Is it a trend? Housing starts were recently reported to have jumped 15% in September, to the highest point in four years. Since four years ago was 2008, that's not saying much. Yet it's something. One builder commented that his new construction is contracts with clients and not spec houses. At the same time, other indices, such as rising consumer confidence, the Philadelphia Fed's general index, and retail sales reported by the Commerce Department, suggest that the slow movement toward recovery has depth.
Since housing led the way to the 2008 crash, with monetary intervention by the Fed creating an historically steep yield curve, it seems prudent to consider the impact a reversal of an environment which has profited mortgage REITs (mREITs) enormously will have upon them.
A major focus of the Fed's quantitative easing (QE) has been on helping banks get nonperforming paper off their books so they can normalize their retail mortgage business, writing new mortgages which support regrowth in the housing market and in-turn the economy in general.
The current QE3 seems to have been effective in jump-starting the process, if the jump in mortgage housing starts and prepayments from refinancing is any measure. Let us assume that the recent index gains indeed represent a trend, that the growth in housing starts, retail sales and consumer confidence reflect an organically recovering economy. How does this bode for the mREIT sector?
One of the big dangers of repeated QEs for mREITs is an ever-flattening yield curve, narrowing margins and diminishing dividends. A negative yield curve would of course be disastrous. However, if housing continues to recover, with the economy apace, then demand for mortgages will increase and mortgage rates will begin to rise, and the prospect of a negative yield curve will abate. The Fed has said it will not raise rates even if the economy starts to recover. When it says this, I believe it is referring to the cost of funds, the short rates on funds, usually repos, that mREITs use to purchase MBS, which will inevitably average higher coupons. Rising retail mortgage rates will reflect an expanding market, a natural trend, which the Fed manifestly favors and would not intervene against.
Once rates begin to rise, prepayments will diminish and yield curves will steepen. It has been gospel amongst some that rising rates are anathema to mREITs. I disagree. While rate spikes are indeed damaging to mREITs, gradually rising rates are, what Gary Kain of American Capital Agency Corp. (AGNC) calls a "Goldilock" scenario. Prepayments diminish -- and with them the negative convexity risk seen as an aggravating factor particularly for agency mREITs with premium MBS -- the yield curve steepens, and because the rate rise is gradual, the impact on portfolios is moderate as they're rolled.
mREITs that specialize in discounted portfolios, such as PennyMac Mortgage Investment Trust (PMT), would also benefit as the housing market recovers. Although PMT's yield is relatively low for an mREIT (currently about 9%), its business model is based on asset improvement. A recovering housing market, a tide that raises all boats, should substantially raise PMT's book value, since the goal of PMT has been to keep distressed properties afloat until their equity valuations recover.
One question mark is Annaly Capital Management (NLY). Though it steered through troubled waters of both inflation and deflation, its lower leverage as an agency mREIT has not worked well in a QE environment. And its co-founder and CEO Michael Farrell died recently. However, the price history indicates that NLY's strongest years were the early 2000-decade's real estate boom. If NLY continues along the path Farrell set, then it should again prosper in an expansion scenario.
It is commonly accepted that change is bad for mREITs. Rising rates and falling rates have a negative impact, either by lowering book value or by narrowing margins. We have seen the impact of quantitative easing on mREIT prices and dividends. The effectiveness of mREIT management strategies in meeting QE3 is now being put to the test. Unlike some commentators, who say that the mREITs' moment has passed, I believe there is nothing inherent in the sector that prevents a well-managed mREIT from adapting to normal underlying market changes. If QE3 represents the low-water mark in interest rate spreads, then the gradual housing recovery it aims to encourage will bode well for the mREIT that provides as effectively for rising rates as it did for falling rates.
Disclosure: I am long AGNC.