Mortgage REITs have suffered enough at the hands of the Fed’s easing. However, I believe the situation has overturned. This article reviews the latest poor housing data, reasons for the housing sector’s underperformance and the consequences it will have on US mortgage REITs.
According to the latest weekly survey of the Mortgage Bankers Associations [MBA], the US housing statistics continue to deteriorate, despite the Fed’s best efforts to speed up the recovery of the same. The Market Composite Index, which measures mortgage loan applications, decreased 3.8% over the prior week after making seasonal adjustments. Without the adjustments, the index decreased 3% over the same time period. Similarly, the seasonally adjusted Refinance Index fell 5% to its lowest since the week ending Dec 28, 2012. Even though the refinance share of mortgage activity remained the same over the prior week at 77% of total applications, it is still at its lowest since July 2012.
Over the same time period, one witnessed a moderate decline in mortgage rates. The average 30-year fixed rate mortgage rate with conforming loan balances and jumbo loan balances decreased 1 basis point to 3.77% and 3.93%, respectively. This recent moderate decline in mortgage rates is offset by the hike in rates since the beginning of the year. The average 30-year mortgage rate surged 17 basis points while the average 15-year mortgage rate increased 12 basis points to 2.76%. The reason for such an increase in mortgage rates is said to be the shortage of mortgage lenders.
Lost Appetite
Mortgage rates have continued to climb since the beginning of the year, despite the Fed’s best efforts to keep them at their lowest. Low rates would have meant cheaper borrowing thus speeding the US housing recovery. The reason for the rise in rates is said to be the loss in appetite by some of the biggest mortgage lenders.
Some of the biggest mortgage lenders have show their reluctance in originating mortgages. Banks like Citigroup Inc. (NYSE:C) and Bank of America Corp (NYSE:BAC) suffered credit losses and write-downs totaling $258 billion from mortgages from the second quarter of 2011 to the third quarter of 2012. During the third quarter of 2012, mortgage originations at BAC declined 37% over the prior year. Mortgage lending at Citigroup was down 5% over the same time period. When these large mortgage lenders exit, they create an imbalance.
Mortgage Imbalance Capsizing QE3 Effects
The loss in the appetite of mortgage lenders has caused a mortgage supply shortage in a market that is still characterized by relatively low mortgage rates. These low mortgage rates have increased demand for mortgages. The lack of supply and the increase in demand has created an imbalance in the mortgage markets, causing mortgage rates to climb. Increased mortgage rates are overturning the effects of the third round of quantitative easing, better known as QE3. The 10-2 year Treasury yield spread has gone up 5 basis points since the beginning of the year. Further, the spread between 30-year mortgage rate and the 1-year Treasury rate increased 15 basis points to 3.34% since the beginning of the year.
Mortgage REITs earn this spread. Therefore, this widening has caused the mortgage REITs to fly high since the beginning of the current year. Besides, benefiting from the widening of the spread, mortgage REITs will experience fewer prepayments going forwards, causing them to register lower amortization costs. Therefore, mREITs have benefit two-fold from this lender loss in mortgage lenders’ appetite.
Top Picks
American Capital Agency (NASDAQ:AGNC), Annaly Capital Management (NYSE:NLY), ARMOUR Residential REIT, Inc. (NYSE:ARR), Two Harbors Investment Corp (NYSE:TWO), Invesco Mortgage Capital Inc (NYSE:IVR), AG Mortgage Investment Trust Inc (NYSE:MITT) and American Capital Mortgage Investment are among my favored mortgage REITs.
AGNC, Invesco Mortgage Capital Inc (NYSE:IVR), ARMOUR Residential REIT, Inc. (NYSE:ARR), MITT and MTGE have structured their investment portfolios in a way that has resulted in sufficient prepayment protection. This is why they have the lowest respective CPRs of 10%, 14.6%, 14.1%, 7.8% and 6.5% in the industry during recent quarters. Lower prepayments caused lesser compression in the net interest rate spreads for these companies. Two Harbors Investment Corp (NYSE:TWO) reported a 7 bps sequential decline while Invesco Mortgage Capital Inc (NYSE:IVR), ARMOUR Residential REIT, Inc. (NYSE:ARR), MITT and MTGE reported declines of 2 bps, 27 bps and 11 bps, respectively.
In contrast, American Capital Agency and American Capital Mortgage reported 21 bps and 27 bps expansions in their net interest rate spreads during the fourth quarter over the linked quarter. Two Harbors Investment Corp (NYSE:TWO) provides complete diversification as it is invested in MBS and real estate properties at the same time. The invested MBS yield interest and the real estate properties generate rental income for the company. Annaly Capital is the only mREIT with accelerated prepayments (19% CPR) and an investment portfolio exclusively invested in Agency MBS, providing little diversification.
These mREITs have displayed tremendous YTD performances in the first two months of this year, and I believe they have the potential to deliver in the coming quarters if the mortgage imbalance remains intact.
Conclusion
While a majority of the analysts will be cautiously recommending mortgage REITs, I recommend investors buy the aforementioned mREITs until smaller mortgage lenders step in and stabilize mortgage rates.
The article Buy mREITs on Mortgage Lender Shortage originally appeared on Fool.com and is written by Adnan Khan.
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