American Capital Agency Corp. (AGNC), Two Harbors Investment Corp (TWO) – Freddie Mac to MBS Buyers: We’re Done Shouldering All the Risk

In July, Freddie Mac closed a $400 million mortgage-backed bond offering of a new product called Structured Agency Credit Risk. This new product is part of a trend to shift credit risk to the private investors buying the bonds from the government-sponsored enterprise. As a taxpayer, this may be a welcome innovation, but for mortgage REITs the impact is, well, risky.

What makes this security different?

The security, which closed on July 24, represents a slice of a $22.8 billion pool of residential mortgage loans not guaranteed by the government. Freddie has agreed to take the first losses from the portfolio — if they occur — to the tune of $68.5 million, about 0.3% of the entire pool. Further, the offering includes increased disclosures to give investors a much clearer picture of likely losses in the event a portion of the pool defaults.

Fannie Mae , the other government-sponsored mortgage company, is preparing an alternative structure for later this year that uses mortgage insurance to spread the credit risk. Details on the exact structure of this product aren’t yet final, but the takeaway from both products points to a potential and significant change in the business: Investors in mortgage-backed securities may soon be taking on more risk in their MBS portfolios.

What to expect

Over the short term, the effects of this trend will be muted as the impact of changing interest rates will drown out other influences. Rising interest rates and a still flat yield curve have driven mREIT prices sharply lower over the past few months.

The interest-rate story will continue to dominate mREIT trading for the foreseeable future. However, as the yield curve stabilizes and becomes steeper, higher long-term interest rates will increase interest income, which, over the long term, will benefit the mREITs. To assess the impact for individual mREITs if credit risk moves from the government to the private sector, look to the REIT’s experience managing non-agency — that is, non-government-guaranteed — mortgages, as well as their historical credit risk performance.

Two players to watch

American Capital Agency Corp. (NASDAQ:AGNC) is an agency-only mortgage REIT, meaning it invests only in mortgage-backed securities issued by Fannie and Freddie, now explicitly backed by the full faith and credit of the U.S. government. As such, we must look to management to determine the REIT’s future in a hypothetical world where agency bonds carried credit risk. CIO Gary Kain, a career Freddie Mac executive coming up through the trading desks, only entered the REIT industry in 2009. While Kain is a highly experienced executive, he lacks significant experience outside the world of Freddie Mac and agency-issued securities. If the industry does swing to a broader base of mortgage security products, it may take Kain and American Capital Agency Corp. (NASDAQ:AGNC) a little longer to catch up on the learning curve compared with some competitors.

One of those competitors, Two Harbors Investment Corp (NYSE:TWO), is a hybrid REIT, meaning it invests in both agency and non-agency mortgage-backed securities. At the end of the first quarter of 2013, the company’s portfolio consisted of approximately 80% agency bonds. That experience investing outside Fannie and Freddie is all well and good; however, the company’s focus is increasingly in subprime mortgages.

At the end of the first quarter, Two Harbors Investment Corp (NYSE:TWO) reported that 87% of its non-agency bonds were subprime, an increase of 3.3 times from Q1 2010. That indicates, in my view, that the company is too comfortable with high credit risk on the balance sheet. The question going forward is: Could Two Harbors successfully diversify the portfolio outside agency bonds if credit risk increases?