying or part-time jobs that don't provide enough income to cover mortgage payments.
The underemployment rate did go up slightly in May from 14.5% to 14.8%. That's bad news for mortgage providers because it indicates that people are losing faith in the economy and their prospects of finding a better. People who lose faith in the economy obviously are not going to take out mortgages.
Underemployed individuals will also be more likely to walk away from mortgages or be underwater. That means we could see the foreclosure rate start to go up again. If that happens, some mREIT stocks are sure to fall in value. Those companies, such as PennyMac that like to dabble in uninsured paper, will take a bigger hit in that situation.
A few months of employment figures like these could convince the market that mREITs have nowhere to go. The growth will be over and so will the higher dividends and increased stock values. That situation could lead to a slight selloff and an industry shakeout.
Lousy Economy Could Help Some mREIT Stocks
There are some mREITs that could benefit from a bad economy. These include the larger more stable players such as Annaly and American Capital Group. Those REITS, such as MFA Mortgage Investments (MFA) that only invest in government issued paper, could also benefit. The reason they could benefit is that they could be seen as safe and stable investments in a volatile economy.
The recent collapse of stock values will make any share that is gaining value or paying a dividend look really good. Investors will find the high dividends and the security offered by federally guaranteed mortgages very attractive in an extremely volatile market. Institutional investors could find such stocks extremely attractive when other shares are falling. Large-scale institutional investment in any mREIT stock will raise its value by legitimizing it.
It looks like mREIT and mREIT investors are in for a bumpy ride in the near future, just like the rest of us. The only difference is that some of them might come away with increased dividend income and stock values.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.