How Freddie Mac's Woes Could Impact MREITs

by: Investment Underground

by Daniel Jennings

Freddie Mac (OTCQB:FMCC) is having a hard time selling its mortgage-backed securities. Bloomberg reported that the mortgage guarantee company is getting extremely low prices for the debt it sells. At the same time its rival, Fannie Mae (OTCQB:FNMA) seems to be having no problem finding buyers for its securities.

Freddie Mac bonds are now selling at record low prices because investors don't seem to like them. The reason those bonds are not selling could be that alternatives such as major mortgage real estate investment trusts (mREITs) like Invesco Mortgage Capital (NYSE:IVR) and American Capital Mortgage Investment (NASDAQ:MTGE) are more appealing to investors. These stocks offer high dividends and earnings per share.

The other reason that Freddie Mac is having such a hard time selling bonds is that it is simply harder for buyers to make money on its securities. Fannie Mae securities are apparently more liquid and more profitable. Freddie Mac's volume of securities sales is now around 50% of Fannie Mae's.

Freddie Mac Fixes could Boost mREIT Business and Stock Value

What does this mean for mREIT investors? Freddie Mac's troubles could have a big impact on mREITs and their stock values because it could necessitate a remaking of the housing finance system. The entire market for mortgage securities could be radically transformed if the government tries to fix the situation. Several plans designed to fix the situation have been put forward. Most of these involve combining Freddie and Fannie's business.

The most likely scenario would be for the government to create an interchangeable Freddie Mac and Fannie Mae security. Instead of two different federal mortgage bonds there would be just one. That scenario would make life easier for mREITs because they would have just one kind of federal paper to buy. They'd have just one interest rate and one market to deal with when they bought federal paper. That of course would reduce costs and raise earnings per share.

That would increase opportunities and raise profits for mREITs because it would lower costs. That could lead to increased earnings per share and dividends. Mortgage securities would be easier and cheaper to buy, which would mean more leverage, as well as a larger market.

Congress is currently working on a fix for the federal mortgage system. Such a fix could boost the stock values of those mREITs that specialize in buying Fannie Mae and Freddie Mac paper. That includes CYS Investments (NYSE:CYS) and AG Mortgage Investment (NYSE:MITT). Those companies would see higher stock values because such a system would make it easier for them to buy up government paper. That would reduce costs and raise earnings per share.

FHA Proposal Could Increase Mortgage Security Market

The Federal Housing Finance Administration (FHFA) has outlined a plan that would essentially combine Freddie Mac and Fannie Mae bond markets. That would make buying and trading mortgage bonds easier and cheaper. There would be one place to buy the bonds. It would also make Freddie Mac more liquid, which should increase the volume of securities that it trades.

If implemented, that plan would actually create a bigger mortgage securities market and more opportunities for mREITs to generate additional income. Such an effort would essentially eliminate the standard Freddie Mac security or gold which the agency is having hard time selling. That would also give investors fewer alternatives in the bond market so they might be more likely consider alternatives such as mREIT equities.

That could bring even more investors into the mREIT arena which could increase stock sales and stock values. The market could become larger and attract institutional investors such as pension funds and European investors. That would increase the amount of cash in the market and raise dividends on mREITs.

It would also increase liquidity which would make it even easier for mREITs to expand and buy more of the new combined securities. That too would increase cash flow and dividends. mREITs would be able to borrow more money and buy up even more mortgages.

Any effort to rationalize the federal mortgage bond market could raise some costs and cut profits for mREITs. In the current system, Freddie Mac has had to discount its securities in order to sell them, which cuts costs and allows some mREITs to pick up bargains. A rationalized system would increase trading costs and cut into profits and potential dividends.

Some observers also think that Freddie Mac has been deliberately shoring up some mortgages securities values. If that it is true, it could mean that Freddie has been helping to boost the profits of mREITs like MFA Mortgage Investments (NYSE:MFA) which specialize in buying Freddie and Fannie paper.

So, if Freddie goes away, we could see a drop in the profits and the stock value for mREITs such as the New York Mortgage Trust (NASDAQ:NYMT) which buys its securities. Therefore eliminating Freddie Mac paper could take away some mREIT profits.

Freddie's Future is in Congress's Hands

It should be noted that there is no indication that Congress is serious about combining Freddie Mac and Fannie Mae's bond operations. It would take an act of Congress to combine the operations and create a single U.S. mortgage security. There is no guarantee that Congress is even considering such an action.

The mortgage industry is putting pressure on Congress to take that kind of action. Industry groups are doing this because it would lower their costs and make it easier to sell mortgage securities. Federal regulators seem to be sympathetic to such efforts even though they haven't commented publicly on them.

Congress is likely to delay any sort of action until after the election because it does not want to touch mortgages. Mortgages have been a political hot potato since the great meltdown back in 2008. Nobody wants to propose serious mortgage reform because it would associate politicians with bankers and other politically unpopular groups.

The most likely scenario is that Congress will try to sneak through such a reform after the election in November. If that happens, the effect on mREIT stocks is likely to be eliminated because it would several months or a year before the new system could be implemented. Its effects on the market would take a while to be felt.

The most likely effect will be increased demand for mortgage-backed securities because they would more profitable. Costs would be lower and securities would be easier to buy. That means mREITs would have more competition for the securities and pay a higher price for them.

If the price of federal-mortgage securities were to start rising, mREIT stock values and dividends would fall because these companies business model is based on low priced mortgage securities. Annaly, in particular, is designed to buy and sell high volumes of low priced mortgages. Without them, its profit center and the basis for its dividends disappears.

Raising the price of federal-mortgage securities would be good for Freddie and Fannie because it would increase their profits. Therefore those companies are likely to keep pushing for such a reform. Mortgage companies are likely to do the same because they want to eliminate low priced federal bonds.

mREIT investors need to realize that their stock values are partially dependent on the government. Freddie Mac and Fannie ultimately set the prices for mortgage securities. So any plan to combine their operations will have an effect on this stock sector.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.