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by Daniel Jennings

The biggest potential risk for mortgage Real Estate Investment Trust (mREIT) stocks could be defaults on refinanced mortgages. A new study from TransUnion concluded that 6 out of 10 refinanced mortgages will be in default again within 18 months. But, how much of a risk is this, and how will it impact investors looking at mREITs? Below, I will discuss this finding in the context of eight major mREITs to see how it will affect opportunities for investment.

mREITs such as Two Harbors Investment (TWO) and Chimera Investment Trust (CIM) that buy up refinanced mortgages could be taking on much greater risks than previously thought. The high dividends these shares offer could come with a much greater risk; the bottom could drop out on them suddenly and quickly. These risks could be magnified by the dismal economy and lousy job figures. The U.S. economy has not been adding as many jobs as was expected. Only 69,000 jobs were added to the US economy in May. To make matters worse the unemployment rate rose slightly from 8.1% to 8.2%. Since unemployed people would be the most likely to default on their mortgages that means the default rate could soon go up.

Refinancing is a much riskier business now than it was just a few months ago. The rate of default seems to be higher and so is the unemployment rate. The only way that companies like Chimera can be successful in refinancing is if the mortgage holders are working and making payments.

If rising unemployment leads to a wave of refinancing defaults it could induce panic in the market and cause investors to sell companies such as Chimera and Dynex Capital (DX). These companies buy up lower quality paper which would be the first to start tumbling. All it would take is a few news stories about refinancing foreclosures increasing to start that sort of panic.

Another problem that this could create is that some companies might not be able to raise additional funds to buy mortgages through financing if refinanced homes start showing up in foreclosure. That would pull the rug out from their business model which is to use bundled mortgages to create securities. If nobody buys the securities the money dries up and the system shuts down.

This is not likely but such a worst case scenario will be on investors' minds. Even slight problems in raising money could cause both stock values and dividends to fall. That would not mean mREITs were a bad buy. They would still be a good value buy because their basic business model is still pretty good.

Some Refinancing Deals Carry Less Risk

Something else to keep in mind is that not all kinds of refinancing offer the same kind of risks. There are less risky kinds of refinanced mortgages that mREITs can buy up. That means it is possible to lower your risk of losses by buying shares in REITs that buy up specific kinds of refinanced mortgage paper.

A study by Amherst Securities Group found that homeowners who get their mortgage principal reduced were much less likely to default than those who just got an interest rate reduction. Around 40% of the refinanced mortgages done so far this year have been principal reductions.

That means that the inherent risk in mortgage refinancing is being reduced. mREIT stock buyers are actually taking fewer risks because mortgage underwriters are taking the steps necessary to reduce market volatility and risk. That should boost the long-term value of mREIT stocks.

The increase in principal reductions should boost the value of trusts such as Hatteras Financial (HTS) and MFA Mortgage Investments (MFA), which specialize in buying up government paper. They will be in a position to buy up more mortgage paper, increase their ability to leverage, and generate more cash flow and dividends.

That means REITs that buy up paper from government programs such as Home Affordable Modification Program (HARP) could actually be taking fewer risks. One of HARP's most noticeable features is reduction of mortgage principal. That reduces the inherent risks because it makes it easier for people to pay their mortgages.

Only about 12% of mortgage holders that received a principal reduction defaulted in 2011. Around 30% of the people who refinanced without principal reduction defaulted. That means there are some ways to reduce the inherent risk that lenders or mREITs take by buying up refinanced mortgages. The market may not be as risky as some of the bears have led us to believe.

Therefore investors should be able to protect themselves by buying more traditional mREITs such as Apollo Commercial R.E. Finance (AMTG) and Anworth Mortgage Assets (AHN). These companies seem to be taking fewer risks than some of the less traditional trusts such as PennyMac Mortgage Investment Trust (PMT) and Chimera even though they may offer lower dividends.

Volatility is the Name of the Game

Investors need to realize that this is not your father's mortgage industry. Mortgages are now inherently volatile investments and will remain so for the foreseeable future. The market is riskier but the potential profits are now much higher because of that volatility.

This volatility is the reason that mREITs have been able to issue such great dividends in recent years. A volatile market makes for potentially higher returns and for bigger risks. So investors should welcome it but understand what they are getting themselves into here.

The mREITs make their money by picking the least risky mortgages from the pile. They go through mortgages like a picker goes through an old house full of antiques. They're looking for the few items that they can make money on and ignoring the rest. It can be especially tough but it looks like some mREITs are getting really good at.

Dynex seems to be doing a really good job of picking mortgages because its management team really knows the industry. Its management team seems to know how to manage risk by picking the best deals. Chimera also seems to do a really good job of picking through some of the lesser asset classes.

The mortgage industry has become more of a traditional financial market and less of a lending arena. Mortgages must now be viewed as a sort of commodity with the same kinds of potential risks and gains as other commodities. Okay it's hard for most of us to think of mortgages that way but it is how the market has developed.

mREITs have been successful because their managers view mortgages as a commodity and treat them accordingly. A company like Chimera can offer 16.9% dividends because its managers know which mortgages are most likely to make money.

Refinanced mortgages are among the most profitable because they make up the bulk of new issues in this market. They are also cheaper and easier to process so they reduce costs and raise earnings per share. Lower interest rates make refinancing cheaper and more attractive to both lenders and to homeowners.

Despite the increased risks the increasing amount of refinancing is good for mREITs and their investors because increased refinancing raises the potential profits and cuts costs.

There are also some good methods of reducing refinancing risks such as principal reduction out there. As long as homeowners keep taking advantage of these methods, companies as diverse as Chimera and MFA should see higher earnings per share and dividends. The risks in the mREIT sector are actually falling in spite of some the headlines being published.

Source: 8 mREITs Being Impacted By Defaults Now