Should Investors Unload Their Mortgage REITs?

May 5, 2015

by Keith Jurow

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For the past several years, I have written extensively about the Fed’s dangerous efforts to drive interest rates low enough to stimulate a stronger recovery. As a consequence, large and small investors have been compelled to go out on the risk curve in a desperate search for higher yield.

Lured by almost irresistible double-digit yields in 2012 and early 2013, investors dived into mortgage REITs with abandon. Having discussed the serious risks of equity REITs in my previous article , now is a good time to examine whether mortgage REITs pose similar risks for the unwary.

Essentials about mortgage REITs

What are the key considerations to assess when deciding whether to buy, sell or hold any of the larger mortgage REITs? Most analysts and investment advisers believe that future changes in interest rates are the most important factors. An example of this obsession with interest rates can be viewed in a January 2015 analysis by Nomura Securities.

Are these analysts right or are there more important considerations that investors usually overlook?

Let’s start with the basics. Mortgage REITs hold residential mortgage-backed securities (RMBS), and finance them primarily through short-term repurchase agreements. These REITs have benefited directly from the Fed’s policy of keeping short-term interest rates very low. Their income is derived from the positive spread between the cost of their short-term borrowing and the cash flows that are provided by the longer-term RMBS.

How can mortgage REITs throw off double-digit dividend yields in our low-interest-rate environment? It is really simple – very high leverage. Those REITs that invest primarily in Fannie Mae or Freddie Mac RMBS have debt-to-equity ratios of 6-to-1 or higher.

Because the REIT is able to buy RMBS tranches that total many times its equity through borrowing, the dividend that this leverage throws off to investors is magnified. So a dividend yield of 12-18% seems too good to pass up for many investors.

However, leverage is a double-edged sword. When their cost of funds rose, as it did after Chairman Bernanke’s taper speech in May 2013, this dramatically cut REIT earnings and forced most of them to sharply reduce their dividend. Some of the most highly leveraged REITs faced margin calls from their lenders because of the drop in the value of their RMBS collateral. They were forced to sell some of their RMBS holdings to meet those margin demands.

A second factor that has been almost totally disregarded is the serious delinquency problem with their mortgage portfolios. This is especially true with American Capital Agency (AGNC), Two Harbors Investment (TWO) and Invesco Mortgage Capital (IVR).

Non-agency mortgage-backed securities

Non-agency mortgage-backed securities hold mortgages that are not guaranteed by Fannie Mae or Freddie Mac nor insured by the Federal Housing Administration (FHA). Nearly all of them were originated prior to early 2007 when the sub-prime mortgage market collapsed.

The vast majority of those still outstanding today were issued during the bubble years of 2005-2007, when underwriting standards totally disappeared. Many of their mortgages required little or no down payment. Borrowers could often qualify with debt-to-income ratios (DTI) of 50% or more, which was not acceptable in prior years. Low-documentation mortgages that became known as “liar loans” enabled rampant fraud.

Two Harbors Investment Corporation

Let’s take a look at the portfolio of one of the large mortgage REITs that is loaded with these non-guaranteed RMBS – Two Harbors Investment Corp. (NYSE: TWO)

As described in its 2014 10-K report filed with the SEC, this REIT allocated roughly $3.04 billion to non-guaranteed RMBS. That was a 10% increase over 2013. More than 85% of them were originated in 2006 or later.

In this 10-K report, I also discovered that $1.82 billion of these mortgages were sub-prime loans – 77% of the entire non-guaranteed portfolio. Here is the stunner: more than 13% of all the non-agency loans were considered so bad that they did not have any rating at all. Two years earlier, only 5% of these mortgages were unrated.

Because of the high delinquency/default rate on these sub-prime loans, this REIT was able to buy the entire non-guaranteed RMBS portfolio at a substantial discount. They paid an average of only 59% of the par value. That sounds like opportunistic investing, right?

It isn’t that simple. To comprehend the risks of default in any RMBS piece (known as a tranche), you have to find out as much as possible about the characteristics of the mortgages housed in it.

Let me give you an example. The 10-K report reveals that more than 26% of all the non-guaranteed mortgages in this portfolio were seriously delinquent by 60 days or more. That should not come as a big surprise. What does this mean for investors who own shares of TWO?

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