Dividend Investor Boot Camp, Part 2: Non-Agency Mortgage REITs

by: Philip Mause

In Dividend Investor Boot Camp: ABCs of Mortgage REITs, we reviewed Agency Mortgage REITs - real estate investment trusts (REITs) which invest exclusively or almost exclusively in government agency guaranteed pools of securitized residential mortgages. Because of the government agency guarantee, there is little or no risk of default and this has supported relatively high levels of leverage and has provided some very attractive dividend yields because of the "spread" between the relatively low interest these companies have to pay on their borrowings and the higher interest rate they can earn on the residential mortgage securities they own. The major risk associated with investing in these companies is interest rate risk.

Non-agency residential mortgage REITs are much more diverse and present different issues for investors. Some of them invest in a mix of agency and non-agency mortgage backed securities. Others include some commercial property mortgages in their portfolios. Some are "hands on" and actually service individual mortgages, in some cases focusing on troubled mortgages acquired at deep discounts to par from banks. Some package mortgages into pools, sell interests in the pools and retain a subordinated interest.

Because these different activities involve very different levels of default risk, companies in this group have widely varying levels of leverage; to make things more complex, some of the debt on some of these balance sheets is non-recourse and is secured solely by one of the pools of mortgages described above.

At this point, anyone who has read this far is probably scratching his or her head and asking whether it is worth the considerable effort to evaluate these companies. I think it is worth the effort because the confusing nature of this sector is likely to lead some of these companies to be mispriced at least for certain periods of time. I have definitely seen this happen with Business Development Companies (BDCs) - when many of them were selling for much less than 50% of book as recently as two years ago. These companies will tend to be owned by yield oriented investors and there may well be an investor overreaction to one or more companies in the sector reducing its dividend sharply.

I will list the companies and after each symbol, I will provide Thursday's closing price, the price to book value, the leverage, and the annual dividend yield based on the most recent dividend.

  • Chimera Investment (NYSE:CIM): (4.19)(1.15)(1.2)(13%)
  • Dynex Capital (NYSE:DX): (10.38)(.83)(4.5)(10.4%)
  • Invesco Mortgage Capital (NYSE:IVR): (21.72)(1.05)(4.7)(17.9%)
  • Redwood Trust (NYSE:RWT): (15.60)(1.15)(3.9)(6.4%)
  • Two Harbors Investment (NYSE:TWO): (10.39)(1.10)(4.3)(15.4%)
  • PennyMac Mortgage (NYSE:PMT): (18.57)(.98)(.8)(9.0%)
  • Walter Investment Management (NYSEMKT:WAC): (19.19)(.87)(2.4)(11.1%)
  • New York Mortgage Trust (NASDAQ:NYMT): (7.21)(1.00)(4.2)(10.0%)
  • MFA Financial (NYSE:MFA): (8.21)(1.02)(3.0)(12.3)

As in the previous article, some of these yields are likely to bring tears of joy to the eyes of yield hungry investors. I think that this sector does offer some promise for diligent yield hungry investors. There are also some situations here in which there is not very much leverage and so the exposure to loss in the event of interest rate increases is not as great as it may be with the agency mortgage REITS.

As noted above, these companies are very diverse. It is beyond the scope of this article to analyze all 9 of them in detail here; I hope to review some of them in more detail periodically in the future. However, a few general points can be made. Some of these companies are hybrid in the sense that they invest in a mix of agency and non-agency mortgage securities. DX has roughly 60% of its portfolio in agency mortgage securities; it is probably for this reason that it is able to operate with a higher level of leverage than some of the other members of the group. MFA and NYMT both have relatively high percentages of agency mortgage securities but appear to be moving in the direction of non-agency mortgage securities. In this regard, MFA has acquired considerable quantities of these non-agency securities at prices well below par. IVR appears to be opportunistic in the sense that it will invest where it perceives the risk-adjusted profit potential to be greatest. It currently has roughly half of its portfolio in agency securities but is not committed to any particular ratio.

PMT appears to follow a different model. It acquires residential mortgages that are not performing at deep discounts from lenders and tries to work with borrowers and achieve a stream of payments on the mortgage as well as continued ownership of the property by the borrower. Of course, this kind of business does not support high leverage. On the other hand, the yield on the price paid by PMT for these mortgages can be very high because the mortgages have been acquired at such a deep discount. WAC is somewhat similar and appears to focus on individual, less-than-prime loans in the Southeast United States. They describe their business model as "high touch" in that it involves frequent contact with the borrowers. WAC apparently packages its loans into securities and then sells debt interests secured by those mortgage securities. The debt is non-recourse to WAC and so the leverage as it appears on the balance sheet is somewhat misleadingly high; WAC's capital is out of reach of most of the creditors in the event of defaults on the non-recourse debt.

CIM, which is operated by the same folks who run Annaly Capital Management (NYSE:NLY), has low leverage but is able to generate high returns partly because it has some very high-yielding subordinated non-agency debt (this category of debt apparently yields 16.8% on its book value for CIM) but, of course, this presents risks of its own.

You are looking at an important element of the private sector that would be called upon to replace Fannie (OTCQB:FNMA) and Freddie (OTCQB:FMCC) if that ever comes to pass. I suspect that the next few years will see regulatory developments and rumors of regulatory developments, as well as interest rate increases, developments in the housing market, and all sorts of other things which will affect the price of these stocks. I think that there will be some attractive entry points - I own some CIM and I am looking over IVR, PMT and WAC.

These stocks are not Treasuries - their inherent values can change due to changes in the value of the underlying mortgages and their stock prices can change even more because of market sentiment or rumors. For example, if something negative happened to one of the bigger names in the mortgage REIT group, I would not be surprised to see it drag the entire group down, the way Allied Capital's problems dragged down other BDCs or the way the entire electric utility sector tanked when Con Ed skipped a dividend years ago.

Dividends can vary considerably from quarter to quarter because these companies are REITs and generally pay out 90% of their income as dividends leaving little "cushion" to sustain the dividend if income goes down. When dividends decline, investors are likely to get a "double whammy" in the form of a decline in the stock price as well. Of course, any of these developments could create a great "fat pitch" buying opportunity for an investor who understands just how a new development does or doesn't affect the underlying value of different companies in this very diverse group.

Disclosure: I am long CIM, NLY.

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