High-Yield Hybrid Mortgage REITs Start Off 2012 On A Good Foot

Includes: CIM, DX, IVR, MFA, RWT, TWO
by: Zvi Bar

Within the world of residential mortgage REITs, there are two primary subdivisions: those that own mortgages insured by federal agencies and those that own mortgages without agency insurance. Hybrid mortgage REITs hold both agency and non-agency mortgage paper.

Hybrid mortgage REITs are usually more diversified, but also present more risk than agency mREITs. The non-agency residential mortgage backed securities, RMBSs, that they hold provide a significantly higher yield than agency RMBSs, but also carry the risk of actual default.

Most hybrid mREITs also hold large positions in agency RMBSs, so they are often not truly non-agency mREITs, though often called as such. Currently, very few non-agency mortgages are being issued, so most hybrid mREITs have accumulated larger positions in agency debt out of necessity, but also to reduce their volatlity. Still, most hold large, if not majority positions in non-agency RMBSs.

Defaulting agency mortgage holders are backed by the government agencies, which generally buy out the mortgage. This transfers the default risk to prepayment risk, which is worse than a performing loan, but far better than an outright default. When an RMBS is prepaid, the main problem is that the holder may not be able to find as good or well-priced of an invesment with which to replace the old one. If purchaed at a premium, that premiun may also be lost. Non-agency debt has no such backing, making a non-agency default a highly problematic event.

Some non-agency debt is collateralized by the underlying property, while other debt is non-recourse. Nonetheless, hybrid mREITs are generally not designed with the intent to take over collateralized property. Non-agency REITs also employ differing levels of leverage and hedging techniques. All these issues add risk and uncertainty to the asset class. Several non-agency lenders used loose lending practices through the past decade, which caused a great deal of default and other systemic issues we now witness.

Types of Non-Agency Mortgages

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 (OTCQB:FNMA)and Freddie (OTCQB:FMCC) allow. Prime mortgage loans have historically carried low default risk because they are usually made to high-credit-quality borrowers.

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.

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.

Subprime: Subprime mortgages are provided to borrowers with low credit ratings due to poor 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.

Examples of Non-Agency REITs

Through screening I have identified several REITs that are largely invested in non-agency RMBS paper, though not necessarily exclusively or to a majority, depending on their current portfolio mix: Chimera Investment (NYSE:CIM), Dynex Capital (NYSE:DX), Invesco Mortgage Capital (NYSE:IVR), MFA Financial (NYSE:MFA), Redwood Trust (NYSE:RWT) and Two Harbors Investment (NYSE:TWO). None has yet released a Q4 or annual report for 2011, but most will do so in the next 2-3 weeks. Below, I have provided recent equity performance rates and current annual dividend rates.

Non-agency RMBS paper declined in value significantly during 2011, bringing down most of these hybrid mREITs along with it. If housing were to sustain a recovery in 2012, even if a mild one, combined with no real increase in forclosures, then the asset class appears poised to appreciate. Of course, if forclosures were to spike upward along with interest rates, all bets are off and RBMSs without an agency backing may sustain accelerated declines. Thus far in 2012, these hybrid mREITs are all positive, with an average appreciation of over 6 percent.

REITs must distribute at least 90% of their taxable income in order to eliminate the need to pay income tax at the corporate level. Under the current tax laws, mREIT dividends are taxed as ordinary income, and not at the lower corporate dividend rate.

Because these REITs must give away so much income, they cannot grow through retaining and re-deploying earnings. As a result, these REITs often choose to place secondary offerings in order to raise capital and increase market valuation. Such actions can be either dilutive or accretive to actual share value depending on how productive the REIT is at using the acquired funds. This can also make the quarterly payout volatile.

Mortgage REITs continue to be one of the highest-yielding options available to income-oriented investors. Nonetheless, due to their significant risks, exposure to mREITs should be limited to a reasonable percentage of a portfolio, based upon an investor's risk profile, time-horizon and other investments. Additionally, because mREIT dividends are taxed as regular income, and not at the lower corporate dividend tax rate, they are generally considered substantially better performing investments when held within tax deferred or exempt accounts.

Disclosure: I am long CIM.

Disclaimer: This article is intended to be informative and should not be construed as personalized advice as it does not take into account your specific situation or objectives.