Mortgage Reits: Impact Of Operation Twist

Includes: AGNC, ANH, CMO, NLY
by: Bidness Etc

The Fed has made efforts to stimulate the sluggish U.S. economy, first through its Operation Twist, then through the extension of this operation on June 20, 2012. Later, it also implemented the maturity extension program, where the Fed intended to sell $667 billion worth of shorter-term Treasury securities by the end of the year. The program intended to use the proceeds from the sale to buy longer-term Treasury securities. The extension program was proposed to put downward and upward pressure on longer term and shorter term interest rates, respectively, resulting in the flattening of the yield curve.

Short-term interest rates have been hovering around zero since December 2008. Despite all the efforts to ease the U.S. economy, which is rocked with disappointing economic data, the economy is showing no significant signs of respite. GDP growth expectations have been lowered from 2.4% to 1.9% this year. Since the financial meltdown, unemployment in the country has remained stubborn at 8.3%. As far as the major industrial production is concerned, the ISM Manufacturing Production Index has reached 51.3, the lowest since the beginning of the year.

Talks of another round of quantitative easing by the Fed are widespread. Ben Bernanke, the Chairman of the Federal Reserve Bank, has signaled his unease with the pace of growth. The Chairman in June said that another round of easing may be required to stimulate growth. However, Ben Bernanke faces significant resistance from three of the Federal Reserve's regional banks in setting the tables for another round of quantitative easing. The recent remarks by Philadelphia and Kansas City's Fed presidents underscore the divide among top officials of the Fed. The Minneapolis Fed President voiced his concerns and suggested that the interest rates may be required to be raised before 2014. However, none of the three have votes on the policy setting committee of the Fed this year. The three officials suspect that any further bond purchases would not have a positive effect. One of the officials said:

The evidence is not strong that somehow more (bond purchases) are going to help the unemployment rate move faster to where we'd like it to be. I don't see that there is much benefit,

Supporting Ben Bernanke's intentions are the Boston and Chicago Fed presidents, demanding new rounds of quantitative efforts. Ben Bernanke's success or otherwise will have an impact on the financial sector of the United States, particularly mortgage REITs. Mortgage REITs behave much like leveraged bond funds. Mortgage REITs (mREITs) use short-term repurchase agreements to fund their portfolios of mortgage-backed securities. These mortgage REITs have been enjoying near zero interest rates. Some of the most followed mortgage REITs like Annaly Capital Management (NYSE:NLY), American Capital Agency (NASDAQ:AGNC), Capstead Mortgage (NYSE:CMO) and Anworth Mortgage Assets (NYSE:ANH) have YTD performances of 6%, 19%, 11.25% and 5%, respectively. Further, efforts by Ben Bernanke to stimulate the economy will decrease interest rates, and investors could expect both sustainable dividends and capital appreciation from their mortgage REITs investments. However, decreased interest rates will result in lower mortgage rates. Lower mortgage rates will accelerate prepayments on the higher-rate mortgage securities. Therefore, we believe that in such a case, mortgage REITs, which make use of appropriate hedges and have significant proportions of adjustable rate and hybrid mortgage backed securities, will be the ones which will be impacted the least. If the rates increase, the interest rate spread that these mortgage REITs earn will be depressed, and investors can expect dividend cuts besides capital depreciation. Mortgage REITs could face further headwinds if the interest rate yield curve further flattens.

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