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The Mortgage REIT Explosion

You might have heard of Annaly Capital Management (NLY) which has been the darling of income starved investors.  Annaly is one of the mortgage REIT’s, which is a fancy way of saying that they raise capital through an IPO, borrow enough money to leverage 5-7 times and then invest in mortgage backed securities.  By leveraging 5-7 times, they are able to pay out very handsome dividend yields to their investors.  In the case of Annaly Capital, they currently pay a 14.2% dividend yield.

The reason I bring them up today is that the business model is particularly perverse when the federal reserve is artificially keeping the front interest rates at or near 0%.  Since Annaly capital is able to reverse-repo their agency mortgage back securities (secured loan from a bank) and borrow money at .25%, they are able to make a spread of 3-4% on the mortgage back securities that they buy.  Borrow short, invest long, earn the spread.  The business model is particularly simple, but a few are getting handsomely rich from it.  What makes it particularly interesting is that Annaly invests exclusively in Agency backed mortgage securities, meaning that Ginnie Mae, Fannie Mae, and Freddie Mac guarantee the securities that they are buying.  The agencies are backed by the government which is backed by the taxpayers.  So in full circle, Annaly is borrowing short term from the Federal Reserve (through the Repo line) and investing in government backed securities.  The taxpayers are lending to Annaly at a near 0% rate and the taxpayers promise to pay Annaly full Par value if any mortgages in the pools default.  According to the recent filings, the heads of Annaly Capital are taking the Fed’s gift to the bank:

I cannot wait to see the 2010 comp

Who felt like they were being left out of the party?  Well, PIMCO of course:

PIMCO REIT plans to raise $600 million in its IPO to invest in residential and commercial mortgage-backed securities and other residential and commercial real estate debt, according to SEC documents filed Tuesday.

When the new REIT completes its private placement, it will acquire a portfolio of agency residential mortgage-backed securities.

PIMCO is not the only asset manager getting into the mix, plenty of issuance to sate the investors’ yield hunger:

The bright note is that with $3.5B of issuance shown above levered at 5x, we could theoretically see $17.5B of demand for mortgage securities.   Mortgage REIT’s could act as replacement buyers for the Fed.

 

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4 Responses

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  1. Wet Willie says

    There are many MREITS out there these days, but each has subtle, yet important, differences. For instance, NLY owns ~ 86% fixed-rate securities and 100% agency backed. Whereas, MFA Financial owns ~ 14% fixed rate securities (i.e. 86% adjustable rate) and 68% of its securities are agency-backed. This means that MFA has more default risk and less interest rate risk than NLY. Currenly, MFA is the best buy of the group due to it trading at a a discount to book value. Historically, MREIT dips below BV represent short-lived buying opportunities.

  2. SurlyTrader says

    Thanks for the tip. Grant’s just ran an article mentioning Annaly (NLY), Chimera (CIM), American Capital (AGNC), MFA Financial (MFA), and Hatteras (HTS). Their conclusion was that Annaly was the most risky because of its 86% fixed rate and Hatteras was the last risky at 0% fixed rate. Both are yielding above 14%. Grant’s was arguing that Hatteras was the best bet, but I agree with you – at leverage of 3x, dividend yield of 11.5, and only 106% of book, MFA looks like the best of the bunch. I think one thing to note is that regardless of what these guys say they are hedging, if they were truly hedging their interest rate risk then they would be earning the risk free rate. In other words, there is no free lunch.

  3. Wet Willie says

    Disclosure: I own both NLY and MFA. However, I have been accumulating MFA lately b/c it has recently dipped to about 94-97% of book value, which is historically pretty cheap. Also, last quarter MFA did a secondary offering that increased share count by ~25% and it was still able to payout a .235 cent dividend. Once the proceeds from the offering are put to work, I foresee dividend increases. Thanks for the blog…it is well done.

  4. curmudgeonly troll says

    borrow short, lend long, leverage up, what could possibly go wrong?

    works great as long as the Fed keeps the ZIRP and the long end doesn’t tank.



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