The Fed's Effect On Mortgage REITs

Includes: AGNC, NLY
by: Stocks-Options

Before the market meltdown in 2008, the Federal Reserve was known for controlling short term interest rates and not long term rates. They control short term rates by fixing rates on money that banks borrow from the Fed for very short time periods.

Starting in 2008 the Fed's influence on long-term rates greatly expanded. The main way to accomplish this is to buy 10 year Treasuries or mortgage backed securities in the open market. The Fed is potentially the biggest player of all because of their power to create the money to buy bonds or securities with.

In July 2008 the ten year Treasury rate was 4 percent. It almost reached that again in April 2010. Since then it has gone down, down, down, rather consistently to about 1.50 percent. No one can deny that the Fed has influenced this decrease. In my opinion the Fed is the primary reason for the huge drop.

The first thing you learn about mREITs like Annaly Capital (NLY) or American Capital (AGNC) is the importance of the spread between short term rates and long term rates. It's the primary way they make money. MREITs borrow short term to buy mortgages long term. And rates of residential mortgages rise and fall with the ten year Treasury rate.

The point is the Fed has a great effect on the spread between short term and long term rates and therefore the fate of mREITs.

There's a lot of talk these days about what the Fed's going to do next. Will they buy more long term Treasuries and mortgage securities? About two years ago when testifying before Congress Ben Bernanke telegraphed that the Fed was planning on buying long term. The market quickly discounted this information and drove long rates down before the Fed had a chance to act. This forced the Fed's hand - something no Fed leader likes. Now he HAD to buy even if he had planned to wait. Timing is critical and he had lost his room to maneuver. He had to buy just to keep the rates where they were.

We all want his testimony to be clear. But I submit that he must be vague. Otherwise his words will move markets and he doesn't want the markets to force his hand. In testimony before the Senate Banking Committee this week, he is being vague.

In my opinion, the Fed wants nominal GDP to increase. (Nominal growth is the absolute growth in production. REAL growth is growth after inflation is taken into account.) Since inflation has no effect on money already borrowed, nominal GDP growth will help pay down the debt. He would like to see that happen.

Buying ten year Treasuries to put more dollars into circulation is supposed to help the economy grow, or at least keep it from slowing down. Most experts (and I'm not an expert), believe the Fed will stimulate further, but no one knows how much, and Bernanke isn't going to give us the timing.

What we do know is this buying could lower ten year rates further. And that's where mREITs come in. Lower long term rates will squeeze their profits unless they borrow more money. I don't think they want to increase their leverage any further, so that leaves a reduction in profits.

This is an added risk to owning mREITs, but I think it's a risk worth living with. The two most well-known mREITs are Annaly Capital and American Capital. Annaly's leverage is much less than American Capital's, and the lower dividend shows it. There are disagreements over which strategy is better for the future, but up to now American Capital's payouts and stock price has far surpassed Annaly's.

American Capital has been around since 2008 and hasn't seen a collapsing spread environment or an inverted yield curve. That doesn't mean it can't handle it. It means we don't know. Annaly has been around since 1998 and it's survived when many others haven't. There have been times when NLY has drastically cut the dividend, but he company hasn't imploded. In my opinion both companies have excellent management.

So, when will the Fed's action bring so much pressure on mREITs' earnings that we should consider selling? I don't know the timing and I don't see how anyone else does either. Bernanke doesn't want us to know, and he IS the major player. mREITs bear close watching. That's the price of getting dividends north of 10 percent. It's not free money.

I recently had a stock with a 33 percent rise over a year's time to an all time high. It was an ownership REIT whose yield had fallen to 5.8 percent. I decided I could put the money to better use in today's environment by purchasing my fourth mREIT. So I did. I guess you could say I didn't switch to a different market sector, but really - I did. mREITs are strange animals and it's impossible to keep them caged.

Especially with a tiger-trainer like gentle Ben.

Disclosure: I am long NLY, AGNC.

Disclaimer: Please perform your own due diligence before investing.