Thoughts On A Handful Of mREITs And The State Of The Industry (Week 72)

Summary

• The yield curve recovered somewhat, but it was through longer rates rising.
• The curve isn’t steep, but we went from terrible to merely bad.
• The steeper yield curve is positive, but book value losses will still matter. These are losses early in Q3 2017, so they won’t show up in Q2 earnings releases.
• Wells Fargo deciding to withhold principal on non-agency RMBS pools could be a headwind for many mortgage REITs.

Rating updates are sent to subscribers first.

Welcome to week 72.

The yield curve recovered materially over the last couple of weeks. It steepened from a 10-2 spread (10-year Treasury rate minus 2-year Treasury rate) of 81 basis points on 06/23/2017 to 99 basis points on 07/07/2017.

This is still a long ways from being the kind of steep yield curve that makes leveraged duration exposure a big winner, but it is a material improvement. We went from terrible to bad, so that seems like enough to celebrate.

However, the change in the yield curve came from long-term rates running higher rather than short-term rates moving lower.

Let’s run through the list and then we’ll get deeper into the analysis:

The mREITs (and two ETFs)

The table is demonstrated below:

(NLY)	Annaly Capital Management
(AGNC)	American Capital Agency Corp
(ARR)	ARMOUR Residential REIT
(CMO)	Capstead Mortgage Corporation
(CYS)	CYS Investments
(DX)	Dynex Capital
(NYMT)	New York Mortgage Trust
(ORC)	Orchid Island Capital
(TWO)	Two Harbors Investment Corp
(WMC)	Western Asset Mortgage Capital Corp.
(MFA)	MFA Financial
(EARN)	Ellington Residential Mortgage REIT
(AI)	Arlington Asset Investment Corporation
(SLD)	Sutherland Asset Management
(ANH)	Anworth Mortgage Asset Corporation
(MTGE)	American Capital Mortgage Investment
(CHMI)	Cherry Hill Mortgage Investment
(STWD)	Starwood Property Trust
(BXMT)	Blackstone Mortgage Trust
(ARI)	Apollo Commercial Real Estate Finance
(RSO)	Resource Capital Corporation
(CIM)	Chimera Investment Corporation
(NRZ)	New Residential Investment Corp.
(REM)	iShares Mortgage Real Estate Capped ETF
(MORT)	Market Vectors Mortgage REIT Income ETF

Click to enlarge

Spreads

These are the spreads, and they stink.

	7 to 1	10 to 2		2 to 1	10 to 7
Q4 2014	1.72	1.50	Q4 2014	0.42	0.20
Q1 2015	1.45	1.38	Q1 2015	0.30	0.23
Q2 2015	1.79	1.71	Q2 2015	0.36	0.28
Q3 2015	1.42	1.42	Q3 2015	0.31	0.31
Q4 2015	1.44	1.21	Q4 2015	0.41	0.18
4/1/2016	0.94	1.03	4/1/2016	0.14	0.23
7/1/2016	0.82	0.87	7/1/2016	0.14	0.19
9/30/2016	0.83	0.83	9/30/2016	0.18	0.18
10/28/2016	0.97	1.00	10/28/2016	0.20	0.23
11/29/2016	1.34	1.21	11/29/2016	0.31	0.18
12/16/2016	1.50	1.32	12/16/2016	0.37	0.19
12/23/2016	1.48	1.33	12/23/2016	0.35	0.20
12/30/2016	1.40	1.25	12/30/2016	0.35	0.20
1/6/2017	1.38	1.20	1/6/2017	0.37	0.19
1/13/2017	1.38	1.19	1/13/2017	0.39	0.20
1/20/2017	1.46	1.28	1/20/2017	0.38	0.20
1/27/2017	1.46	1.27	1/27/2017	0.40	0.21
2/3/2017	1.45	1.28	2/3/2017	0.39	0.22
2/10/2017	1.41	1.21	2/10/2017	0.39	0.19
2/17/2017	1.41	1.21	2/17/2017	0.39	0.19
2/24/2017	1.32	1.19	2/24/2017	0.32	0.19
3/3/2017	1.34	1.17	3/3/2017	0.34	0.17
3/10/2017	1.37	1.22	3/10/2017	0.33	0.18
3/17/2017	1.31	1.17	3/17/2017	0.33	0.19
3/22/2017	1.23	1.13	3/22/2017	0.28	0.18
3/28/2017	1.22	1.12	3/28/2017	0.27	0.17
4/7/2017	1.12	1.09	4/7/2017	0.21	0.18
4/13/2017	1.02	1.03	4/13/2017	0.18	0.19
4/21/2017	1.06	1.04	4/21/2017	0.21	0.19
4/28/2017	1.03	1.01	4/28/2017	0.21	0.19
5/5/2017	1.07	1.04	5/5/2017	0.22	0.19
5/12/2017	1.02	1.04	5/12/2017	0.18	0.20
5/19/2017	0.95	0.95	5/19/2017	0.18	0.18
5/26/2017	0.89	0.95	5/26/2017	0.13	0.19
6/2/2017	0.80	0.87	6/2/2017	0.12	0.19
6/9/2017	0.82	0.86	6/9/2017	0.15	0.19
6/16/2017	0.76	0.84	6/16/2017	0.11	0.19
6/23/2017	0.77	0.81	6/23/2017	0.13	0.17
6/30/2017	0.90	0.93	6/30/2017	0.14	0.17
7/7/2017	1.00	0.99	7/7/2017	0.18	0.17
Source: Data from Treasury Website

Click to enlarge

Interest Rate Impact

When the Treasury rates suddenly soar higher as they have over the last couple of weeks, the impact on book value is almost always negative. There are two reasons for the impact to be negative.

