Increasing Uncertainty Continues to Overshadow Non-Agency Mortgage REITs

by: Zvi Bar
Without the agency guarantee, non-agency debt tends to pay a higher interest rate and offer these REITs a larger spread than agency REITs. Of course, this higher return comes with default risk, which is significant in the present market. Some non-agency debt is collateralized by the underlying property, while other debt is non-recourse. Non-agency REITs also employ differing levels of leverage and hedging techniques. All these issues add risk and uncertainty to the asset class, but also greater present yield.
Types of Non-Agency Mortgages
  1. Prime mortgages: High-quality mortgages that meet rigorous underwriting requirements, similar to those used for agency mortgages. Such loans are usually non-agency because the balances are above what Fannie and Freddie allows. Prime mortgage loans have historically carried low default risk because they are usually made to high-credit quality borrowers.
  2. Alternative-A (Alt-A) mortgages: Alt-A loans are usually provided to borrowers with average or above average credit scores, and have historically required looser loan documentation requirements and allowed larger loan sizes than under agency underwriting guidelines.
  3. Option Adjustable Rate Mortgages (Option ARMs): Option ARMs are a specific hybrid type of Alt-A mortgage that has flexible repayment terms. Option ARM mortgages allow for interest-only payments and sometimes even less than interest due payments. The loan balance of an Option ARM can increase over time (negative amortization in lending jargon). Such loans are designed to start with an exceedingly below average rate of interest, usually called a teaser rate, to attract borrowers.
  4. Subprime: Subprime mortgages are provided to borrowers with low credit ratings due to a damning or limited credit history. Subprime mortgages usually require minimal income and asset verification and carry high default risk. Lenders usually charge Subprime borrowers a higher than average interest rate.
The following six REITs have exposure to non-agency paper to varying degrees and of varying type (others certainly exist). Some may and usually also do hold large positions in agency paper:

Chimera Investment (NYSE:CIM); Yield: 15.8%
Invesco Mortgage Capital (NYSE:IVR); Yield: 17.6%
MFA Financial (NYSE:MFA); Yield: 11.9%
Redwood Trust (NYSE:RWT); Yield: 6.7%
Two Harbors Investment (NYSE:TWO); Yield: 15%
Walter Investment Management (WAC); Yield: 11.2%

These companies own different types of mortgage paper and also many own significant levels of agency paper that is considered far lower risk. Some even have a majority of their portfolios presently in agency paper. Some paper may act better than others in the coming years, depending upon the underlying property values and also the interest rate on the mortgages (especially where it reset). Additionally, the borrower must be considered, which is difficult to do in total, but it is believed by many that the credit-worthiness of at least certain borrowers within the non-agency realm is higher than in agency paper and that these better borrowers will be more capable of paying and less willing to default. Such, of course, remains to be seen.
Non-agency paper has recently suffered significant pressure within the financial world, as continued default and devaluation fears proliferate the domestic and international markets. In particular, the U.S. housing market is experiencing significant over-supply and under-demand issues, with high unemployment and relatively low levels old homeowner equity. Globally, the world is grappling with Greek and other restructuring, as well as the coming end to the U.S. Federal Reserve’s present monetary expansion endeavor.
Three-month performance:
[Click all to enlarge]
As the chart above shows, these REITs returned between about 1% and negative 16% over the last three months.
One-month performance:

The one-month chart shows that five of the REITs had a negative return, with the only exception being WAC, a recent REIT convert that was performing negatively until the end of the first week of June, when it returned to even for the period on the strength of a one-day move.
Two-week performance:

The two-week chart further highlights the recent WAC spike upward and the general trend downward for REITs with agency exposure. The other five returned between -1.58% and -11.25% in the last 2 weeks.
REITs must distribute at least 90% of their taxable income in order to eliminate the need to pay income tax at the corporate level, and these REITs offer some of the higher yield in the market (outside of Greece). Under the current tax laws, REIT dividends are taxed as ordinary income, and not at the lower corporate dividend rate.
A good deal of this negative pressure may be removed by the simple action of these companies reporting their quarterly dividend, though a sharp reduction could further exacerbate the decline. The longer-term risks appear primarily related to the housing market and the unknown willingness/necessity of the present U.S. non-agency mortgage borrowers to default.
Disclosure: I am long CIM.