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.