Buying MBS at a Discount

An unusual event occurred last spring, and it may happen again.

Exactly one sub-segment of the stock market has flourished during this crisis. The Fed’s tsunami of liquidity and the Government’s “guarantee them all, and sort it out later” crisis strategy has been nirvana for a small group of mortgage REITs that specialize in buying guaranteed mortgage securities and financing them through repo (repurchase agreements).

By offering the Federal Reserve’s balance sheet to broker-dealers for repo and by taking over Fannie Mae and Freddie Mac, Washington created the closest thing to free money that we’ve seen in two decades.  It reminds me of the Savings and Loans offering any  CD rate they could remotely justify, yet investors had a rock-solid taxpayer guarantee that the CD would be paid even if the S&L was drinking real estate developer kool-aid.

Last night two of the companies in this sub-sector reported their third quarters, and the results were impressive.  Annaly (symbol NLY) and Capstead Mortgage (CMO) each surprised some analysts by growing their shareholder equity and simultaneously paying dividends north of 15%.

The others in the group are Anworth (ANH), Hatteras Financial (HTS), American Capital Agency (AGNC), and MFA Financial (MFA). Some include Cypress Sharpridge (CYS), but it has some non-Agency MBS that keep it from being a pure play.

The two newcomers to the group are HTS and AGNC.  They both had their IPO’s last year.

A recent Stifel, Nicholas report estimated book values as follows:

NLY – 16.88 (last night NLY reported book value 16.52, a nickel of which is intangible)

CMO – 12.83 (last night CMO reported 12.21)

HTS – 25.57 (on Wednesday, HTS reported 26.07 book value after issuing new shares at 26.60)

ANH – 7.84 (the stock went ex-dividend for 28 cents/share on Oct 28, so this would adjust to 7.56.

MFA – 7.11 (other analysts estimate 7.25 – 7.30)

AGNC – 22.93 (just reported, but with a secondary at nearly 1.2 times book just completed, this will rise)

CYS – 13.58 (this should be adjusted downward to reflect holdings of private-label MBS)

It’s not that surprising if you look at what they do.  Repo borrowing costs less than 1% per year right now, and government-guaranteed MBS yield much more.  All the mortgage REITs that specialize in Agency MBS (amREITs) reported net interest margins in the 2% to 3% neighborhood, even after hedging costs.  The hedging, by the way, is to protect against the Fed raising short term rates in the future, since even Adjustable Rate Mortgages are typically fixed rate for a period of three to five years.

Each of the half dozen publicly traded mortgage REITs that concentrate on Agency MBS has a slightly different flavor, but they all use leverage to increase their return.  That leverage comes from the deepest pool of liquidity the bond market has – the repo market.  At roughly 6x leverage, these companies are actually pretty modest users.  By comparison, banks can hold Agency MBS with less than 5% capital, or 19-1 leverage.  Brokerage firms can go even higher.  Even hedge funds operate at 9-1 leverage in this sector, down from 19-1 before the crisis.

The simple back-of-the-envelope analysis would run like this:

“Raw” yield on the MBS is around 4.50% for fixed rate mortgage securities and 4.0% for ARMs.  ARMs cost much less to hedge, so the net margin after hedging is comparable, at around 250 basis points.

6x leverage gives 15% return on the six parts borrowing, plus around 3.5% return on the 1 part owned as equity (after hedging).

Raw return on equity comes to 18.5%.  Figure overhead eats up 1% to 2% or 1.5% average for our envelope calculation, for a net of 17% yield on equity.

From there, we adjust for how much you pay to buy a slice of that equity (price-to-book).

For an amREIT trading at 1.1 times book, we could estimate earning a yield around 17%/1.1, or 15.45%.  On the other side of the coin, if we could buy at a 10% discount, we might expect to earn 18.7%.

A pretty attractive envelope, wouldn’t you say?

