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09-05-11 Mortgage REITs primer: assessing the risk, where next?

As you my know, I hold a lot of these. What I've taken in dividends (approximately 9% over last 2 quarters) I have basically given back in price declines. The worst, IVR is down 20%, some of the others down 4-5% to 8-9%.  There are three (3)  risks being factored, one of a double dip recession or even real estate depression, coupled with a recession driven lack of repo liquidity ; the second a change in regulatory/tax treatment; and thirdly, risk of a national refinance plan.


The real estate market/default risk

This is one I am willing to to assume for the 20% dividends. I have confidence in how these portfolios are structured and hedged in context of 0% to .25% interest rates for at least 2 more years. 


"The stocks, which invest in pools of home loans and then borrow to boost returns, rebounded double-digit drops in late July, as investors fretted about their access to short-term funding in the repo market, resulting in the sector’s own little flash crashAnd with Fed Chairman Ben Bernanke committing to ultra-low interest rates well into 2013, the future looked bright..."


I think for the most part the portfolios are solid, the credit markets are sound and the risk is contained. Double dip or not, Fed action or not, my view is the credit, access to funds/liquidity risk to reward is acceptable. That is not the thrust of this post.


The second, and possibly third risks are new and unexpected uncertainty. I think the reaction/price declines reflect more fear/uncertainty, but the risks are real, so lets take a look: 


SEC Rule Making Risk

1.  "The SEC is concerned that mortgage-related pools potentially are making judgments about their status under the Investment Company Act without sufficient SEC guidance on the interpretive issues that arise under that provision. The SEC also is concerned that certain mortgage-related pools today appear to resemble investment companies such as closed-end funds and may not be the kinds of companies that were intended to be excluded under this section.


2. The implications per the WSJ: " Mortgage REITs are getting hit for a second day following the SEC’s announcement that it was seeking comment on whether it should change rules that exempts the companies from paying taxes or the amount of leverage they can use..."


3. " On Aug. 31, the U.S. regulator sought comment on whether mortgage REITs should lose their tax exemption or their ability to use leverage. The plan seems to be to force them to choose one of two options: become a regular corporation—and get taxed like one—but keep the leverage or lose the leverage and keep the tax exemption.



Well, the problem is who knows what the Administration will come up with. They are unpredictable, that is what has prevented any economic recovery. This is more of same. The comment period ends at the end of October, after the next record date and distribution for most of these REITs. I will try to hold to get my 3rd distribution, boosting me to 15% in return this year. But if the REITs really start to sell off (like another 10%) I may have to get out and decide whether to get back in. A huge selloff from here may signal that industry insiders have knowledge that a real change in tax status is coming. That could cut these to 50% of their current returns and trading pricing. I just doubt it, but this is an abnormal time. NOT knowable. So, the risk is real, hard to measure and the fear is real, I'll be watching closely.


National Mortgage Refi Plan from Obama

"...analysts at KBW in a research report said that the Federal Reserve has given its “stamp of approval” to letting homeowners underwater in their current mortgages refinance at lower rates....The Obama administration is reportedly considering such a proposal, which is seen as a negative for investors in funds buying mortgage-backed securities such as REM and MORT. But such a plan would need to be implemented by the Federal Housing Finance Agency, an independent regulator which oversees Fannie Mae and Freddie Mac. That could be a problem since the FHFA’s acting chief Edward DeMarco is focusing on limiting costs to taxpayers..." And this from another analyst: "...We believe the Obama Administration is running out of bullets to stimulate the economy prior to the 2012 election, particularly when Congress is unlikely to be supportive of any Obama-lead initiatives that increase government spending, and that could lead to desperate actions that have significant unintended consequences..."

My assessement on this risk: a national mandated forgiveness of some principal, to permit refi's to reduce mortgage payments across the nation is unrealistic and unconstitutional. I think this risk is already discounted and not needing further factoring.

Bottom line overall: Lots of "hair" on these REITs. Thats a sell signal. I'm in pretty deep, but have enough dividends in my pocket that I am a holder, even now. But I may trim a bit here and there and look to get back in as distribution dates come near. The selling is overdone, based on fear. But the feared risks are real, so more selling may come. This is a dangerous and fluid situation. The only "safe" position is cash. This one more example. I may have to get to cash  at some point, even as to my high yielders, but not yet.