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.