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Although mortgage REITs have common attributes -- they deal in the same commodity, mortgages, they distribute 90% of their earnings, they use leverage to augment their rate arbitrage spreads -- they are by no means identical in their charters, strategies and results. Annaly Capital Management Inc. (NLY) and American Capital Agency Corp. (AGNC) are chartered to invest only in government agency-backed mortgage pass-through securities. Both operate in the same interest rate universe.

Though mREITs have a checkered history, going back to the early 1960s, many of today's mREITs, such as AGNC, have clean slates. NLY is a venerable mREIT, having been founded in 1996.

Today's mREITs have profited from the response of the Federal Reserve to the 2008 recession, leading to an extraordinary spread between cost of funds -- a typical repurchase agreement or "repo" costs about 0.4% -- and current mortgage rates -- a typical 30-year coupon earns about 4%.

The metric most often used to evaluate mREITs is book value: mortgage security assets less liabilities such as cost of funds, hedging expenses and, if they are externally managed, management fees.

(click to enlarge)Book Value per Share Chart

Since 2008, the book value slope of AGNC has been roughly the inverse of the mortgage rate slope, while the book value slope of NLY has been relatively flat. From this graphic, in can be concluded that AGNC has prospered more by the secular mortgage rate trend than NLY.

Why the different results between mREITs with similar profiles? One of the signal differences between NLY and AGNC has been leverage. While NLY's leverage factor was 5.8 at last report, AGNC's leverage factor was 8.4. The difference in payout yield between NLY and AGNC -- 13.10% and 14.8% respectively -- has been accounted for by the difference in their leveraging. Actually, the yield difference has been greater, but AGNC's share price has risen faster than NLY's, thus narrowing the difference. But while share price can be influenced by outside, market factors, book value is set largely by internal financials. And while it is said that an asset is worth what the market will pay, it seems that the market is looking at book value.

NLY has been regarded a the more conservative of the two, because its lower payout rate reflects lower leverage. However, lower payout may also reflect fewer funds available to grow book value. The earnings picture seems to bear this out.

(click to enlarge)NLY Earnings Per Share Chart

The yield difference between NLY and AGNC and the latter's book value growth, which has led to a handsome share price appreciation, are factors in weighing leverage against risk-reward. The investor should first evaluate how risk is managed by an mREIT. Exposure to prepayment and rate changes contribute to aggregate risk. Better management of these risks, through asset selection and hedging, allows for higher leverage. Conversely, with a higher CPR, or prepayment rate, the investor should expect the mREIT to adjust its leverage accordingly. By how much depends on how prepayment-protected the mREIT's portfolio is. For example, lower-balance mortgages have lower prepayment exposure. A prepayment-protected portfolio allows for profit even in a prepayment-rich environment of falling rates. It has been argued by AGNC that in a falling rate environment, such as a QE, low leverage is not where to be, because with the inevitable need to reinvest, the mREIT will be competing with the Federal Reserve on the mortgage market.

Of course, past performance does not guaranty future results, and while the 30-year mortgage rate continued its trend in the second quarter, it will be interesting to see if NLY and AGNC continued theirs.

Disclosure: I am long AGNC.

Source: Annaly And American Capital - A Tale Of 2 Mortgage REITs