March 9, 2012
Written By Stephen P. Percoco
“The carry trade is alive and well. Mortgage REITs borrow short and lend long, capturing the spread between investment and borrowing rates, known as the net interest margin. This fuels big distributions to shareholders. mREITs utilize repurchase agreements, a form of very short-term secured borrowing, to finance their portfolios of mortgage-backed securities and related assets. At today’s rates, mREITs can borrow at an incredibly low 30 basis points (i.e. 0.30%) and invest in mortgage-backed securities (MBS) that currently yield between 3.00% and 3.50%.
“Hedging costs, primarily through interest rate swaps, can add another 60 basis points to funding costs. So their net interest margin is currently 210 to 260 basis points. After paying operating expenses of less than 0.50%, mREITs have a net income margin of between 1.60% and 2.10%, most of which can be passed on to shareholders as dividends.
“mREITs invest in a variety of mortgage-related securities. These include mortgage pass-through certificates, which are issued by real estate mortgage investment conduits to capture the interest and principal payments on a pool of mortgages. Most of the mortgages included in these securitization pools are backed by government-sponsored enterprises (GSEs) like Fannie Mae, Freddie Mac and Ginnie Mae. These are known as Agency securities. Private label pass-through certificates, not guaranteed by the GSEs, are typically backed
by riskier mortgages (e.g. subprime, Alt-A and jumbos) and are known as Non-Agency securities. Another type of investment held by mREITs is the mortgage- backed security (MBS), which is issued by a special- purpose entity to take the cash flows from pass-through certificates and carve them up among various classes of security holders according to a priority ranking. The most senior of these tranches are typically rated AAA, even if backed by riskier collateral like subprime mortgages. Subordinated tranches are rated below investment grade, since they are required to absorb losses from foreclosures first. MBS are issued against both Agency and non-Agency pass-throughs and so their risks vary accordingly. While most mREITs focus on MBS backed by Agency pass-throughs, their strategies differ and some do embrace the riskiest tranches of MBS.
“mREITS employ leverage to boost shareholder returns. Today, a typical mREIT that invests solely in Agency MBS (i.e. those guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae) will have $8 in debt (i.e. repurchase agreements) for every $1 in equity. mREITs typically use much less leverage for non-Agency MBS, especially for subordinated tranches of debt backed by riskier mortgages, such as subprime. In theory then, each $1 of equity for an mREIT that invests solely in Agency MBS can generate income, potentially payable as a dividend, of between $0.14 and $0.19. ($9 in MBS multiplied by the net income margin of between 1.60% and 2.10%.)
“By my count (and with much help from NAREIT), there are 26 publicly-traded mortgage REITs. Seven of these focus primarily on commercial MBS; eleven on residential MBS and the remaining eight on both. … One of the most striking features of residential mREITs is their dividend yield. The eleven publicly-traded residential mREITs currently offer an average yield of 13.7%. (By comparison, the average dividend yield on the S&P 500 is now around 2.1%.) Obviously, the high dividend yield reflects considerable uncertainty about the sustainability of those dividends, and with good reason. For one, interest rates are now exceptionally low, and despite the Federal Reserve’s stated intentions, the market apparently believes that rates cannot stay this low forever. Rising interest rates would hurt mREITs in several ways: First, they would reduce the value of the fixed-rate payments from their MBS portfolios and at the same time lower the prepayment speeds on those fixed-rate MBS, effectively increasing their maturities (and duration). … Second, higher rates would cause financing costs to rise, perhaps sharply. …
“Most mREITs have sought to compensate for these risks in several ways: Many hold adjustable- rate mortgages, so that the income that they receive will rise with interest rates (albeit with a lag). ARMs typically price every one, three or five years, which is longer than the average repo maturity of 30 days. Most mREITs also hedge their interest rate exposure (either on the asset or on the liability sides) with interest rate swaps. … Finally, a few mREITs have issued fixed-rate bonds to finance a part of their portfolios, usually in an effort to match their fixed-rate MBS exposure. … On the positive side, the recent settlement between the big mortgage servicers and the state Attorneys General over foreclosure practices could result in a windfall for non-Agency MBS investors, since the servicers have agreed to forgive principal for underwater homeowners. Some analysts have pointed out that the $20 billion or so set aside for bailouts does not nearly cover the $700 billion that homeowners must get back to become whole. Nevertheless, any bailout will provide some benefit to non-Agency MBS that are trading at discounts. Those discounted subordinated tranches will also benefit if the economy continues to improve, more people go back to work and more delinquent homeowners to catch up on their mortgage payments. I assume that the servicers will foot the bill for the debt forgiveness, since they (and not MBS investors or mortgage insurers) agreed to the settlement. Consequently, investors may receive payments of 100 cents on the dollar for any mortgages currently carried on their books at a discount that are covered under this settlement.
“So in the current economic environment, with funding costs low, spreads wide and the potential for gains in credit quality, mREITs look like a pretty good bet. This has not been lost on the stock market, which has bid up the prices of mREITs by an average of 30% off of the early October lows (slightly better than the S&P 500’s 25% gain). Thus, while yields are extraordinarily high at an average of 13.7%, they are actually down meaningfully from the October stock market lows.”
Stephen P. Percoco, Income Builder, 732-763-0763, February 16, 2012