Mortgage REITs (mREITs) underperformed last week as fears of tighter regulation and spread compression weighed on the sector. The Financial Stability Oversight Council (FSOC) may cite mREITs as a source of market instability, and may have the instruments under greater regulatory scrutiny. This was expected by institutional investors and it is not a major concern. Industry experts and institutional investors alike agree that there is no imminent material change in policy, according to Barclays. If there is a change in policy, it will be related to imposing some realistic constraints on leverage that will have limited impact on how mREITs function. Practical regulatory impact may include restricting leverage on mREITs to 10x-12x. Barclays analysts note that the average leverage for the agency mREIT universe is 7x-8x and the average for hybrid mREITs is about 4x-5x. The potential leverage cap will likely not limit the Mortgage REIT business model, according to Barclays PLC (NYSE:BCS) (LON:BARC).

Mortgage REITs

The outlook for agency Mortgage REITs may become more challenging as agency mREITs hold GSE bonds yielding 1.5-2 percent and such yields are being pushed lower by the Fed buying such bonds in the open market. In turn, prepayments of these GSE bonds could accelerate forcing agency mREITs to reinvest in instruments with lower yields. Leverage of about 7-8x will magnify the negative return impact. However, such impact for Mortgage REITs may partially be offset if the Fed reduces GSE purchases. Agency mREITs could start paying higher dividends again as spreads widen and purchases of GSE bonds will be cheaper. Book values for agency mREITs will likely decline, as the value of existing GSEs in the mREIT portfolio will decrease as interest rates rise.

Large bank results for first quarter 2013 point to a slowdown in mortgage lending. However, Bank of America Corp (NYSE:BAC) believes mREITs will probably expand in sectors where banks have pulled back, such as correspondent and jumbo lending. Such expansion presents possible price appreciation and earnings improvement for mREITs in the medium term. Dividends for the majority of mREIT stocks have stayed the same for the first quarter of 2013 after a period of decline.

Dividend Chart

Two ETF options to invest in mREITs include iShares FTSE NAREIT Mortgage Plus Capped Index Fund (REM) and Market Vectors Mortgage REIT Income ETF (MORT). The ishares REM attempts to mirror the performance of the FTSE NAREIT All Mortgage Capped Index. REM has an 11.15 percent 12-month yield and 0.48 percent expense ratio. The Market Vectors MORT tries to replicate performance of the Market Vectors Global Mortgage REITs Index. MORT has an 8.22 percent distribution yield and a 0.40 percent expense ratio.