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Mortgage REIT Roller Coaster

Jul. 25, 2013 10:53 AM ET
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When I was 10, I was afraid of Roller Coasters with upside down loops in them. As soon as I was tall enough, my friends wanted to ride them, but I sat out the first time because watching the people ride the loops and hearing them scream was just too much for me. I stuck to the slower and calmer rides. On the next visit, I didn't want to miss out again because they had been all smiles when they got off and couldn't stop talking excitedly about it. Here is a link to a video of a ride on that coaster.

My experience investing in the mortgage REIT (mREIT) market has been remarkably similar to that first upside down roller coaster. After riding some calmer rides like VWLTX and T and VZ and pocketing decent returns, I took a look at the mREITs. The yields were exciting, people were talking about great returns, and I thought I had the stomach for any drops and loops as long as I arrived safely back to my starting point after pocketing some thrilling yields.

The first part of the coaster was a dark tunnel. I didn't fully understand the mREIT model and couldn't see how it all worked. After some study on SA and elsewhere, the tunnel ended and light returned. I could see a long ride up in front of me. The motor pulling the mREITs up was the rising Book Values (BV) that were being caused by the lowering long term rates on mortgages making the values of the Mortgages Backed Securities (MBS) mREITs hold go up. The fear of spreads shrinking in November caused a slight dip after a top that was quickly smoothed out into a turn that ended in a steep drop. The long dreaded rise in long term rates had arrived.

People said the increase in spreads would make it worth it, but that drop was terrifying. The long term rates rose dramatically in June 2013 and caused MBS values to seem like they were falling off a cliff, taking BV with it. People screamed. Many wanted to get off. Some did get off to go ride another coaster. I held on, I wanted to have those yields to talk about afterward, so many others had arrived safely.

We have been through a few loops as the back and forth on QE3 tapering has caused the stocks to rise and then fall again.

Nothing has shown that more dramatically than the rise on the 11th of July (around 10% in AGNC) and the 12th July's fall (3% drop in AGNC)

On that coaster, the next part was a tunnel. I see this time as the darkness we are traveling in as we wait to see what earnings reports say towards the end of this month. No one really knows what the mREITs have done with their books and how their hedges have worked. Some articles have tried to estimate what happened (Scott Kennedy, Positive Concavity, REIT Analyst) and they are like the lights flashing in that tunnel, giving us insights that BV is not as bad as the price would have us believe. The coaster did rise after that tunnel. I am hoping that a better than expected earnings report shows hedges are working and BV is not as bad as the price to book now suggests.

The rest of the coaster had a few corkscrews and I expect those to come from the FED and the economic data, but perhaps from dividend changes in Q3.

Of course sometimes coasters have break downs. The chances are very slim, but a failure to meet margin call would be a breakdown. I think the chances of that happening are slim to none for my ride.

My goal is to come out at the end of this with some pocketed dividends or thrills in this analogy and to come out where I started in terms of stock price. I don't plan on getting off this coaster as long as short term rates stay low and/or spreads hold up. Maybe Im missing the point that BV is more important and this is a coaster that doesn't come back to where it started if rates continue to rise. People have started saying "everything they buy goes down in value as rates rise and increased spreads wont make up for that. Hedges only partly cover the losses in BV, if they were to cover everything, they wouldn't make any money" A statement mostly applicable in Q2, but rates have remained somewhat steady in Q3. With the FED tapering priced in somewhat, I think the value drops we saw in Q2 wont happen again. I will re-evaluate as earnings come out. I want to see mREITs make a strong case that they can still function in this environment, that hedges or other holdings will counter BV drops as spreads increase. It seems this coaster relies on rates that don't move too fast or squish spreads too much. They have historically been reliable earners when that is true. A good mechanic can keep a coaster running for decades, and many of these companies have good mechanics (management) that have been keeping the coaster running for many years without a serious breakdown.

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