Patrick Harden's  Instablog

There is no doubt after the third quarter's earnings reports that the agency-backed mortgage REIT sector is beginning to splinter into markedly different strategic approaches.  FOMC minutes confirm the high demand for agency MBS, noting that:

To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of $1.25 trillion of agency mortgage-backed securities and about $175 billion of agency debt. The amount of agency debt purchases, while somewhat less than the previously announced maximum of $200 billion, is consistent with the recent path of purchases and reflects the limited availability of agency debt.

Several of the amREITs I follow noted on their conference calls that the prices for hybrid ARMs had gotten absurdly high, into the 105s, with effective yields (net of expected premium amortization) falling below 4%.  With seasoned fixed-rate MBS already overpriced, the sector appears to be at a crossroads for strategic direction going forward.

The major players appear to have divided themselves into three camps:

1) Focus on cost of funds through liability management:  Annaly Capital (NLY) and Hatteras Financial (HTS)

2) Focus on cost-basis control and prepayment risk:  Anworth Mortgage (ANH), American Capital Agency (AGNC), and Capstead Mortgage (CMO)

3) Focus on improving yield through credit risk assumption:  MFA Financial (MFA) and New York Mortgage Trust (NYMT)

Rundown of Camp #1 Tactics:

Both Annaly and Hatteras appear to remain as active purchasers in the MBS market, with Annaly leaning more toward fixed-rate MBS and Hatteras purchasing hybrid ARMs, both to replace portfolio runoff.  These two have focused their strategic efforts on their swap books, attempting to lower their cost of funds through active liability management versus managing the asset side of the book.

Rundown of Camp #2 Tactics

This group has largely sold out of the richly-priced hybrid ARMs, instead seeking current reset ARMs in a bet that the Fed exit from the MBS market in early 2010 will remove the artifical downward pressure on long-term rates.  All three companies hope to see a boost in asset yields during 2010 as the current to reset ARMs react to the upwards movement on the long-end of the curve.

Rundown of Camp #3 Tactics

Perhaps the boldest of the three groups, both MFA Financial and New York Mortgage Trust have chosen to diversify away from agency-backed MBS and chase after the non-agency AAA RMBS, which have rallied strongly this year, but they still believe non-agency RMBS provide more upside than the highly-priced agency debt.  Both companies have lowered leverage dramatically as a result, but believe that the unlevered returns will still be greater than levering up against agency debt.

Whichever group turns out to be the most correct remains to be seen, but the bets have been placed.  I would expect divergence in the stock prices among the sector members as we move through the fourth quarter and gain more clarity on whose strategy is working the best.

Disclosure:  Author has no positions in any of stocks mentioned in this article.

Resource Capital (RSO) is one of the few specialty finance REITs that has been able to maintain a significant cash dividend throughout the credit crisis, most recently sporting a $0.30/share quarterly cash dividend.  At a stock price of about $5.00, that's an amazing 24% yield. 

More compellingly, Resource Capital has been able to maintain this high yield for over a year, since the stock price first dipped below $5.00 in September 2008.  At one point during the lows of March 2009, RSO was paying a quarterly dividend of $0.30/share against a share price of $1.43 - a yield of nearly 84%!

Although Resource Capital has done an extraordinary job maintaining a cash dividend while materially reducing recourse debt on the balance sheet, the company's most recent results indicate that lofty dividend is no longer supportable, at least from an economic standpoint. 

Q3 2009 taxable income decreased significantly for the second quarter in a row, to just $0.14/share - well below the $0.30/share dividend amount.  For the nine months ended September 30, 2009, REIT taxable income was just $0.61/share versus distributions of $0.90/share declared for 2009 to date. 

RSO had been able to maintain a level of taxable income necessary to support the dividend in previous periods because of the taxable income flowing from its Apidos CLOs, three foreign-domiciled taxable REIT subsidiaries collateralized by bank loans.  REITs are required to include income from foreign TRSs in their taxable income and the Apidos CLOs were producing taxable income requiring distribution. 

