MFA Financial, Inc. (NYSE:MFA) is an mREIT investing in both agency and non-agency MBS. Since I covered the assets of the company in my last article, I'm going to focus on the interest rate swaps in this one. It might seem like liabilities would be the opposite side of assets, but is the interest rate swaps that determine a substantial portion of the interest expense for an mREIT. Interest rate swaps may have a balance as a liability, an asset, or may have no value, depending on the interest rate curve. Therefore, it is important for investors to understand the notional value of the interest rate swaps.
Notional Value of swaps
The notional value of the interest rate swap is a value agreed upon between the company and another entity that determines the amount of interest that will be paid. For investors that are not familiar with interest rate swaps, pretend that the company and counterparty both lend each other money. One side pays a fixed rate of interest, and the other side pays a variable rate of interest. In reality, the companies don't have to make loans to each other; they just set a value for the hypothetical loan and use that to determine how much each party is expected to pay.
I prepared the following chart to show the notional value of swaps for MFA:
The time periods at the bottom of the chart reflect the longest period included. For instance, the 6-month category reflects all interest rate swaps that are longer than 3 months but shorter than or equal to 6 months.
We can see right away that the largest risk exposure for the company in the interest rate swaps is in the range of 5-6 years. The company has $1.5 billion in notional value of interest rate swaps in that time range, compared to $3.88 billion in total notional values.
Fixed rate paid on swaps
The next part of the interest rate swaps requires understanding the fixed rate that is paid on the swaps. I prepared the chart below to show the fixed rates that are paid on the swaps.
Normally, the yield curve has a positive slope. In other words, if the company was regularly rolling its positions, we would expect the right side of the chart to be much taller than the left side, because borrowing for longer periods normally requires paying a higher interest rate.
However, this chart doesn't look like that normal yield curve. That happens because the company is staying in the position, rather than exiting it and opening new positions. Therefore, the fixed rate paid for a given maturity reflects the rate that was originally agreed upon when the swap was entered into, rather than the rate that the markets are currently requiring.
The highest rate is a swap that will end during the quarter; based on the reporting dates for the document, it should have already ended. That will help the net interest spread, but it was a fairly small percentage of the company's total notional value of swaps, so the impact will be limited.
It is possible to exit a swap
When the company wants to exit a swap, it is possible to exit the position; but due to fluctuations in interest rates, the value of the swap may be positive or negative. If interest rates go down, the value of the swap will be negative, because no investor wants to pay a higher interest rate than what is currently available in the market.
Swaps to MBS
The company is using the swaps to hedge its exposure to movements in interest rates. That risk is initially created by the company investing in MBS. The following chart compares the value of all MBS relative to the value of the swaps:
As you can see, the notional value of the swaps covers a fraction of the book value of the mortgage-backed securities. The math comes out to 35.48% of the value of MBS being hedged through the notional value of swaps.
How are those swaps doing?
Have a look at the table below. I'll explain how to read it below:
The most important value here for MFA is the "-5" value on the 5-year LIBOR swap. We already determined that a substantial portion of the swaps had maturities between 5 and 6 years, so we can use this chart to look at the impact of the rate movements. According to this chart, it appears the rate on the 5-year LIBOR swap has fallen from 1.74% to 1.69%. Assuming that MFA has not, and will not, exit its position in the interest rate swaps, this movement will create an unrealized loss for the company.
The decrease in the 5-year LIBOR shouldn't be a big deal
A decrease of 5 basis points really isn't that bad, and the unrealized loss shouldn't be that significant. The 10-year rates fell by more, but the 2-year rates fell by less, and MFA has more short-term swaps than long-term swaps.
How are the assets doing?
The agency portion of the company's portfolio is a mix of 15-year fixed rate securities and hybrid adjustable rate securities.
The following chart tracks the movements in rates for newly issued mortgage securities:
Looking at the 15-year fixed rate mortgage, we see that the rate has decreased from 3.37 to 3.31. That raises book value, while creating prepayment risks. On the other hand, the adjustable rate mortgages have actually been fairly steady and are up slightly in the arbitrary period of one month.
It looks like MFA may have a tiny unreported loss on the notional value of its swaps, but not enough to represent a meaningful risk to the company. Prepayment risk would be my largest concern, but the last month hasn't made the prepayment risk much worse. When you consider the 15-year rates in place at the start of the quarter, it does appear that prepayment risk could become a larger factor for the company if the rates don't inch back upwards.
I'm not a huge fan of the company facing 2.22% on its substantial position in interest rate swaps with a maturity of 5-6 years, but some swaps are necessary to limit the risk. I am concerned that MFA has only 35.5% of MBS hedged with interest rate swaps, and the swaps have relatively short durations (around 5 years). That may leave the company with a little more exposure to rate movements than I would like. I would have expected either a larger percentage of MBS to be hedged in swaps or a longer duration on the swaps.
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