One thing I’ll look at in later posts is the fact that several of these companies have a tier of capitalization above the common equity.  Those preferred stocks have various terms, but all of them take a dividend ahead of the common.  When looking at the risk profile, I take that into account.

Other elements of the risk analysis include how much fixed-rate MBS they have vs. ARMs, how they hedge their exposure to price moves in the MBS and rate moves in their repo funding, and whether they hold premium or par-priced MBS in their portfolios.  Another risk element is the proclivity to trade to boost reported profit.

Right now, all the amREITs are priced just below or above book value once you adjust that book value for non-guaranteed MBS or , but several flirted with decent discounts yesterday when the market hit an air pocket.

I’m raising this possibility now because the rally since March has plenty of internal weakness that indicates a major correction may be coming.  If that happens, chances are that the amREITs will sell off along with everything else.  If they do, I want to be ready to buy.

After all, the most likely “reason” – I prefer rationale – for a major stock market correction will be some sort of bad news on the economic front.  Such bad news will only reinforce the Fed’s desire to keep short rates, especially repo, low.  That’s how banks earn enough to offset the losses they take for owning bad loans.

When you read that the Fed is concerned about the US Dollar, unemployment, or inflation, just remember what they really have as their first priority.  The Fed exists to keep the banking system alive (or even healthy).  Every other goal will go by the wayside if the banking system is threatened.  By keeping rates low, the Fed is recapitalizing the banking system, and that’s going to take some time.

Unfortunately for people looking to start or grow businesses, it’s too easy right now for banks to just hold securities and collect the spread.  At least by owning amREITs in an environment like that, we get to enjoy some of the benefits ourselves.

Still, I don’t like overpaying, and this is one purchase where getting a discount really matters.

I won’t be going into the difference between the half dozen amREITs just yet, but I’m sure you can take the names and find plenty of detailed analysis from your broker.  I’m keeping my eye on the macro picture, and it looks good for the next year or two, or at least until the banking system is healthy again.

If the opportunity arises to buy these at a reasonable discount, I’ll let you know, and share some of my impressions on how the various companies in the group operate.

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4 Responses to Buying MBS at a Discount

  1. Tom Drake says:

    I owned NLY for the June and September dividend payment dates and got a nice gain as well. I looked at most of the other mortgage
    REITs in some depth and HTS looks “second best”. But NLY has the depth and history that give comfort even though with senior securities. (Some high yield advisors have been recommending one of those issues as a bit more conservative but still with a decent high yield.)

    My problem was gauging when the market would begin to factor in FED exit (from zero) moves. Looking at the long term price chart of NLY (and also the total return chart) FED moves were anticipated in some cases, but in some cases (2008) NLY declines came much later.

    Redwood Trust (RWT) is one to look at for which merely surviving was a great triumph. They are another tree altogether with mainly non-federal mortgages. Having lived in a redwood grove in Marin County California as one time, I know that those huge trees have shallow roots with occasional distructive outcomes in storms.

    I very much look forward to your on-going study of this REIT category.

    • hhill51 says:

      Addendum re: ANH. They will announce their earnings Nov. 3 and hold a conference call an hour after the stock market closes that day (5 Eastern, 2 Pacific). Lloyd McAdams, CEO and Chair, will host.
      Along with CMO, this is the most fully-hedged and conservative among the group, with a portfolio almost exclusively in ARMs, and a rigid adherence to the discipline of hedging out the funding risk during the fixed-rate period of the typical 5/1 ARM. As a result, their spread widened much more slowly than others like NLY when the Fed crushed rates downward. They basically had a couple of years’ worth of hedges to run off.
      Lloyd is a pretty good speaker, and explains the amREIT business model so the ordinary investor can understand. Call-in 866-356-4279 with passcode 27700944, replay 888-286-8010. Also webcast through company website at http://www.anworth.com.

  2. Scott says:

    Love your blog.
    Wonder if you can help me. Seeking warehouse/gest. repo/early purchase facility. We have equity.
    Targeting ginnie loans.

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