Mortgage REITs And Risk Management

by: James Shell

I was asked a simple question by one of my followers the other day, and as sometimes happens, the simpler the question, the more complicated the answer.

In this case, I was given a short list of mortgage REITs and asked the question we are all asking, which is: Which one would be the best to put money into right now?

The choices were as follows: New York Mortgage Trust (NASDAQ:NYMT), Armour Residential REIT (NYSE:ARR), and Apollo Residential Mortgage (NYSE:AMTG). Since we have done a lot of work on American Capital Mortgage (NASDAQ:MTGE) I threw it into the comparison.

Here is a stock chart:

Click to enlarge

All of these REITs have had a good six months, the star of the group is MTGE, which is another good reason for including it. AMTG has had a good couple of weeks.

I've collected a little table of financial data as follows:

Current Yield 14.5% 13.30% 14.40% 15.20%
Interest Spread 5.95% 2.80% 2.15% 2.12%
Leverage 1.2 5.5 8.92 6.7
Assets, Dec 30 $M 682 1400 6200 1740
Assets, Jun 30 $M 4250 3300 13900 5778
6-Month Growth Factor 6.23 2.36 2.24 3.32
Price to Book Ratio 1.12 1.14 1.08 1.2

For those that wish to follow along, the most recent 10Qs for the stocks are reachable at the following links: NYMT, AMTG, ARR, MTGE.

There are several points of interest:

You will note that all of these mREITs are on the steep part of their growth curve. The slowest growing of the group, ARR, "only" doubled in size in the last six months. The much more rapidly growing NYMT went up six times in size, as measured by total assets.

You will also note that the outlier in this group is clearly the NYMT, and for good reason. This company is about 80% engaged in multi-family residential mortgages, i.e apartment buildings. The interest rate spread in this marketplace is obviously the most favorable, and the company is using lower leverage to offset some of the risk. The interest rate spread is the difference between the borrowing cost and the coupon value for the mortgage, and the borrowing cost calculation includes the results of the hedging activity for each company.

We had discussions in the last few days about Dynex Capital (NYSE:DX), as well as Resource Capital (NYSE:RSO), both of which are participating in the non-residential and/or non-agency-backed marketplace. Some arguments were made in the discussions that followed that this made these companies "different" somehow than the rest of the mREITs.

In the NYMT management discussion, there was actually some talk of this:

Our leverage ratio for our investment portfolio, which we define as our outstanding indebtedness under repurchase agreements
divided by stockholders' equity, was 1.2 to 1 at June 30, 2012. The Company's policy for leverage is based on the type of asset, underlying
collateral and overall market conditions. Currently, the Company targets an 8 to 1 maximum leverage ratio for Agency ARMs, a 2 to 1
maximum leverage ratio for Agency IOs and a maximum ratio of 3 to 1 for all other securities.

Leverage is the extent to which these companies inflate themselves using hedging and borrowing to increase their available capital. The more they do this, the riskier it is, in theory. In essence, the management of NYMT, is taking it on themselves to manage the perceived lower risk portion of their portfolio less conservatively, by allowing a higher degree of leverage.

The giants in this marketplace, American Agency Capital (NASDAQ:AGNC) and Annaly Capital Management (NYSE:NLY) deal only in agency-backed residential mortgages. When we checked in with the most recent quarterly reports a month or so ago, these two giant companies have interest rate spreads in the 1.5 or 1.7% range, AGNC was leveraged at 7.5 to 1, and NLY was more conservatively leveraged at 6:1.

So, we have a marketplace for mortgages with all sorts of different risk levels. We know that Two Harbors (NYSE:TWO) actually specializes in the high-risk borrowers, and gets paid an interest rate premium for it. The commodity portion of this industry, AGNC and NLY, have much lower spreads, but these mortgages are in theory nearly risk-free, since they are backed up by a government-sponsored entity. The only drawback is that there are problems with prepayment as the reliable customers have been refinancing their mortgages. In between are companies that are engaged in commercial mortgages and in other markets, and these companies adjust the leverage to offset some of the higher risk, but not all.

You also have the further complication of the dividend yield, which is an artifact of the dividend rate and the market price for the stock. The market also adjusts the price for these stocks by some expectation of risk as well as the expected forward dividend stream, which is by no means guaranteed.

So, back to the original question, which is: Which of the three above mREITs is investment-worthy at this moment in time? I have to say that I would not be afraid to invest in any of these. ARR is the thriftiest at the moment in terms of price-to-book value, which suggests an upside to the stock. The yield is still more than 14%, and they do have that monthly dividend payment, which cuts down on some of the volatility. The drawback is that the dividend is shrinking. The company cut its monthly dividend to 9 cents, and the dividend has been on a steadily downward trajectory.

I am intrigued with NYMT, though. You know that the spreads of all of the mortgage REITs have been steadily shrinking for more than a year, and the higher the spread the better. The residential real estate market in the country is still terrible. There is a generation of young people that has struggled to get into position to become homeowners, and that suggests some demand for apartments. So, inasmuch as you hate to sacrifice yield, since NYMT is only yielding a bit more than 10%, NYMT's dividends might be safer over the long run. The world needs many more "safe" 10% yielding investments.

Strategy note: I favor not investing in these things right before the dividend. We have experience that says about 70% of the time, the price drop that occurs after the passing of the ex-dividend date is greater than the amount of the dividend. So you are, at that level of probability, better off by waiting until after the ex-dividend date to go long, if you choose to do so.

As we are so fond of saying, the world is chaotic and there are no guarantees on anything. This Risk Management idea deserves some additional investigation.

Disclosure: I am long AGNC, TWO, MTGE, ARR. I am also long a handful of other REITs, which I review periodically. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.