The steady decline in new mortgage rates continues to put pressure on the future earnings of the leveraged, high-yield mortgage REITs. Right now, the interest rate environment works well for the mortgage REIT companies, but the situation could quickly change. The best environment for the mortgage REIT leveraged investment strategy is little movement in either short or long term interest rates.
Yet a continued trend of record low or near record low mortgage rates will eventually eat into the earnings power and dividend payments of the mREIT stocks. The bulk of the mortgage-backed securities held by the mREIT companies were issued in the hot housing market years of 2003 through 2007.
For the month of May 2012, Freddie Mac reports the average rate for a new 30-year mortgage at 3.80%. This is down from 3.96% in December of 2011. Here are the average 30-year mortgage rates for the since 2005:
- 2005: 5.87%
- 2006: 6.41%
- 2007: 6.34%
- 2008: 6.03%
- 2009: 5.04%
- 2010: 4.69%
The decline in mortgage rates effects mortgage REITs in this manner: The REITs own mortgage-backed securities - MBS - which are backed by pools of individual mortgages. When a homeowner refinances his home loan, the REIT will receive some principal repayment from the MBS which holds that specific home loan. The rate at which mortgages in a specific mortgage pool refinance their loans - and make monthly payments which slowly reduce principal outstanding - is called the prepayment rates. The mortgage REITs report repayment levels through the constant prepayment rate - CPR - which is the annualized rate at which principal is being returned from MBS to the REIT company. The prepayment of MBS principal in the current low-interest rate environment has several effects on the finances of the mortgage REITS:
- The returning principal is less than the premium amount at which the MBS assets are carried on the books. For example, the current price of a Fannie Mae MBS with a 4.5% coupon - about 5.5% rate mortgages - is 108. For each dollar of principal a mREIT receives from one of these mortgage bonds, the REIT incurs an 8 cent loss on the book value.
- Then the principal received has to be reinvested in new mortgage-backed securities at the current, lower interest rates.
- Currently, about 80% of new mortgage originations are for refinancing higher rate home loans. If mortgage activity increases, the prepayment rates for older, high coupon MBS securities would increase, resulting in both book value erosion and interest earnings erosion for the mortgage REITS.
Of course, this process has been going on for several years as indicated by the portfolio earnings rates of the mortgage REITS. Here are the reported portfolio yields over the last six reporting quarters from Invesco Mortgage Capital (IVR), American Capital Agency (AGNC) and Annaly Capital (NLY) as representative companies in the agency mortgage REIT sector:
These results show the steady decline of the earnings rates from the mortgage REIT portfolios as mortgage rates have fallen over the last couple of years. The presentation materials from American Capital Agency for the June 12 Morgan Stanley Financials Conference stated that prepayment levels on generic mortgages are starting to increase and current interest rates plus government programs such as HARP 2.0 could lead to much more rapid prepayment rates than mortgage securities have experienced in recent history.
The point of this discussion is to point out that the trend of lower dividend payments from the mortgage REITs will continue for the foreseeable future and there is no magic potion which will change the inevitable squeeze on the mREIT margins. Mortgage rate will not soon increase enough to stop what could turn into a refinancing flood. Rising mortgage rate are not the answer either. As a recent MarketWatch column noted that mortgage security funds, " "tend to lose more when rates rise than they can earn back when rates fall."
The larger mortgage REIT companies, American Capital Agency and Annaly Capital are the best positioned to survive the coming pressure on mortgage securities values. Investors should keep a very close eye on the values of the smaller mortgage REITS. All of these stocks have performed very well so far in 2012 and it may be a prudent choice to sell shares and lock in some profits.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.