The first issue is that most mortgage REITs will be taking on positive duration risk. That means they will carry more positive duration from their assets than they are offsetting through their hedges. Since the mortgage REIT is really the equity position in a leveraged portfolio of bonds, the positive duration leads immediately to a negative impact on book value.

The second issue is referred to as “negative convexity”, a term that still annoys me. If the original finance professionals had a decent education in mathematics, they might have simply referred to it as concavity. On the other hand, when spreadsheets were much simpler than they are today it would’ve been easier to make “negative convexity” as the opposite of “convexity”.

Negative convexity refers to the way that agency RMBS will gain less in value when rates decrease and lose more as rates increase. The reason for this behavior is simple: refinancing. The homeowner has the option to refinance into a new loan. If mortgage rates decline dramatically, the value of the old loan at the higher interest rate can’t rise very much because all the bond owners know the odds of refinancing just increased dramatically. On the other hand, if rates increase significantly the homeowner has a huge incentive to avoid refinancing and may even keep a property as a rental when moving rather than selling it and repaying the loan. Consequently, the life the loan shortens when interest rates are falling (reducing gains) and lengthens when rates are rising (increasing losses).

This causes some analysts to say that mortgage REITs are fundamentally “long duration and short volatility”. If mortgage rates hardly move for years, the mortgage REITs perform exceptionally well. On the other hand, if rates move rapidly it produces losses. If the rates move rapidly lower the investor wins on being long duration but loses on being short volatility. If the rates move rapidly higher, as they did the last two weeks, the investor loses on being long duration and also loses on being short volatility.

NRZ and WFC

There was another major development for the mREIT industry when Wells Fargo (WFC) decided to start withholding a material portion of the pool on non-agency RMBS pools that were being called. This has a couple negative impacts for investors in non-agency RMBS (such as several of the mortgage REITs). The first is that it the mortgage REIT may have to reevaluate their cash flows. If a pool is called, they can’t expect to get the full outstanding balance. Were they buying the pools and planning on a full payoff only giving them $.80 on the dollar? WFC is able to withhold legal fees from the pool, which is a bit problematic since legal fees may increase as companies sue WFC for withholding their capital. This isn’t all theoretical, in the press release WFC stated they had incurred legal fees and expected to continue incurring legal fees.

I put together a piece for subscribers on New Residential Investment Corp. and their use of call rights (subscription required). It became clear that there was a mix of good information and bad information available to investors, but even the good information often left out very material parts of the analysis.

This could also send fair values for the non-agency RMBS positions lower in the third quarter since investors have more risk to evaluate. Remember, risk demands return and this premise is best exemplified in bond investing.

This is problematic for the mortgage REIT sector because the yield spread on agency RMBS to the cost of financing that position with a combination of repo agreements and LIBOR swaps for hedges just isn’t good enough to support the dividends investors are expecting. The non-agency RMBS were the answer, but this threatens to throw a wrench in it. Maybe everything blows over, but the sector has generally been priced for perfection. Buying in when securities are priced for perfection is dreadful.

Heads = Nothing Happens

Tails = You Lose

Sounds like a terrible bet to me, but that’s why I’ve been exceptionally careful and accepted more concentrated positions. Diversification is important, but being able to watch your investments very carefully is also important.

Positions

My current positions related to REITs and preferred shares or baby bonds (all long) are:

BMNM, WPG, GPMT, DX-A, CBL-D, GBLIL

GBLIL is a baby bond from an insurance company, but I include it when talking about high yield investments.

I may initiate or close any positions in the near future. I expect to be stepping in and out of the market placing bids on a few preferred shares across the next few weeks. I discuss my planned trades and targets with subscribers in advance, but I don’t publish the public piece until after the trade. The liquidity on preferred shares is often too weak to absorb a public article without missing my target entry price. Want it to be even easier? How about a text message alert when I see a great opportunity? They are a free service for subscribers to The Mortgage REIT Forum. This is your opportunity to lock in prices at $340 per year before the next price increase on August 1st, 2017. On the sign-up page, you can see why I love the preferred shares so much. These preferred shares are offering high yields and dramatically lower volatility than investing in the common shares.

Analyst’s Disclosure: I am/we are long WPG, BMNM, GPMT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

No financial advice. Also long DX-A, GBLIL, and CBL-D. I may trade anything in the near future. Subscribers receive notifications when I'm changing positions. The public release is often delayed.