3 Reasons a Perfect Storm May Be Brewing for Mortgage REITs

In this day and age of almost nonexistent interest rates, one sector that has done quite well by investors is mortgage REITs. These companies have actually reaped benefits from the low-short-term-rate environment, and their yields and dividends have been an oasis for parched investors seeking relief from low returns.

Lately, though, there have been some rumblings regarding the performance of these companies, whisperings that maybe the heyday of mREITs is over. Is it time to panic? Let's take a look at some of the issues that may disrupt the smooth sailing that these companies have enjoyed so far.

1. Interest rate spreads are getting narrower.
Mortgage REITs make much of their money by borrowing at low short-term rates, then buying assets with higher long-term rates. This has worked very well for these entities since the recession took hold, but the yield curve is slowly flattening, which cuts into profits. While short-term rates remain low, Federal Reserve actions to help float all boats have depressed long-term rates, such as those for mortgages.

Invesco Mortgage Capital (NYS: IVR) noted in its second-quarter report (link opens PDF file) that the less-steep curve is causing yields to decline, and that adjustable-rate loans are actually dropping lower when they reset. So far, though, the REIT doesn't seem to be suffering terribly: The yield is nearly 10%, and it recently paid out a nice dividend.

2. Accelerated prepayments could soon be a real problem.
The refinance boom is a godsend for borrowers, who can save a little money each month by taking advantage of lower mortgage rates. It is an even bigger boon for banks, which can make oodles of money helping homeowners save a little. Unfortunately, it is a bad omen for mREITs.

Just as Invesco noted the issue with ARM resets these days, refinancing presents a similar problem when higher-rate mortgages are paid off as the borrower takes out a new loan at a lower rate. Recently, FBR Capital Markets downgraded top-drawer REIT Annaly Capital Management (NYS: NLY) due to its higher-than-average exposure to mortgage loan prepayments. This is due largely to its size. Annaly's market cap sits at more than $16 billion, compared to Invesco's, which is a mere $2.3 billion.

Of course, just one analyst's opinion does not a trend make, but FBR also argues that a dividend cut may also be in Annaly's future. The REIT has decreased its dividend payments over the past year, though the most recent stayed stable. Unfortunately, this was possible because Annaly sold some of its assets -- which is normal for mortgage REITs but less sustainable than collecting interest. Replacing those assets with current mortgage-based securities may crimp margins even more.

Other mREITs are taking notice of this phenomenon, too. American Capital Agency (NYS: AGNC) , for instance, has made a point of concentrating on purchasing those MBS's that it believes will have a low prepayment rate. It also uses higher leverage than Annaly. American has experienced a 21% jump in its stock value just this year, and its dividend yield, though slightly lower than in the three previous years, is still a bit larger than Annaly's. It seems that American Capital's game plan has paid off, particularly when you consider that the market for MBS's has heated up in general, and for certain types of mortgage bonds in particular -- which leads us to the next issue facing mREITs today.

3. Fierce competition for MBS vehicles is driving prices higher.
Mortgage REIT managers seem the most concerned with the current market for MBS's, which is much more crowded these days. Investors want vehicles that pay, and interest in these securities is high -- which results in higher prices. Cypress Sharpridge Investments' (NYS: CYS) CEO noted just these issues in that company's conference call last month, pointing out both the increasing prices for these investments and the increased competition, including activity by the Federal Reserve. Cypress has recently sold off some of its portfolio assets that were too pricey considering their prepayment risks, replacing them with securities that are better balanced. Annaly's CFO also commented in its latest conference call that the company is more concerned with the escalating price of mortgage assets than prepayment levels.

It's a valid concern. Investors are falling over one another to pay premium prices for MBS's that sport the type of mortgages that are the least apt to be paid early -- namely, those written for amounts under $85,000. With overall MBS prices so high, investors consider it a bargain to pay a little more than face value for those with some degree of insurance against prepayment. Still, if refinance levels ratchet up appreciably, these investors may find themselves on the losing end of the gamble.

Some bright spots on the horizon
All of these headwinds facing mREITs are worth consideration, but certainly don't mean that these companies are in a downward spiral. For mREITs that invest in non-agency MBS's, things are looking up. Analysts note that revised capital rules for banks mean that senior nonagency MBSs will be treated differently, with more emphasis on underlying performance rather than credit ratings. The uptick in prices can be a plus, too, as noted by MFA Financial (NYS: MFA) in its earnings report. The company reported that, despite a slight increase in prepayments, senior notes in the REIT's portfolio have done well, since they were purchased at a discount to today's prices.

For Annaly, management is aware of the prepayment risk, noting that it is nowhere near the levels of 2003, a rough patch that the company managed to work through. It is possible, too, that Annaly has been selling those MBS's that have a higher prepayment risk to backfill its dividend, and replacing them with low-prepayment-risk securities, as Cypress has done. In that case, the effects of that type of program should be evident in later quarters.

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The article 3 Reasons a Perfect Storm May Be Brewing for Mortgage REITs originally appeared on Fool.com.

Fool contributorAmanda Alixowns no shares in the companies mentioned above. The Motley Fool owns shares of Annaly Capital Management.Motley Fool newsletter serviceshave recommended buying shares of Annaly Capital Management. The Motley Fool has adisclosure policy. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. Try any of our Foolish newsletter servicesfree for 30 days.

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