Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

My Layman's Explanation Of MREITs In The Current Market. Did I Get It Right?

mREITs pay out almost all of their profit in dividends which means that while they have a highdividend yield their capital doesn't appreciate very much because the reinvestment rate is low. Personally, I've always thought that an investor should focus on cash flow rather than on capital appreciation.

You asked why the returns on these stocks are so high. It is sort of complicated so to really explain this well, I'll need to talk about the Fed's QE3 program and their hints about slowing it down, how mREITs make money, asset valuation, and investor's time horizon.

QE3 stands for the third round of quantitative easing. QE3 started in September 2012, the Fed said that they would inject $85 billion into the financial system each month. 40 of that 85 billion would be dedicated to buying mortgage backed securities. The Fed committed to QE3 to achieve two direct objectives, they wanted to inject liquidity into the financial system so that banks would lend again and they wanted to bring down the long term interest rate which would help consumers. They wanted people to spend money rather than hoard it.

Consumers hoarding their money is a perfect example of a self fulfilling prophecy. Because of the recession, consumers hoard their money to protect themselves against future bad economic conditions, but because the economy runs off of people and businesses spending money, everyone gets hurt more because no one is spending money which leads to another recession which confirms consumers belief that they needed to hoard money to protect themselves.

So to keep people from hoarding money, the Fed injects liquidity into the markets and brings down the interest rates. This encourages people to spend money because the typical consumer has to make a utility choice about saving versus spending. The consumer has to decide if the future value of his saving is greater than the current value of consumption, if it is, than s/he will save. If the current value is greater than the future value than s/he will spend. The lower the rate of return on investments the more a consumer is willing to spend rather than save.

So QE3 starts in September 2012 and it works perfectly, the 10 Treasury bill and mortgage interest rates drop significantly, liquidity flows into banks, and spending starts growing again. Awesome! But the Fed can't keep this up forever, mainly because constant injections of liquidity can lead to rapid inflation. The Fed set benchmarks for when they would stop QE3, when the unemployment rate fell below 6.5% and inflation stayed within 2.5%. Fast forward to May 2013. People on the Fed Board drop hints that they may ease up on buying MBSs which immediately scares the market and mortgage interest rates jump. Pause.

This is where we talk about mREITs. mREITs make money by leveraging short term liabilities and long term assets. So they borrow money in the short term to invest in mortgages in the long term. Its important here to think about risk. You can be fairly certain that if you give someone a dollar today they'll pay you back tomorrow, so there is very little risk on that loan and therefore you charge them only a small amount for borrowing that dollar. mREITs do this too with what are calledrepo loans. They use the money to build a portfolio of Agency (meaning government) and non Agency backed MBSs. But because a mortgage is a much longer investment, the mREITs make a much higher rate of return on their money because there is a higher risk involved. The difference between these two rates is the profit that the mREITs make.

The other thing you need to know is that a bond price is inversely related to the bond yield. For example, if I have a bond with a purchase price 1,000 dollars and it has a 5% yield, and if I wanted to exchange it for a bond with a purchase price of 900 dollars, then I would need a higher yield for it to be worth the investment. Basically I want to make sure that the future value of the bonds are equal. There is a lot of fairly basic finance math that's involved with this, but I'm not very good at it, I'm much better with the monetary economics theory.

Unpause. The Fed just said that they'll ease up on buying MBSs sometime in the near future. Because of this long term interest rates rise dramatically. You are thinking that's great mREITs make money on the difference between long term rates and short term rates, and if long term rates have risen while short term rates have stayed the same, then they'll make more money! Which is totally correct. However! Because the long term rates have gone up the value of their current MBSs go down and the value of their assets plummet because people expect a higher rate of return, and to achieve that, the current value of the mortgages they hold go down because they have a lower interest rate. And because mREITs do a moderate amount of leveraging, their leverage ratio goes up . They still owe the same amount of money but the value of their assets have dropped.

Investors look at all of these indicators and make buying/selling decisions based on what they believe will happen in the future. But investors have different time horizons. For investors with long term horizon, mREITs look like a good investment because in the long term they will make more money because of the difference between long term and short term rates. For a investor with a short term horizon, mREITs look like a bad investment because their book value has dropped and their leverage ratio has gone up.

So the value of the stock has dropped, it seems, because short term investors are leaving. This means it's a great time to buy for long term investors, because the dividend yield goes up with a drop in stock price. And because I'm much more focused on cash flow and yield than I am on any sort of short term trading (mostly because I know my limitations), then I'm buying mREITs to make money from their dividend pay outs over the longer term (say 3 to 5 years).

I'm not going to talk about individual mREITs and their portfolios, because that would take up way more space and more of my time, and that is more about which specific ones I should buy to maximize my return, rather than the basic gist of it all.

Disclosure: I am long NLY, AGNC, TWO.