Anybody that follows the mortgage REIT sector has probably seen the scare stories about the high level of volatility associated with these stocks in the financial press. So how much truth is there to these stories? How vulnerable are mortgage REITs, and are some of them safer than others?
The biggest potential threat to mortgage REITs identified by the doomsayers is rising interest rates. The standard argument runs something like this: mortgage REITs need low interest rates to keep the spread they need to make money. Any rise in interest rates will kill their ability to make money and send the stocks into a nosedive.
This scenario is not likely to pass anytime soon, because the Federal Reserve has a policy of keeping interest rates under 2%. The Fed does this in order to stave off inflation, which most of the economists that run it think is the worst economic evil of all. The inflation hawks at the Fed have been keeping the interest rate as low as possible since 2008 in an attempt to stave off inflation.
News articles also indicate that the Fed expects interest rates to stay low through 2014. That means the lending environment that mortgage REITs profit from should stick around for at least two more years. That's very good news, especially to smaller fast-growing mortgage REITs, such as Chimera (NYSE:CIM) and Two Harbors (NYSE:TWO). They should continue to see their business grow as long as the economy remains relatively good and interest rates remain low.
It may not be very good for the biggest player, Annaly (NYSE:NLY), because smaller trusts seem to have been able to siphon off some of its business. If smaller companies keep growing at its expense, Annaly's stock could lose a lot of its value in the near future.
This brings us to another potential problem for mortgage REITs, unemployment, which could threaten their future value in two ways. First, if unemployment stays high, fewer people will be able to afford to refinance mortgages. These companies can only see a lot of growth if a lot of people can afford to refinance their mortgages.
If unemployment remains high, fewer people will be able to refinance and more homeowners will simply walk away from underwater properties. That means a smaller mortgage market and fewer opportunities to profit from mortgage-backed securities.
The second way that unemployment can hurt mortgage REITS is that if it remains high, there will be pressure on the Fed to implement inflationary policies to increase job growth. Some economists, such as Nobel Prize winner Paul Krugman, have been demanding this. It is unlikely that Ben Bernanke would listen to them, but if unemployment remains high, the pressure to take such steps will increase.
The good news for mortgage REITS is that the unemployment rate appears to be dropping. It has fallen by about 1% since August of 2011, and the trend does not seem to be reversing. The bad news is that the unemployment rate is dropping slowly. Ben Bernanke does not think there will be significant growth in employment until next year at the earliest.
That means that the pool of new mortgage and refinancing applicants that the mortgage REIT industry needs to stay viable is not growing. Since more companies seem to be moving into the field, we could soon see a situation in which an ever =-growing number of REITS are competing for a shrinking mortgage market.
This could be really bad news for the biggest players like Annaly and American Capital Agency (NASDAQ:AGNC). Annaly's growth is already a lot lower than its smaller competitor, which suggests that it is losing ground to them. That means a fall in Annaly's stock price could be imminent.
That situation would definitely benefit the smaller mortgage REITs, such as CYS Investments (NYSE:CYS) and Armour Residential (NYSE:ARR). Their business and their stock values both seem to be growing. The question is whether these companies can protect themselves if newer more aggressive players enter the field, which seems to be likely. In the short, smaller mortgage REITs will continue to grow, but they're going to hit the glass ceiling imposed by unemployment rates sooner or later. When that happens, expect to see at least some of these stocks plummet.
The question we have to ask ourselves is when will they hit that glass ceiling? That will depend on how fast the economy recovers and the rate at which employment will grow. Given recent history, it is probably sooner than we think.
SEC Not Moving to Regulate Publicly Traded Mortgage REITS
Another threat that has been raised is the Securities and Exchange Commission's [SEC] regulation or investigation of mortgage REITs. The SEC is investigating the largest non-traded REIT in the U.S., the Inland American Real Estate Trust, Inc. Inland revealed the SEC investigation in its quarterly report released earlier this week.
It is not clear what the SEC's sleuths are looking for at Inland American. The REIT has issued the usual press releases that state it has not done anything wrong. It should be noted that Inland American does not appear to be involved in mortgages. Instead, it is mainly an owner of office buildings.
Even though Inland American is not a mortgage REIT, any news about SEC investigations of REITs could cause skittish buyers to sell. The situation could be made worse if the SEC finds some evidence of wrongdoing there.
The Inland investigation may be related to a rule-making process going on at the SEC. A press release indicates that the commission is reviewing the rules governing what it calls mortgage-related pools and REITs. The commission is apparently looking at changing rules that exclude mortgage bankers from the requirements of the Investment Company Act of 1940, which governs vehicles like mutual funds.
This action, like the Inland investigation, seems to be aimed at privately held REITs rather than publicly traded ones, such as Annaly and Invesco (NYSEARCA:INR). Since these companies issue stock, they are already regarded as investment companies and are already regulated by the SEC. The commission seems more intent on going after privately traded REITs, which may try to get around securities laws than regulating publicly traded ones.
That means the SEC's actions would not hurt stock values because they are aimed at private REITs. This action could actually help some of the publicly traded REITs by discouraging private trusts from entering the mortgage arena. Since traditional asset-backed REITs have been doing badly in recent years, some of them might have an incentive to enter the mortgage business.
The good news from the SEC's actions is that there could be less competition for the established players if more versatile privately held REITs are kept out. The bad news is that the barrier being put up by the SEC is not as tough as some people might think. All the privately traded REITs would have to do to enter the mortgage REIT business would be to organize investment companies and start issuing shares.
There does not seem to be a flood of private hedge funds or trust operators rushing to enter the mortgage business, so this possibility is not a serious threat to the values of established stocks. The SEC's actions could be designed to head off such moves, which means that they could actually help protect the value of established stocks.
The moral of the story is that the volatility of mortgage REIT stocks seems to be overstated. Yes, there are threats to stock value, but they are not as great or as immediate as some analysts would have us think.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.