Time to Sell Out of Mortgage REITs

by: Nicholas Pardini

S&P's downgrade of Treasury Bonds will have widespread impact on the bond market. How will this affect the high yield mortgage REITs that rely on interest spreads? REITs such as Cypress Sharpridge (NYSE:CYS), Annaly Capital Management (NYSE:NLY), and the New York Mortgage Trust (NASDAQ:NYMT) will be drastically hurt by the downgrade. In addition to Monday's panic sell off, expect the mortgage REITs to get slammed because of increased risk in RMBS's and increased costs for the REITs short term borrowing.

On Monday S&P added downgrades to Freddie Mac (OTCQB:FMCC), Fannie Mae (OTCQB:FNMA), and municipal bonds to match Treasuries and eventually this will pass on to agency bonds and agency RMBS'. The expected downgrade should lower the value of existing RMBS holdings to the point that yields rise twenty basis points. Depending on the REITs composition of fixed versus adjustable rate mortgages, a rate increase may also add a significant amount of additional default risk. Although not a short term concern, inflation risk from rampant money printing continues to grow with the debt ceiling and this will erode the real value of dollar denominated debt such as agency RMBS's.

On the other side of the balance sheet, an S&P downgrade and the current negative economic outlook will raise short term financing costs for debt used to leverage their MBS holdings. The net result of higher borrowing costs will narrow the spread between the RMBS's underlying return and the borrowing rate will translate to lower dividend yields to shareholders. A lower yield will also drive down prices as investors will go to higher yield or less risky alternatives with the same return. With rates currently at record lows, expect interest rates to rise in the long run and this cycle of declining return margins to compound itself.

Overall, I recommend investors to sell out of these mortgage REITs. The lost value created by the S&P downgrade and increased risk in long term higher interest rates have changed my outlook on the asset class (sold my own shares of CYS on Friday). To replace the yield, there are plenty of quality dividend stocks in the U.S. and abroad that investors can buy at fire sale prices once the market panic subsides.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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