Simply put, a Mortgage REIT borrows money cheaply at short term rates, and lends effectively at higher long term rates by buying mortgage backed securities (MBS). MBS are essentially individual mortgages pooled together as a security and sold by banks to investors. By pooling mortgages, the risk of losses to the investor from individual mortgage defaults is reduced.
A normal yield curve shows the relationship between interest rate yields and time to maturity. Lenders, concerned about the long term risk of default, offer longer term loans at higher interest rates than short term loans. Mortgage REITs borrowing money at the cheaper short term rate and buying higher yielding government backed MBS from banks pass through 90% of their taxable income to investors. This money is made on the difference between the spread on the interest rates payed on the money the Mortgage REIT borrows and the interest rate earned on the MBS that they purchase.
By leveraging up, a Mortgage REIT can make up to 6 to 8 times the spread. Mechanically, the REIT leverages by taking a new, purchased agency mortgage-backed securities (MBS) pool and entering into a repurchase agreement (repo) with a dealer, where the dealer gives the REIT cash. Then the REIT then purchases another agency MBS pool. REITs repeat this process until they have achieved six to eight times leverage earning investors double digit yields.
After the financial crisis in 2008, the FED bought over 1 trillion in MBS to keep interest rates down. With the FED buying MBS off the banks, bankers were able to offer borrowers lower rates on their mortgages. The massive amount of buying by the FED drove up prices of MBS reducing yields. With QE3, the FED plans to buy 40 billion in MBS every month. This represents 56% of the MBS market. Yields for MBS have fallen to record lows at 1.8% to 2% as prices soar. The decrease in spread between higher yielding MBS and short term borrowing costs brought about by QE3 should theoretically, drive prices of Mortgage REITS down as payouts shrink.
Some of the risks of owning Mortgage REITs include:
1) Record High MBS prices: New purchases of MBS by Mortgage REITs have yields that are significantly lower than whats already on their books.
2) Extremely tight spreads. Spreads over a comparable maturity U.S. Treasury or swap are at historically low levels; thus, these bonds don’t have the ability to tighten in spread to offset a decline in price.
3) Expected increase in prepayments. Given the recent drop in mortgage rates, there has been a dramatic pickup in refinancing activity. The problem for the mortgage REITs is that an increasing amount of their earlier purchased MBS yielding 3% or higher will be returned at par (100), instead of where they may be currently trading (Higher than par given the current 1.8% to 2% yield).
4) Margin compression. The implication of reasons one through three is that mortgage REITs are facing and will face strong margin compression in the coming quarters. High-yielding bonds are running off and being replaced with lower-yielding securities, while the cost of their funding hasn’t changed. This is a perfect combination for future dividend cuts, which have already begun in some cases.
5) Dividend popularity. With dividend paying stocks now in vogue, mortgage REITs are trading under a halo; they are one of the few places to find a significant yield. As quickly as these stocks have come into favor, they can also fall out of favor. Stocks that were trading at a premium to book value could quickly find themselves trading at a discount.
Investors looking for yield in Mortgage REITs need to be cautious. With the FED buying up 56% of MBS on the market, yields payed out by Mortgage REITS will come down. As the spread between yields on MBS and short term borrowing costs decrease, payouts for Mortgage REITs should fall. Falling share prices will lead to capital destruction for incognizant investors.
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