Orchid Island: Shuttering Mortgage Market Signals Potential Bearish Move

Oct. 22, 2020 12:27 AM ETOrchid Island Capital, Inc. (ORC)21 Comments
Harrison Schwartz profile picture
Harrison Schwartz
13.42K Followers

Summary

  • Orchid Island Capital has been trading at its $5.2 book value for months, which is unlikely to rise without a deflationary shock.
  • Even with the economy showing recovery signals, a large portion of homeowners are failing or struggling to make payments.
  • Fannie and Freddie do not have adequate financial resources to meet likely obligations, and another government bailout is by no means guaranteed.
  • The perception of credit risk (not the reality) could be enough to cause another round of dangerous margin calls in the RMBS mREIT market.
  • Rising inflation factors could cause short-term rates to rise sooner than expected, possibly limiting Orchid Island Capital's profitability and asset value.
  • Looking for a helping hand in the market? Members of Conviction Dossier get exclusive ideas and guidance to navigate any climate. Get started today »

The U.S. mortgage market has had a wild year due to the intense economic volatility. During the initial phase of the COVID-19-related crash, many mortgage-owning REITs ("mREITs") lost well over half their value, as investors feared a 2008 repeat. This period also saw residential mortgage rates spike, which led to a wave of book value-deteriorating margin calls for levered RMBS investment companies.

To review, residential mortgage-backed security is essentially an ETF, i.e., pool/fund of residential mortgages. Most often these are backed by a government-associated agency like Freddie Mac (OTCQB:FMCC) or Fannie Mae (OTCQB:FNMA). These can be invested in directly through a residential mortgage ETF like the iShares MBS ETF (MBB) or, if you're looking for much more attractive yields, a mortgage REIT which usually uses 7X-10X leverage (with short-term low-rate borrowing) in order to deliver double-digit yields. However, not all that glitters is gold.

The March plummet led to extreme over-selling of many mREITs like Orchid Island Capital (NYSE:ORC), as I bullishly described in early April in my article "Assessing Survival Potential: Orchid Island Capital Has A Major 'Fed Put'". However, the stimulus that I saw as saving REITs ended over summer, which caused me to take profits on ORC. This is detailed in "Orchid Island Capital Has Short-Term Risks Due To Slowing Stimulus". Moving to today, it seems ORC is likely headed lower and may even be a short-term short opportunity. This is predominately due to growing credit and rate stress in its portfolio, which is almost entirely concentrated in 30-year fixed-rate residential mortgages.

Economic Data Spells Mortgage Market Stress

Today, the data and trends have shifted further, making the downside risk ORC greater than its upside potential. The Fed is not purchasing mortgage-backed securities at their past rate and has even gone as far as to warn that

ChartData by YCharts

ChartData by YCharts

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This article was written by

Harrison Schwartz profile picture
13.42K Followers
Harrison is a financial analyst who has been writing on Seeking Alpha since 2018 and has closely followed the market for over a decade. He has professional experience in the private equity, real estate, and economic research industry. Harrison also has an academic background in financial econometrics, economic forecasting, and global monetary economics.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in ORC over the next 72 hours. 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.

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