Relative Value

Ron W asked a good question in response to the post about the share buyback authorized by ANH.

“Wondering your view of ANH after seeing the vulnerability of their holdings to GSE buyback. Book could take quite the hit.”

Now that the selloff in ANH shares looks near the end of its run in response to those fears, I think once again we see that share price can be more vulnerable than the business it represents.

That’s not to say that ANH’s fundamentally more conservative strategy of owning ARMs rather than fixed-rate MBS hasn’t bitten them in the you-know-what as Fannie and Freddie get ready to clean house on severely delinquent loans.

After all, the delinquencies are much higher in ARMs than fixed rate mortgages, with both being an order of magnitude worse than any time in history.

From the standpoint of taxpayer funds, I applaud the action, because it’s the only way to stop the bleeding, and to stop a kind of back door bank bailout no one is talking about.

That bailout is the embodied in how servicing works for prime Agency MBS.  There was little reason for this to be a problem when people who told the (verified) truth on their loan applications, put down 20%, and complied with Agency standards for household income debt service coverage.

Basically, those borrowers had enough equity in their homes and enough economic lasting power to sell the house if they had to, and leave the closing table with cash in hand, no matter what kind of difficulties they faced (job loss, catastrophic health costs, divorce, death of a breadwinner, etc.).  That gave the borrowers the incentive to move quickly if they had to give up the house, because that maximized the amount of money they would have to start the rest of their lives.

Today, in many markets, those same people actually can’t sell and make a new start.  They are economically better off staying in the house without paying as long as possible, and let the bank pile up its late fees and penalties as much as it would like.

It’s the latter consequence, those late fees and penalties, that I call “back door bailouts,” because they turn what was a thin-margin servicing business into a major profit center.  Loans that have all those penalties accruing also give the servicer first priority (after real estate taxes) on any recovery from selling the house.

Even in really lousy markets, you can expect the house to cover what might be thousands of dollars in unpaid servicer fees, but comparing that to the tens or hundreds of dollars in fees from ordinary borrowers, that’s a goldmine for the servicers.

On top of that, virtually every politician is busy making hay (along with the media) on telling the sad stories of “unlucky” borrowers being thrown out of their homes by mean old banks.

The solution if you manage a bank mortgage servicing operation?

Slow walk any foreclosure, and pile up the profit.

Things change, of course, once Fannie or Freddie “buy out” the delinquent loan from the MBS pool.  Now they can take the servicing contract away from anyone who isn’t moving as quickly as they like.  They also stop owing MBS investors the monthly principal and interest payments on those loans.

Of course, if an investor (like an amREIT) paid more than 100% for the loan as part of a pool, the sudden payoff at 100% might cut into profits.

That’s the current fear slamming most, but not all, amREITs.

Annaly was very proactive with their recent public relations, claiming that they had specifically avoided buying MBS that might suffer this effect.  I wonder if that was an after-the-fact rationalization for the fact that they have been buying 75% fixed rate MBS for a couple of years now, primarily for the higher stated yield.

In general, holding fixed-rate MBS is riskier than holding adjustable rate (ARM) MBS.  That is precisely because of the borrower option to prepay a loan is a much stronger incentive for fixed rate mortgages than for adjustable rate mortgages.

In the bond business, we call that price risk due to interest rate movements “effective duration” and we observe about twice the risk in fixed MBS as in hybrid ARM MBS.

But, for the next couple of months, bad credit will be the driver of Agency prepays, not borrowers selling their houses or refinancing.

JMP Securities (my personal favorite among the Street firms analyzing these animals) has summarized their estimates of the amount of book value exposure among the amREITs as follows:

NLY …………..$0.11
AGNC …………$0.44
ANH ………….$0.08
CMO ………….$0.12
CYS …………..$0.09
MFA ………….$0.04
HTS …………..$0.28

Color me shocked, I tell you that the only stock in the group that went up since that report was published on February 11th is the one that’s about to pay $25 million or more in fees to Wall Street.

Here are the closing prices of the group on the day that report was published, and the prices as of yesterday’s close:

NLY …………..$17.19  …  $18.21
AGNC …………$25.64  …  $25.00
ANH ………….  $6.90  …   $6.67
CMO ………….$12.56  …  $12.48
CYS …………..$13.05  …  $12.97
MFA …………. $7.09  …   $7.09
HTS …………..$25.83  …  $25.41

Now, I have to say that I think NLY’s issuance of convertible preferred is a long-term positive for their common shareholders, which is why I bought some trading shares the night that issue was announced and the stock went down in price.

