Here It Is

Remember when I posted about buying Agency MBS at a decent discount?

For a couple of them, it’s here.  The price of MBS have continued to rise, causing enough pain that fund managers are willing to be quoted about what a wonderful short sale they are.

The fact is, though, that with even non-Agency MBS now getting financed at 10-1 leverage, all the Agency mortgage REITs (amREITs) have lots of leverage upside available.  On top of that, with prices near last month’s local multi-year high, barring extraordinarily bad spculation disguised as hedging, book values are quite a bit higher than they were at the end of Q3.

Since the book value is also the equity base for leveraged borrowing, any amREIT manager can now easily take on 10-1 leverage.   The amREITs’ leverage current ranges from 5-1 up to about 7-1.  With the Street offering to finance Agency MBS with 5% to 7% “haircuts,” leverage is available as high as 19-1.

The amREITs have the option of buying and financing additional MBS and locking in 150 to 250 basis points of income after hedging the LIBOR-based funding cost.   For “back of the envelope” figuring, that means the amREITs could add anywhere from 450 basis points to over 1000 basis points to their current yield without exceeding the leverage ratios now being offered to hedge fund holders of non-Agency MBS paper.

The risk is still there that prices will fall in a general increase of longer interest rates, or that mortgage-specific spreads will widen after the Fed buying program comes to an end.  As noted earlier, however, the Fed’s buying is likely to be replaced by Fannie and Freddie increasing their portfolios in accordance with recent advice from their regulator.

Another risk is built into the high prices that MBS command these days.  Last March, both the MBS and the amREITs were trading at significant discounts.  You can’t say that about the MBS today.

All things considered, I think the risk/reward balance shifted in favor of the amREIT holders with the decline in prices we saw on Friday.

To break it into up/down/sideways expected performance, an upward biased stock market would give holders some stock price performance.  In a down market, prices may have farther to fall, but the holders of government-guaranteed debt tend to do pretty well in extended bad economies.  If the stock market just wanders sideways, the high-teens dividend yields would continue, and dividend maintenance would not be an issue for management teams willing to take on minor additional leverage.

The risks are also there:

1) The repo market could experience another Lehman-style panic and loss of liquidity.  That could precipitate selling into a hostile bond market, locking in principal losses.

2) The stock market could experience another round of hating all things financial, so that even 15% or 20% yields wouldn’t be believed, or would be seen as still too low.

3) The hyper-inflation crowd could be right, so that MBS yields pop up to much higher levels, which translates into much lower prices for the underlying assets.

That said, with my own money, I increased my amREIT exposure by 5% of NAV on Friday, and I’m prepared to put even more cash to work if the selloff continues today.

(Not saying you should do this — all individual circumstances are different, and I can’t possibly know what would be advisable for strangers out on the web.)



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