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Mortgage REITs Are Wrong

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Prepayments threaten yield.

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Here Comes the Money Boo Boo

But a few things have changed over the past year that negatively alter the outlook for the returns, and therefore negatively alter the outlook for the share prices.

First and foremost is the Fed's latest version of QE, which will have the Fed buying up to $40 billion in MBS each month. This follows the Operation Twist, which targeted buying long term Treasury bonds. The result has been a flattening of the yield curve and has brought mortgage rates to historic lows.

The second change is that home prices have stabilized, thus helping to boost loan demand and the willingness of banks to lend. Together, these stabilizing home prices and the Fed's latest QE have helped loosen the lending transmission mechanism. As a result, refinancing and early repayments have surged in the past few weeks.

According to the Mortgage Bankers Association, prepayments in September climbed to their highest level in seven years and are now on pace to erase 25% of debt over the next year. Just this week, refinancing applications rose 20% to their highest level since April 2009.

Making matters worse for MBS-based REITs is the fact that new home loans, or fresh product, is still sluggish. This means that as the high yielding debt comes off their books faster and there is a lower-than-anticipated return, there is little to replace it.

A look at the charts of companies in this sector reveal the concern of the investors. However, note that most companies had handsome payout when they went ex-dividend at the end of September, so the recent decline looks worse than it is. But make no mistake: These stocks have broken their uptrends and the yields they once promised are now in jeopardy.

This is just another example of how difficult it is to invest in an interest-rate sensitive market. Once again, those looking for steady yield and income are being shoved aside.

Twitter: @steve13smith

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No positions in stocks mentioned.

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