In a recent post, I mentioned the “virtuous Ponzi” effect that comes from selling new stock above book value in a mortgage REIT.
The reason I’m talking about it now, when the entire group is trading below book value, is that there is a contrapositive logical truth available today. Before you give me grief about trying to popularize Euclidean logic, let me confess that I was blown away seeing a clip from the new Spielberg movie of Lincoln (click on the clip on the lower right).
If America is ready to understand the transitive property of logical truth, then they should be ready to understand that
If A implies B, then
(not) B implies (not) A
What this means to mortgage REITs is that if new equity can be added at a sale price well above book value, current shareholders get better returns. The current situation is that now that we are below book value, current shareholders will get a better return if the company buys back its stock.
An easy example of each follows. So unless you have to sell, or you think too many other people will have to sell, these discounts to book value mean that the management teams are very likely to start buying as much stock as they can, and the collapse of the stock prices will stop.
After running through the arithmetic for each case, I’ll give a few exceptions to consider when deciding whether to sell, buy or hold in today’s scary market.
CASE I – The “virtuous Ponzi”
Issuing new stock when the stock is trading above book value.
Let’s assume that an mREIT is earning 125 basis points of spread on its financed portfolio, and that they are financing eight dollars of MBS for each dollar of equity. So they have $9 of MBS for each dollar of equity. In today’s market, those MBS might be yielding 2.50%, so the total return on equity is
2.50% + 8 * (1.25%) – expenses (estimated at 1% of equity)
2.5% + 10% – 1% = 11.5%
Let’s say the company has $1 billion in book value equity at $10 per share on 100 million shares, so the raw numbers are gross profits of$125 million less $10 million in expenses, paying $115 million in dividends. If the company’s stock is trading at 1.2 times book value, then it’s a $12 stock yielding 9.583% ($115 / $1200).
Now they issue 50 million new shares at $12, raising $600 million. Instead of $1 billion, they have $1.6 billion in equity. That means net profits are now 11.5% times $1.6 billion, or $184 million to distribute in dividends. But there are now 150 million shares instead of 100 million, so the new market cap is $1.8 billion with a dividend yield of $184 / $1800, or 10.222%. The dividend went up from $1.15 per share to $1.23
Existing shareholders just got a bump in yield from 9.583% to 10.222%. Virtuous, indeed!
(By the way, everybody at the REIT gets a 60% raise. If they want to share the wealth, they can take a 30% raise, and distribute an extra $3 million in dividends, for a new yield of 10.389% for shareholders.)
Now you see why every mREIT that traded at a decent premium to book did as many secondary stock issues as possible these last couple of years.
Case II – The Contrapositive
Buying back stock when book value is at a discount.
Taking the same situation, but with a market price of $8 a share, the company has the same $115 million in net profits, and yields 115/800, or 14.375%. (It’s still the same $1.15 per share in dividends, but the stock costs so much less now.)
Let’s say they decide to buy back 10% of their shares. That will cost $80 million, meaning they will let the portfolio run off without reinvesting, and also sell MBS for a total shrinkage of $80 * 9, or $720 million. That won’t be a problem when the Fed is in buying $40 billion a month in MBS, or about $2 billion every trading day.
So now we have book value of $920 million producing a net of 11.5%. We also have 90 million shares outstanding instead of 100 million. That $920 million of equity capital produces $105.8 million to distribute to 90 million $8 shares, for a yield of 105.8/720, or 14.69%. Put in dollar terms, the dividend went up from $1.15 per share to $1.175.
Sounds great, so what could go wrong?
Most management teams don’t want to take pay cuts just because they’re doing the right thing for shareholders. Also, there are some expenses that are truly fixed costs. So if the company still has $10 million in expenses after the buyback example above, the increase in dividend is a bit smaller, because the $920 million in book value produces a raw return of 12.5%, or $115 million. That leaves $105 million to pay out as dividends, which would only increase dividends from $1.15 to $1.166, and increases yield from 14.375% to 14.575%.
The fact of fixed costs puts a limit on the company’s ability to do these buybacks.
The other thing that could go wrong is if there’s real pressure on the price of MBS because everyone else is doing the same thing. That situation, if drastic enough, would argue for investing new money rather than shrinking the portfolio.
Finally, a true liquidity crisis like that in 2008 might make it impossible to “roll over” the financing, or the banks offering financing might set terms that don’t allow 8-1 leverage any more. In 2008, the Fed stepped in and provided leverage of up to 14-1 to any bank holding Agency MBS, so it’s unlikely that the amREITs will get locked out of the financing market, though they might get charged a nasty premium that squeezes funding margins downward. Unlikely, but possible.
Slightly more likely in the liquidity crisis is that the yields on the underlying MBS are forced upward, or that swap spreads increase, or that hedges using Treasuries get too expensive as the market panics and drives the prices up on those Treasuries, forcing the amREITs who hedge that way to buy them back at a loss. Any of those developments would hurt the book value of the company, so it would have to shrink its portfolio.
Having said all that, I still expect the larger amREITs to start buying back their stock when it hits 80% of book value, or maybe a bit lower, assuming we don’t hit TEOTWAWKI. (The End Of The World As We Know It.)