The Less Obvious Risk mREITs Face

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Includes: AGNC, CIM, CMO, MORT, NLY
by: Paulo Santos

Imagine yourself holding a fixed income portfolio of long maturity bonds, levered 5-10 times and without (interest rate) upside protection.

That's what you'd be holding, if you hold mREITs such as Annaly Capital (NYSE:NLY), Capstead (NYSE:CMO), American Capital Agency (NASDAQ:AGNC), Chimera Investment (NYSE:CIM) and others, and long term interest rates turn up strongly. This happens because what these companies mostly hold is a portfolio of fixed rate MBS usually issued and guaranteed by one of the GSEs such as Fannie Mae or Freddie Mac. This portfolio is levered several times over (around 6 times for NLY), so that the spread between the borrowings and what the MBS pay can produce a large return.

Usually, the risk that's perceived regarding mREITs is that the short term interest rates might start going up. This would make the borrowings being used to buy the MBS more expensive, would narrow the spread that the mREITs are able to get, implode profits and compromise distributions. But, most likely, it wouldn't be a killer. And indeed, so recognized is this risk, that NLY even carries a great deal of swaps ($42 billion notional as of last quarter, with a $2.2 billion unrecognized loss) to counteract it.

However, the main risk -- one that's not usually so obvious, because its effects are contradictory, but whose impact can be much larger than a move on short term interest rates -- is that long term interest rates might head up quickly.

As I said in the beginning, "Imagine yourself holding a fixed income portfolio of long maturity bonds, levered 5-10 times and without upside protection". The thing is, those fixed rate MBS with estimated maturities in the 1-5 year range would magically mostly turn themselves into fixed income bonds with much longer maturities if long term interest rates headed up. They'd do this because prepayments and refinancing activity would drop like a rock.

So if long term interest rates headed up quickly, and if you were long mREITs, you'd instantly be long large, 5-10 times levered, unhedged, fixed income portfolios. And that would really be devastating.

How devastating? If we take NLY's $16 billion equity, $102 billion in fixed rate MBS, 3.25% yield, 4.63% average coupon and use a 10 year maturity, then an increase in yield to around 5.5% would wipe out the entire equity. The chart below shows how a synthetic $102.7 billion fixed income bond with $92 billion notional, 10 year maturity, 4.63% coupon and 3.25% yield, would do if the yield increased several levels. At 5.5%, it produces a loss about the size of NLY's equity.

What could bring about a jump in yields?

It's hard to say, the kind of jump that would materialize the risk can come from a jump in inflation, for instance. Which could be driven by a floating Yuan and lower dollar. Or by an oil shock.

The fact that we're on a 30 year bond rally, however, somewhat clouds us to the possibility. But it's there, it exists. And that's what risk is about, the possibility of something going wrong, and the impact of that event.

Conclusion

Although mREITs in general can be very attractive due to their high yields, they're not without risk. Indeed, they're not without catastrophic risk, which is why the yields are probably so high to begin with.

Finally, some might ask "couldn't the mREITs hedge for the risk of long term interest rates going up?". Hardly, for that would eat up the spread.

So basically the high-yielding mREITs are a bet that long term interest rates won't head up quickly. And the "quickly" part is important. If long term interest rates headed up slowly, the increased profitability from a larger spread would compensate a lot of equity losses.

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