REITs Riding On A Mortgage Powerhouse

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Includes: AGNC, AMTG, BRK.A, CYS, DX, HTS, NLY, PMT, TWO, WFC
by: Vatalyst

Wells Fargo (NYSE:WFC) could be the biggest supplier that major mREITs, such as Annaly (NYSE:NLY) and American Capital Agency (NASDAQ:AGNC), have. The bank now makes one out of every three home loans in the U.S., according to Reuters. How will this impact investors looking at mREITs? Let's find out.

Wells Fargo now controls around 34% of U.S. home lending and 13% of the mortgage business, according to Bloomberg. If that was not enough, the historic bank's officers have plans to control 40% of U.S. home lending. The interesting thing is that they could actually achieve this goal at the rate their business is expanding.

The mortgage business at Wells Fargo is expanding quickly; its mortgage income increased by 42% in the first quarter of 2012. The bank's management team thinks it can do even better, and they are planning to add 1,000 loan officers nationwide to generate more business. Wells Fargo also wants to hire hundreds of new processors and underwriters, many of them for federally sponsored programs to refinance underwater mortgages.

That is very good news for mREITs because Wells Fargo sells about 90% of the mortgages it generates. That should boost the number of high quality mortgage securities available for mREITs to buy. Wells Fargo has essentially become a mortgage packager, creating and bundling loans to sell to investors such as mREITs. The more mortgages and home loans Wells Fargo sells, the more securities mREITs can bundle and sell.

The numbers at Wells Fargo indicate that the mortgage securities market is growing and should continue to grow for the foreseeable future. The expansion of Wells Fargo's mortgage business is definitely good news for Hatteras Financial (NYSE:HTS) and Apollo Commercial R.E. Finance (NYSE:AMTG) that buy federally guaranteed paper. These companies will have more mortgage paper to buy, which should generate more profits and increase their ability to issue dividends. That could lead to at least a short-term increase in share value.

This could also be good news for mREITs that invest in riskier paper, such as PennyMac Mortgage Investment Trust (NYSE:PMT) and Dynex Capital (NYSE:DX), because it could increase the volume of less traditional mortgages. If Wells Fargo really is serious about increasing its share of the business, it will need to increase the number of non-government mortgages it issues. That should generate more business for mREITs that are willing to take risks.

Interest Rates could Threaten Wells Fargo Growth

There is one potential threat to Wells Fargo's mortgage business, and that would be an increase in interest rates. It is the record-low rate for mortgage interest that seems to be fueling the company's growth. Therefore, it stands to reason that any increase in interest rates would reduce its business.

Since it's doubtful that the Federal Reserve will increase interest rates any time soon, that possibility is remote. The most likely scenario is that Wells Fargo's mortgage business will continue to grow for the foreseeable future and the amount of mortgage securities mREITs can buy will increase with it.

The low interest rates are driving refinancing, which is now about 68% of today's mortgage business. Most of Wells Fargo's new mortgage business is presumably refinancing, which should create even more opportunities for mREIT growth. That is also good for mREITs because refinanced mortgages are their bread and butter. Many traditional investors won't touch refinanced paper, but mREITs will.

Concentration in Market could Create Problems

There is, of course, one great danger in the rise of Wells Fargo to the top of the mortgage heap. That danger is that its dominant position in the mortgage industry would give Wells Fargo a stranglehold. It could throw its power around and perhaps use it to help or hurt mREITs.

One danger is that Wells Fargo executives would be in a position to shut out certain mREITs. They could make a sweetheart deal with one of the larger mREITs, such as Annaly or American Capital Agency, and effectively shut out smaller players, such as Two Harbors Investment (NYSE:TWO). If Wells Fargo were to stop selling to certain mREITs, those mREITs stock values would certainly fall. If Wells Fargo were to direct most of its business to one company, that mREIT's stock value could go through the ceiling.

Another possibility is that Wells Fargo might spread its business around in order to keep costs lower. A situation with a lot of small mREITs begging for Wells Fargo's business would be the best for the bank. It could dictate what rates are, as well as other terms of business by threatening only to sell to trusts that are willing to play by its rules.

This could create a rigid environment in which newer players would have a harder time entering the market. This scenario would increase costs, which would definitely cut into those big dividends that some popular mREITs have been offering. The resulting decrease in earnings per share would make it impossible to offer large dividends.

An even bigger potential threat to mREITs would be if Wells Fargo started looking for alternative mortgage markets. There are some alternative buyers for mortgage paper out there. The biggest one appears to Warren Buffett, whose Berkshire Hathaway (NYSE:BRK.A) has been trying to buy at least some of the bankrupt Residential Capital's mortgage business.

Other players, such as hedge funds, could follow Buffett into the business and make deals for mortgage paper. A big danger here would be that deep pocketed investors would buy up the good paper and leave only risky mortgages for mREITs to buy up. That would increase their operating costs and lower their earnings per share, which would sink stock values. Smaller mREITs, such as Cypress Investments (NYSE:CYS), would have a harder time competing in such an environment.

If Wells Fargo decides to sell most of its mortgages to somebody besides mREITs, the business could be devastated. The business would have to contract because the volume of mortgages needed to sustain the number of firms might not be there. Naturally, stock values would fall and dividends could disappear.

Uncle Sam Could Break Wells Fargo Mortgage Business Up

There's another possibility here: Wells Fargo might have to cut back on its aggressive mortgage industry expansion because of Uncle Sam. Wells Fargo is a bank, so it is regulated by the Federal Deposit Insurance Corporation (FDIC) and other agencies. Federal regulators, including Edward J. DeMarco, head of the Federal Housing Finance Agency (FHA), have already expressed concern that mortgage lending is too "concentrated."

That means they think Wells Fargo is too exposed to the mortgage market. Regulators like the FDIC and the Comptroller of the Currency have the power to force Wells Fargo to reduce its involvement in mortgages. They could even force the bank to spin off its mortgage business.

Any such action by Uncle Sam would be good for mREITs because it would increase competition in the mortgage business. There would be more underwriters and higher volumes of business for them. The biggest beneficiaries from a forced reduction of Wells Fargo's mortgage business would be the really big mREITs, such as Annaly and American Capital Agency. Their share values would probably go up on any decision to break up Wells Fargo's mortgage unit.

Anything that affects Wells Fargo and its mortgage business will have a profound effect on mREITs and their stock value, because Wells Fargo is the biggest player in the business. Until that changes, mREIT investors will have to pay close attention to Wells Fargo and what it does.

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