Recently, however, Resource Capital has had to sell & replace (at a loss) certain assets out of the CLOs to maintain covenant compliance & keep the CLOs cash flowing at all tranches.  These realized losses have materially reduced the taxable income coming from the Apidos CLOs.  Thus, in order to maintain the cash flows to the junior tranches of the CLOs, RSO has had to accelerate taxable losses that normally would not have been recognized so quickly.

RSO seems to be determined to maintain a significant cash dividend as a way to prove its general health and support a lagging stock price.  While Resource Capital has done an outstanding job managing its balance sheet & overall operations during the credit crunch, in this environment, it appears foolish to distribute a return of capital to shareholders.  Hopefully, RSO will reduce the dividend and use the retained capital to increase share buybacks or repurchase debt at a significant discount.

Disclosure:  Author has no positions in RSO.

High-flying agency-backed mortgage REIT American Capital Agency Corp. (AGNC) recently turned in third quarter numbers - the first in its sector to report for Q3.  The headline numbers were impressive, with $1.82/share in GAAP earnings and $1.89/share in taxable income - well above the $1.40/share Q3 dividend.  However, a quick review of the earnings release and the shareholder presentation reveals that AGNC's stunning results were once again the result of selling off its appreciated MBS holdings. 

Last quarter, the Company traded out its high-yield fixed MBS for higher-yielding ARMs, using the capital gains to boost EPS by $0.72/share.  This quarter, the Company traded out the high-yielding ARMs for lower-yielding ARMs, again achieving capital gains that boosted EPS by about $0.73/share.

To AGNC's credit, the Company included a new slide in its Q3 shareholder presentation noting that its YTD taxable income of $3.90/share includes $1.26/share in (potentially non-recurring) capital gain income.  Ordinary taxable income was just $2.64/share, well below AGNC's YTD distributions of $3.75/share.  For the quarter, the Company earned $1.16/share in ordinary taxable income - below the $1.40/share dividend.  It's clear from the slide presentation that the 2009 dividend is being supported by $0.22/share in 2008 TI spillover plus 2009 capital gain income.

Given AGNC's portfolio actions - swapping into lower-yielding coupon securities - it's likely that the net interest spread for the Company has peaked, pressuring the ordinary taxable income run rate going forward.  Although AGNC has $0.90/share in undistributed taxable income remaining to support the dividend in Q4 09 and 2010, it won't be enough to sustain the dividend at current levels.  AGNC will likely have to cut its dividend to $1.00/share or lower in future quarters, bringing the yield down to a more reasonable 14% or so.  Although the yield will remain attractive, at a price/book value of 1.27x, AGNC is already fairly valued compared to peers.  A dividend cut will likely send retail investors fleeing to other names in the sector that have pursued a more stable dividend policy.

Disclosure:  Author has no position in AGNC.

Have you missed the awesome run in agency-backed mortgage REITs?  There may still be time to get in on the great returns by picking a sleeper stock that is poised to break out.

Cypress Sharpridge Investments, Inc. (CYS) is a recent entrant to the mortgage REIT world.  The Company, which primarily invests in agency residential mortgage-backed securities, came public in June 2009, raising $100 million by offering 9.1 million shares at $11.00, the low end of the proposed $11.00 to $13.00 range.

Since June, the Company has traded slowly but steadily upwards along with the market while quietly deploying its IPO proceeds into agency-backed RMBS.  However, the Company has yet to announce a dividend, which may be keeping it under the radar and in the shadow of the other amREITs.

Based on a recent price to book analysis of the major amREITs, CYS appears to be a better value play than some of the hotter amREITs, which were recently downgraded by JMP Securities on valuation.