Still, they do operate in the same market as the others, and even being the biggest doesn’t make them impervious to the generic risk of the MBS carry trade.

For that reason, I’ve unloaded the NLY shares I picked up a couple of weeks ago, and put the money into some Canadian oil and gas trusts I’ve been watching.  I also couldn’t resist adding a little of the Rodney Dangerfield of the amREIT group, ANH.

All the management teams at the amREITs have to be painfully aware of the very narrow spreads the sector is paying these days.  Most OAS models (Option-Adjusted Spread) show that the prepayment option is worth more than the raw spread to LIBOR.

In bondspeak, the Agency MBS market has been trading at a negative OAS spread to LIBOR for months now.  Nobody expects that to continue, and when it stops, levered MBS investors will take a hit to equity far bigger than the one-time hits this Fannie-Freddie loan buyout will make.

Bear in mind that the “hit to book value” that is the current worry point is simply a potential acceleration of the payment at par for a small fraction of the MBS those companies hold.  They always knew they were going to get par back for those MBS, and for the most part they only paid about a 2 point premium.

The potential 2 points or so in “loss” is only pennies for each stock, even with their leverage.  They just don’t have that many of the bonds in question, and the payments at par from the buyouts only amount to single digit or low double digit percentages of the principal amounts.

On the other hand, if spreads widen for the whole space, the hit to equity is across all of the principal.  It’s also about twice as bad for fixed-rate MBS than it is for ARMs.

To me, that continues to be the reason that these management teams are sitting at 6:1 leverage or even less, in spite of being able to take on 10:1 leverage in the repo market.

I’m comfortable that the low leverage, even on the amREITs that are heavy in fixed-rate MBS, will be sufficient to allow an increase in leverage that will maintain or even increase earnings if and when spreads widen.

In case you hadn’t heard, the economy sucks and the banks whose health is Ben Bernanke’s primary concern still have problems.  Those banks are re-capitalized by holding short rates low.  The banking system will eventually “earn its way out” of the hole they dug by lending to every wild-eyed optimist that came to them with a real estate development scheme.

Those earnings will come from the grandmothers who live on CDs, and from you and me leaving our checking and savings deposits earning bupkus.  They will pay us “squat” and collect 5% or so on their MBS, or 12% or more on their credit card balances, and eventually they will be healthy again.

I’m thinking I have 18 months or more of relatively stable dividends coming from my amREITs.  Your mileage may vary, as the capacity for people to do foolish things, even corporate management teams, sometimes astounds me.

Having typed much of this post three times (save function messed up over my new wireless router), I’m going to get this posted.



6 Responses to Relative Value

  1. Loren says:

    Thanks for this post, I learned too.

  2. Chuck Hinson says:

    As these delinquent loans are cleared, won’t this in turn make the remaining book value of the loans more valuable ? Offsetting somewhat the hit to book by the par calls. chuck

    • hhill51 says:

      It all depends what price the investor paid. If they paid a premium (as most MBS buyers have paid since rates went to zero), then the potential for the very slow prepays from people selling their houses will give a higher yield over time (by waiting longer to be paid back at par).
      That is what was happening to the ANH portfolio previously, as they assumed 20% or 22% prepayment, but actually got results in the teens.
      The biggest boost to yield is in hybrid ARMs that are past their initial fixed rate period, because most of those loans were structured to have a higher margin over the base rate after the reset date, and now those borrowers can’t refi as they had initially planned.
      Unfortunately, that also leads to higher defaults in those loans because the reason most can’t refi is that their equity from paying a 20% down payment has evaporated. If they are the 1 in 14 or so borrowers who have to sell for non-economic reasons, they turn into defaults. (We should note that those defaults are still prepayments at par from the POV of the MBS investors.)

  3. SRG says:

    off the m-reits topic, but what Canadian Oil & Gas trusts have caught your eye.

    • hhill51 says:

      I’m a little leary of naming names there, because I mostly rely on the heavy lifting a couple of friends do in analyzing those beasties.
      Also, they tend to be “juniors,” wildly volatile in price and very illiquid. I’d hate to have others try to follow me in to a trade only to find out that they can’t get out because the next bid is so small and so far south.

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