The news release from Annaly Capital Management (NLY) announcing a $1.5 billion stock repurchase authorization should put mREIT investors on notice that all may not be well in the leveraged MBS business. Mortgage REITs are much better known for issuing shares to raise capital which provide the equity to leverage additions to a company's portfolio. I will speculate - with backup data to follow - that Annaly Capital management has decided it is no longer profitable to put capital to work with the leveraged purchase of agency MBS.
Negative Earnings Potential
Let us take a quick look at a few numbers:
- For the 2012 second quarter, Annaly reported an annualized cost of funds of 1.50%. Annualized portfolio yield was 3.04%.
- The highest current yield-to-maturity quoted on the WSJ website for agency MBS page is 1.64%. The second highest yield was 1.38% and the average YTM of the nine 30-year MBS listed was 1.19%.
- Looking at MBS ETFs as a proxy for yields, the Barclays MBS Bond Fund (MBB) reports a 2.36% yield based on the trailing 12 months of distributions and a current distribution yield of 1.43%. The distributions from the Vanguard Mortgage-Backed Securities ETF (VMBS) have declined by 2/3 over the last year and the fund now yields less than 1%.
Points 2 and 3 show that Annaly would have a very difficult time investing any capital into the MBS market and earning a rate higher than its cost of funds.
- Now the scary fact. For the 2012 second quarter, Annaly Capital received $7.9 billion in return of principal and $15.2 billion for the half-year on a $120 billion MBS portfolio. The company is getting back $2.5 billion of principal every month which it must reinvest. That money can no longer be leveraged to earn double-digit returns. It can be reinvested without leverage to earn 1.5% or so. The negative interest rate spread outlined here would - if it continues - force Annaly into a fairly rapid de-leveraging.
Points of Discussion
The mortgage securities market is much more complex than the simple rate examples given above and the Annaly portfolio managers have been working in this market for a long time. I am sure they are working on strategies which will move the company through this period of tight rate spreads. This is not a falling off a cliff problem, it is more of a slow-moving train wreck and hopefully most of the damage can be avoided.
Annaly Capital reports a higher cost of funds than most of its peers. American Capital Agency (AGNC) listed a 1.08% cost of funds for the second quarter and ARMOUR Residential REIT (ARR) reported a 0.82% cost of money. There different ways to fund a leveraged MBS portfolio and these other mREIT companies show there remains potential to generate a positive rate spread.
There is a big difference between the current 3.5% or so rate for new mortgages and the sub 1.5% yield on agency MBS. The bond markets may have pushed yields too low - or mortgage rates are too high - and the low yield environment will be temporary.
QE-3 and its assault on MBS yields did not start until the second half of September, so the third quarter results from the mREIT companies will look a lot like previous quarters: a slowly tightening interest rate spread offset by profits from bond sales and increasing book values. I will be watching and listening for any discussion of strategy changes to offset the rapid flattening of the yield curve over the last month. I think the mREIT Q3 results will hold more positive surprises than negatives. It will be the final quarter of the year which could be difficult for the sector.