Back in mREIT Land

We’re fully into another round of secondary offerings while we await the bad news of loss of book value this quarter.  I wouldn’t be surprised to see secondaries even at levels approaching or below last quarter’s book values.

That obviously doesn’t apply to AGNC as they continue to sport the highest premium to book and highest dividend yield among the major players in the group.  With the next issue, they’ll be pushing $2 billion in market cap.

This is an interesting time for mREITs.  The back-up in intermediate and long rates has definitely hit the prices of fixed rate MBS pretty hard, and even hybrid ARMs have given up some of their premium.  But repo (financing) rates continue very low, and the universe of paper that gets financing continues to grow.

To interpret all that “market speak” I would say that new money will be put to work at better profit spreads than just about any time the past year or more, but that the money already committed has taken a hit.

As before, I look to Merrill Ross for a succinct description of the market:

We believe the cycle as it relates to mortgage REITs is definitely past the peak, but there are still dividends lying on the table. At this point in the cycle, companies will likely offer shares to try to position and hedge against the eventual tightening of credit. This seems like a toothless lion at this point, given the terribly slow pace of recovery. We don’t expect equity offerings at this point to result in substantially higher dividends; we expect external equity to be used to create a more sustainable dividend.

Ms. Ross is still predicting some improvement in the group-wide price-to-book ratio, and sanguine about the continuation of the nicely positive financing spread.   Here’s her weekly summary.

When we get the news of what happened this quarter (not until annual reports come out in February), I think some investors will be disappointed.  They listen to conference calls, read research reports, follow company press releases, and a lot them who post on message boards hear the word “hedge” and imagine that there is some magical protection against all harm in that word.

New Flash:

No hedge is perfect.  There are multiple kinds of risk, and each type of risk takes a different hedge.  No company I know of hedges all the kinds of risk.  Most don’t even hedge all of the risk of any single type.

The most common risk that gets hedged is financing rate risk.  That’s done with futures, swaps, caps and swaptions, but those all boil down to hedging out some of the risk associated with higher financing rates.  This is the risk you usually hear mREIT management talking about when they discuss hedging.

The next most common risk that can be hedged (but not very common among mREITs) is the principal risk associated with longer term interest rates.  This is where the backup in five-year and ten-year Note rates can hurt.  MBS reprice relative to those Treasuries, and I think almost all of us know that the announcement of the tax rate “compromise” triggered a substantial increase in those Note rates, from around 2.5% to well over 3%.

The next most common risk that can (sort of) be hedged is prepayment risk.  I break the types of hedging to handle this risk into two types:  1) direct prepayment rate swaps or insurance contracts, and 2) other investments, such as IO strips, that tend to increase expected cash flows substantially when mortgage rates rise and fall off the proverbial cliff when mortgage rates fall.  Except for a couple of players (TWO, for example), hedging this risk just isn’t part of the tool box for mREITs, and even those hedges are relatively limited in scope and consist of the complementary investment sector rather than true contractual hedges.  There simply isn’t enough yield in pass-through securities to buy those private contracts.

So anyone who thinks all that talk about hedges means book values won’t drop because of hedging is in for a rude surprise.  Still, the management teams may have gotten their timing right and only increased leverage after the yield curve steepened, or those who are now raising enough new capital they can deploy through January will be able to dance between the rain drops a bit.  It’s awfully late in the quarter to deploy new capital, however, so earnings per share has the potential to surprise to the downside.

That said, I’m looking forward to adding a little Dynex tomorrow on the occasion of a secondary.  Dynex, symbol DX, is a slightly different animal because a lot of what they hold has underlying commercial property mortgages.  They pulled off a nice profit capture recently by calling an old bond deal in that sector, but holding onto the mortgage loans.  We call that the “clean up” call, typically exercised when a deal reaches 10% of its original balance.  In the Dynex case, my failing memory (I won’t be looking it up to confirm) says they hold a wad of 8.9% mortgages that the now-revived financing market lets them finance at 3:1 or so at around 1.5%.  Nice.

More later,

hh

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5 Responses to Back in mREIT Land

  1. Marc says:

    Timing still perfect! Was able to add at $10.73 just before the announcement.

  2. BarryZee says:

    I think Merrill has noted a reason for raising equity, but for that to work towards the end she states – sustainability of dividend – it has to be done in a reasonable time frame before rates begin to rise. Otherwise its just building a base on which to earn fees.

    The corollary of course is that any management in this business may therefore be projecting a rise in short rates in a reasonable period of time. Take your pick.

  3. Patrick says:

    On a slightly more cynical note, the mREITs should all be rushing to the trough to take advantage of the remaining premium to book value they currently enjoy. It looks like the unwinding of the bond bubble isn’t being slowed much by the execution of QE2, and those unrealized gains on MBS will continue to erode throughout 2011.

    It’ll be interesting to see when Q4 reports are issued who harvested gains to support the 2011 dividend (ahem, AGNC) and what the plan going forward is.

      • maxx says:

        If CYS’s book value has dropped to 11.11 as suggested by stifel nicolaus then they will continue to do “accretive secondaries” at lower prices. The question with AGNC is just how much more gain can they harvest?

        Being a bit sceptical, I support the idea that management fees are management’s first priority and protecting the dividend is secondary.

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