A New Threat to the Hottest Dividend Sector in the Market

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Investors have had to work hard lately to find investments that will produce the income they need. Many have turned to mortgage REITs as one of the most dependable income producers of the past couple of years.

Recently, a new announcement from the Federal Reserve seemed to give investors a green light to stick with mortgage REITs as a safe investment until mid-2013. But a possible proposal from the Obama administration might jeopardize mREIT profits and put shareholders in a situation in which they could see dividends dry up faster than they thought.

Why mortgage REITs are hot
If you've visited a bank lately, you know just how hard it is to find a decent interest rate these days. Rock-bottom rates on bank CDs and Treasury bonds have truly punished savers, especially those who desperately need income from their investments to pay living expenses.

But what's bad for savers is good for borrowers, and that's the business model that mortgage REITs have used to perfection since the financial crisis. With the Fed having locked down short-term rates in the 0% to 0.25% range, mREITs borrow money cheaply and then turn around and buy mortgage-backed securities. Using those securities as collateral to get even more financing, mREITs eventually take on impressive amounts of leverage -- and profit from the difference between the returns they get from their mortgage investments versus the financing costs they pay on their borrowed funds.

In fact, that model has worked so well that many mREITs pay almost unbelievably high dividend yields. ARMOUR Residential (NYS: ARR) , Chimera Investment (NYS: CIM) , and American Capital Agency (NAS: AGNC) pay yields in the 17% to 20% range, while even relative laggards like Annaly Capital (NYS: NLY) and Hatteras Financial (NYS: HTS) get you between 14% and 15%.

Taking money off the table
What's supported profits for mREITs so far is that spreads have remained fairly wide. Two things could potentially jeopardize that favorable environment: Short-term borrowing costs could rise, or the long-term investment returns on mortgage securities could drop. Although the Fed has put the kibosh on short-term rate hikes, the other side of the coin is where a new wrinkle has come up.

In particular, one proposal aims to solve a big problem in the current mortgage market: Rates are low, but refinancing is very difficult for many homeowners. The proposal would allow millions of homeowners to take advantage of low rates around 4%.

That may sound great for the economy as a whole, but it's bad for investors in mortgage-backed bonds. That's because if existing homeowners can refinance higher-rate loans, the mREITs that hold the bonds that those loans back will see their long-term returns fall. By some calculations, homeowners would save $85 billion per year -- but that money has to come from somewhere, and in this case, mREITs might end up shouldering much of the burden. In fact, mortgage-backed bonds suffered a big drop in price last week because of the proposal.

One reason why mREIT shareholders shouldn't panic about the proposal is that it isn't the first time it's been suggested as a possible solution to the ongoing housing crisis. Moreover, with some opposition from Fannie Mae and Freddie Mac, which are primarily responsible for loans underwritten with government guarantees, it's definitely not a sure thing that such a proposal would pass.

Your next step
Any time you see dividend yields as high as the ones for mortgage REITs, you need to figure out what the risks are that justify such high returns. In this case, the fragility of the perfect environment for mREITs explains why yields have been so high for so long. Ordinarily, diversifying through an mREIT ETF like iShares NAREIT Mortgage Plus (NYS: REM) or Market Vectors Mortgage REIT Income (NYS: MORT) might help alleviate some risk, but because all mREITs face the same issue to a greater or lesser extent, owning a greater number of mREITs through an ETF doesn't solve the problem.

In the end, if you want to hold onto the huge dividend power of mREITs, you have to reach a comfort level with the risks that they bring. Eventually, dividends will likely come down, but if you're prepared for that, then mREITs can still make good investments.

Mortgage REITs pay great yields, but they aren't the only smart dividend stocks out there. We have 13 more promising dividend stocks in this free special report from The Motley Fool; take a look at them today.

At the time this article was published Fool contributorDan Caplingeris almost always early. You can follow him on Twitterhere. He owns shares of Chimera. The Motley Fool owns shares of Annaly Capital and Chimera. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool'sdisclosure policyhelps put a roof over your head.

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