The basics of mortgage REITs

Mortgage REITs (MREITs) have taken a huge hit over the last couple of months and especially the last couple of weeks. AGNC is down 29% and NLY is down 20%.

Here are some of the basics on how they work. MREITs buy mortgage bonds and use leverage to compound their returns (and their losses). They essentially are borrowing short and lending long. Thus, MREITs like a steep yield curve. That helps amplify their income. But MREITs also trade at prices close to book value. And when interest rates increase, book value of bonds decreases. And when you add in the leverage, they can decrease very quickly and any benefit from a steeper yield curve will be more than offset by a decline in book value over the short run.

Let’s make up an example. Assume you are an investor and buy an MBS bond with a face value of $100,000, trading at par, that yields 2.8% and has a 15-year maturity. The market value of the bond is $100,000.

Now, what if the market yield on that bond increases to 3.4%? Now the market value of the bond is $95,766.95. Your $100,000 investment has declined by $4,233 or 4.23%. However, if you are an MREIT and are leveraged 5 to 1, that would mean that your $100,000 initial investment was composed of debt of $83,333 and equity of $16,667. Suddenly, the book value of your investment has declined from $16,667 to $12,434 ($16,667 less $4,233). The dollar loss to equity is the same but the percentage loss is 25.34% (with leverage of 5 to 1) versus 4.23% (with no leverage).

Investing in variable rate securities, or putting on hedges via options or swaps can help reduce the risk. But a MREIT that concentrates on fixed rate securities with minimal or ineffective hedges will take a big loss in this kind of example.

There is one glimmer of hope, the wild increase in rates has steepened the yield curve. That has the advantage of helping MREITs to increase earnings and to lower the risk of prepayments. Lower interest rates encourage homeowners to refinance, which causes the mortgage investor to lose their higher yielding investment, to likely be replaced wth a lower yielding mortgage. The higher rates now in the marketplace will likely lower the risk of prepayments. That, coupled with the higher spread and some stability in rates, might help the MREITs to help cash in again. Or maybe not if rates continue to increase and/or if the yield curve flattens.

The unintended consequences of a monetary policy gone wild

The market appears to now be in correction mode as the SPY is down about 6%, bonds have been falling hard as well as gold. We have written previously that this rally is overextended and due for a fall and here it is.

What we are seeing now are some of the unintended consequences of a monetary policy gone wild. The Fed encouraged investors to move out of cash and into risky assets, and now that the markets are beginning to reverse, investors are doing the opposite, with many having bought high and selling low.

We believe the market got ahead of itself due to Fed policy, but equities should still be a good investment over the long term. We think it is important that the Fed begin to taper, and in a more rational world, the sooner the better, but when market participants act like feral pigs (the words of Dallas Fed President Richard Fischer), a very slow and more even path might be preferred as investors withdraw from the drug stimulus of money printing.

The Fed’s easy money policy was necessary in 2008 and 2009, and then again when Europe was about to crash, but it was not necessary since. All kinds of investment behavior have been altered by this policy. Savers have been brutally punished and starved of income. Real estate, equity markets, and fixed income markets all have rallied a more than they should have. And now that the drug might be taken away, the markets are taking a big hit.

Hopefully the hit won’t take on a life of its own and turn into a deadly negative spiral. That again was one of the risks of this Fed’s policy. For now, we are looking for a decline of between 10 and 20%.


Back in touch

I have been a little bit out of touch on this blog over the last few weeks, but the market had a big day on May 22 when it shot out to a new high on an intraday basis and then closed below the low of the previous three days. The market has since corrected 2.8% off of that close but has pushed higher the last few days, although still short of the May 22 close. Today the market started with a gap higher, traded in a tight range, and closed at the same price as yesterday (on the SPY).

The Japanese market, and many international markets have been hit hard over this time period, and today, John Mauldin of Mauldin economics talked about why they Yen will decline over the long term.

Fixed income markets, and dividend payers have also been hit over the last few weeks. We have reduced some exposure in this area and moved around some of our MReit investments to better take advantage of the shifting markets.