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Mortgage REITs Are Wrong


Prepayments threaten yield.

MINYANVILLE ORIGINAL For the most part, whenever the Federal Reserve announced some form of "quantitative pleasing," the rallying cry -- to paraphrase David Tepper, head of Appaloosa hedge fund -- to "buy everything" has worked as stocks, bonds, and commodities have rallied following each iteration.

But the latest version, which is targeting the purchase of mortgage-backed securities (or MBS), will have a distinctly negative impact on REITs that are focused on mortgage-backed securities. The names include Annaly (NYSE:NLY), Capstead (NYSE:CMO), and Hatteras (NYSE:HTS), all of which had seen buoyant stock prices over the past 18 months while delivering dividends in the 11%-13% range. Give thanks to the steep yield that allowed them to borrow short-term money at infinitesimal rates to scoop up longer-term mortgage securities that paid several hundred basis points higher. The yield-starved world was grateful to have a place to generate income. And as these firms greatly lowered the leverage and improved the quality of their holdings, the risk adjusted return was very attractive.

Please Pay Me Later

One of the great ironies of the whole housing mess was that holders of the once-toxic MBS were enjoying a Garden-of-Eden-like environment of steep yield curves and the seizure of refinancing or prepayments. Thanks to high unemployment, continually declining home prices, litigation on modifications, and a generally overburdened system, refinancing and accompanying repayments were essentially ground to a halt.

Early repayment speeds determine the timing of principle cash flows coming back to the MBS investor. The faster the prepayment rate, the quicker cash flows are paid back to the bond investors -- and therefore, the shorter the life of the fixed income investment. When prepay speeds slow down, the average life of the bond's cash flows are extended, which is good for mortgage investors.

For example, Annaly and Hatteras portfolios were trading around $102.50 six months ago . This means that if prepayments were to occur (that is, everyone is paid back at par), it would cause a 2.5% haircut in annual returns. If debt were bought and trading below par, then a prepayment at face value would translate into accelerated earnings. Again, in the hunt for yield, investors were willing to pay a small premium to face par value on the notion that the net return would still be in the high-single to low-double-digit range over the five to seven year period.
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