Recently, Jim Cramer expressed his view that Annaly (NLY) was superior to Chimera (CIM) as a levered mortgage real estate investment trust (REIT) investment. Though Cramer is right to caution investors about Chimera, he should not be enthusiastic about levered mortgage REITs in general. At current valuations they are not trading below accounting book values, a condition that investors should demand in a market where many mortgaged properties are underwater.
Valuations Are Too High
Consider the following roll call of levered mortgage REITs:
American Capital Agency
ARMOUR Residential REIT
Annaly Capital Management
The only REIT on this list that trades below book value is Chimera. The remaining REITs are trading above book value, which are not particularly attractive for investment schemes based on mortgages bought on margin.
Chimera's Book Values Are Lagging
Chimera is late in filing its 10-Q and extremely late in filing its 10-K. Though this is not an indication of wrongdoing or material problems at the firm, it denies investors the clarity provided by financial statements. Investors should also be cognizant of Chimera's auditor replacement of Deloitte & Touche for Ernst & Young. An auditor change is not cause for alarm, especially since Chimera dismissed Deloitte & Touche; this was not an auditor bowing out of a dirty situation. However, the auditor change has to do with the accounting treatment for its loans, as disclosed in an 8-K filing:
During the third quarter of 2011, the company determined that the application of ASC 325-40, Investments - Other, Beneficial Interests in Securitized Financial Assets, should be applied rather than ASC 320-10, Investments - Debt and Equity Securities, in evaluating non-Agency RMBS that are not of high credit quality for other-than-temporary impairment and related interest income recognition. As a result, the company determined that as of Sept. 30, 2011, the company had an error in its application of accounting standards that demonstrated a material weakness in the company's internal control over financial reporting …The Audit Committee discussed the subject matter of this error with Deloitte. The company has authorized Deloitte to respond to any inquiries by Ernst & Young LLP concerning the subject matter of this error.
It would be prudent to wait for an updated balance sheet disclosure under finalized accounting standards from Chimera before investing based on a price-to-book discount.
Why Require a Discount?
Investors should require returns that outweigh risks. Don't be blinded by high dividend yields; investors must also try to understand the risks of an investment, even if they are more subtle and mentally challenging than reading a dividend yield. To understand why the mega dividend yields of these REITs are based on structural risks, investors must learn how levered mortgage REITs work.
How Mortgage REITs Work
These REITs buy mortgage loans and then use those loans as collateral to buy more mortgages, and then repeat this buying and borrowing process multiple times. The net effect is that these trusts purchase multiple times their value in mortgage loans on margin. This is financial leverage, the much-demonized, destabilizing force in finance that can make capital structures very fragile.
Currently, mortgage yields are higher than short-term interest rates, allowing these REITs exploit the spread between low short-term interest rates and higher long-term mortgage rates. They further exploit this spread by buying multiple times the value of the fund, allowing them to reap multiple times the spread.
As REITs, they must then distribute at least 90% of income from their holdings. Fixed-income investors are attracted to these levered mortgage REITs because of their high dividend payouts. These high dividend yields are hard for fixed income investors to resist, especially in today's low interest rate environment.
Levered Mortgage REIT Risks
So, what's the problem?
There are many macroeconomic threats facing this REIT subsector. The market values of their mortgage holdings are not guaranteed, and could possibly drop below the value of the outstanding short-term debt a levered mortgage REIT owes. On the other hand, short-term interest rates could rise from the near-historical lows where they lie today. Essentially, the spread between mortgage rates and short-term borrowing costs could tighten, destroying the economic niche that these REITs exploit. Finally, political meddling in mortgage lending can rock the mortgage market, threatening early prepayments for holders of mortgage loans.
There are also risks specific to each individual levered mortgage REIT. The portfolio manager could make a string of bad bets on mortgage pools that fail to provide expected income or plummet in resale value. The loss of income would result in a fall in dividend income to shareholders, and the price of the REIT would fall in the secondary market as fixed income investors become disenfranchised. Worse yet, write-downs to REIT portfolios might trigger loan covenants with their lenders. Losses may result in illiquidity, insolvency, and ultimately default. Clearly, borrowing short and lending long is not a risk-free strategy, as hundreds of bank failures since 2008 attest.
There are also tax implications to the dividend yields of levered mortgage REITs. Their distributions are not taxed as long-term dividend income. Instead, they are taxed as regular interest. As such, these investments are prime candidates for tax advantaged accounts like IRAs or charitable foundations.
Criteria for Investment in Levered Mortgage REITs
Clearly, investors should not compare the dividend yields of levered mortgage REITs to those of Johnson & Johnson (JNJ) or other stable, dividend paying companies. Johnson & Johnson does not need to exploit unusual macroeconomic circumstance or perpetually pick mortgage investments according to rigorous risk management standards.
Instead, investors should require the following to materialize before investing in a mortgage REIT:
- There is available fixed-income allocation in a taxed-advantaged account. As components of tax-advantaged accounts, rendering their fully taxable status doesn't matter. Moreover, by investing in a smaller dollar amount in levered mortgage REITs instead of buying more of a traditional mortgage bond, investors can limit the risks of the mortgage market to a smaller portion of their portfolio while reaping the same income.
- The markets fear rising short rates. This will happen as systemic threats to banking rear their ugly heads.
- The mortgage REIT is trading at a significant discount to book value. P/E ratios are less meaningful since they can be "gamed" using different accounting methods which can be used to classify losses as other comprehensive income to avoid hitting the income statement.
- The mortgage REIT should have up-to-date SEC filings. This is true of any investment. Otherwise, you are just trading cash for a share of a black box.
Given this confluence of factors, investors should consider levered mortgage REITs as a tactical, possibly temporary, opportunity. It is unclear whether these REITs will continue to make massive payouts or for how long.
Investors should not jump without these factors. The broad popularity of mortgage REITs will likely be short-lived, and they will join the list of once-popular investment strategies like holding subprime collateralized debt obligations or the practice of day trading dot-com stocks.