Market Price to 6/30/09 Book Value

Hatteras Financial (HTS)	1.35x
American Capital Agency (AGNC)	1.44x
Annaly Capital Management (NLY)	1.19x
Capstead Mortgage (CMO)	1.33x
MFA Financial (MFA)	1.08x
CypressSharpridge Investments (CYS)	1.12x

The biggest question surrounding CypressSharpridge is the dividend.  As of June 30, 2009, the Company had no distributable taxable income, so the third quarter dividend would be based solely on Q3 taxable earnings. 

CYS disclosed Q2 core earnings of $0.74 per diluted share, compared to $4.3 million or $0.57 per diluted share in the first quarter of 2009.  This increase was primarily due to an increase in the interest rate spread net of hedge of 3.88%, compared to 2.94% in the first quarter of 2009. Leverage remained relatively constant at about 6:1.

If I had to guess, I would say that CYS is capable of delivering a $0.60/share dividend going forward, giving it a forward annual dividend yield of 17% at current market prices. Coupled with a price target of $16.50 once the P/B multiple catches up with peers, I believe CYS has some nice returns to deliver.

Disclosure:  No positions in any company mentioned.

Apparently, there is a reason while REITs include this risk factor in their SEC filing boilerplate:  "The U.S. federal income tax laws governing REITs are complex."

BRT Realty Trust (BRT) learned this lesson the hard way.  The mortgage REIT, which bills itself as a hard money lender specializing in bridge loans and short-term commercial real estate loans, has been unable to collect from its economically-sensitive borrowers and unable to continue originating new loans. 

This development is obviously not surprising news; the Company itself suspended its cash dividend in December 2008, noting that BRT "will likely report a tax loss for the tax year ended December 31, 2008" due to the negative effect of the credit crisis on revenues and earnings.

Even as recently as August, BRT reported in its 10-Q that "[s]ince we will report a taxable loss for the year ended December 31, 2008, no distributions will be required in 2009 in order for us to retain our REIT status."

Oops.  Today's hastily-released press release (coming at the awkward time of 3:56 p.m., instead of after the market close) suddenly announced that BRT would be paying a special dividend on BRT's common shares of $1.15 per share. 

Only mortgage REIT nerds like me would care about the sudden about-face, but the special dividend was declared at the latest possible moment -- mere hours before BRT is required to file its 2008 federal income tax return.  Of course, to avoid taxes at the corporate level, BRT had to distribute 90% of its 2008 taxable income before filing its 2008 tax return, so the date of the dividend is not coincidental.

As noted in the release, BRT's taxable income came as a result of selling its highly-appreciated stake in Entertainment Properties Trust (EPR), which generated quite a bit of precious cash for a company who has suffered a ($0.70) per share cash operating loss for the nine months ended June 30, 2009. 

One can only assume that BRT expected to fully offset the taxable income from the sale of the EPR shares with bad debt deductions from worthless portfolio loans -- a position that must not have materialized upon final review of the tax return.  A similar situation was disclosed by fellow mortgage REIT Anworth Mortgage (ANH) two weeks ago, although its tax reversal did not require any additional distribution by Anworth.

Regardless of what technical tax interpretations caused the snafu, liquidity-strapped BRT is having to dish out $1.3 million in cash and issue 2.4 million shares to satisfy the distribution requirements and maintain REIT status.  Just another reason why investing in REITs isn't that straightforward -- and why investors should be careful before investing in the five new mortgage REITs coming public in the next two weeks.

Disclosure:  No position in any stocks mentioned.

This week, Angelo, Gordon & Co. became the latest of the nine firms awarded the right to take part in the U.S. Treasury's Public-Private Investment Plan to file a prospectus for a new real estate investment trust.  These REITs are designed, of course, as tax-efficient vehicles to hold the legacy assets purchased through the PPIP.  AG follows in the footsteps of both AllianceBernstein (AB) and Invesco (IVZ), who have also thrown together newly-formed REITs for the same purpose -- loading up on distressed real estate debt with the government’s blessing. 

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