Recent Accelerating Prepayments Are Likely To Affect Agency Mortgage REITs

Includes: AGNC, CYS, FNMA, NLY
by: Zvi Bar

Mortgage prepayment rates have risen to their highest level since before the subprime crash as homeowners continue to refinance while borrowing costs hover at or near historic lows. According to a report by Lender Processing Services, prepayments are at their highest rate since 2005. At the rate domestic mortgages were paid in August, the entirety of U.S. home loan debt would be rewritten or paid off in about four years.

The cost of a 30-year loan fell to 3.4 percent last week, after the Federal Reserve announced it would buy $40 billion worth of mortgage securities per month in an effort to stimulate the economy. Lower rates will influence borrowers to refinance, and some mortgage holders that refinanced in the last two years are likely again refinancing if they have the credit and terms to do so. Prepayment speeds are also affected by retiring mortgages through existing home sales as well as borrower default.

Mortgage bond investors risk losses when buying debt for more than par, or the bonds call rate if above par. Conversely, if the debt trades below its face value, and prepayment will generate a gain. Most mortgages trading at a premium are agency-backed, while most mortgages trading at a discount are not. Agency-backed mortgages are guaranteed by government-sponsored entities such as Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC).

The agency guarantee provides an implied government backing, which means that agency-backed RMBSs have virtually no default or credit risk, or at least that the risk of default and/or credit rating cut is minimal and substantially similar to U.S. Treasuries. Mortgages that qualify for an agency backing are more likely to qualify for refinancing so long as the refinanced mortgage will also be agency backed.

The Fed's new mortgage-backed security purchase plan should drive up the price of the underlying agency mortgages, because the Federal Reserve's increased buying is a continuing demand increase. Increased demand should result in an increase in the book values of portfolios of agency residential mortgage-backed securities, such as the holdings of agency mREITs, provided such portfolios do not sustain substantial prepayment increases that negate or even overwhelm corresponding increases to their other holdings. This recent widespread prepayment acceleration is likely to be reported by agency mREITs in the coming quarter.

Currently most agency mREITs are trading at a premium to their book value. For example, based upon last reported book values, from the end of the second quarter, Annaly Capital Management (NYSE:NLY), the largest agency mREIT, is trading at about 1.05 times its book value, while American Capital Agency (NASDAQ:AGNC), the second largest agency now trades at about 1.2 times its last reported book value. Some of that premium could be lost to a rising prepayment rate. This LPS report indicates these companies should sustain accelerated prepayments.

Annaly's Constant Prepayment Rate for Q2 was 19%, which is the same prepayment rate it reported for Q1 of 2012. Though Annaly did not recognize a significant prepayment spike compared to last quarter, its prepayment rate was 11% in Q2 of 2011 and a prepayment rate of 19% is reasonably high. CYS Investments (NYSE:CYS), another agency mREIT, reported a Q2 constant prepayment rate of approximately 18.1% and that its portfolio recognized a net amortization of $22.7 in premium within Q2. During the first quarter, CYS had a constant prepayment rate of approximately 17.2% and net amortization of $16.9 million in premium.

AGNC reported that its constant prepayment rate during Q2 was 10%, unchanged from the first quarter. AGNC noted that it "repositioned the portfolio during the quarter into lower coupon MBS and lower loan balance and HARP securities, which are less susceptible to prepayment risk, reducing the impact of the decline in long-term interest rates on the Company's prepayment forecast."

If these agency mREITs sustain accelerated prepayments, as this LPS report indicates is likely, they will be forced to buy new lower yielding paper or already existing paper that might have a slightly superior yield to new RMBSs, but that also carries new prepayment risk due to that premium which is already built into the market price.

As a result of this apparent and logical recent increase in mortgage prepayments, agency mREITs are likely to broadly utilize a strategy like the above-mentioned one that AGNC used during Q2, or suffer prepayment related losses. By taking a reduced prepayment risk profile, these agency REITs should have reduced margins that will eventually result in dividend cuts or increased leverage rates. Through proactively reducing prepayment risk, agency mREITs may sensibly choose the lesser or two evils.

Disclosure: I am long NLY. 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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