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Are These Companies Creating a Mortgage Bubble?

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When an investment gets hot, investors plow money into it as fast as they can. As long as a market is big enough, that doesn't necessarily pose a problem. But in the aftermath of the housing bubble of the mid-2000s, could investors be stampeding into an area that's just as likely to fall as home prices were at the peak of the housing boom?

The increasing importance of mortgage REITs
The housing market relies on mortgage financing to function properly, and the mortgage market in turn has come to depend on securitized investment vehicles in order to maintain the free flow of trillions in mortgages. Along the way, real estate investment trusts that specialize in buying mortgage-backed securities have arguably become more important than the big banks that actually create those mortgages in the first place.

You can see one sign of the role reversal in mortgages by looking at executive pay in the industry. As Bloomberg reported late last month, Annaly Capital (NYSE: NLY  ) CEO Mike Farrell received $35 million in compensation last year, eclipsing pay levels at the six biggest banks in the nation. Given how much smaller mortgage REITs are than big U.S. banks, that compensation may seem upside down.

But when you look at growth figures in the industry, you can see that mortgage REITs are now a huge magnet for mortgage-related capital. Annaly's balance sheet shows that its assets have multiplied more than sevenfold since the end of 2005. Similar trends exist at Annaly's rivals:

Mortgage REIT

Current Assets

Rise (Since)

Annaly Capital $120.3 billion 649% (December 2005)
American Capital Agency (Nasdaq: AGNC  ) $88.4 billion 1,811% (December 2009)
Chimera Investment (NYSE: CIM  ) $9.7 billion 557% (December 2008)
ARMOUR Residential (NYSE: ARR  ) $12.8 billion 5,025% (December 2008)
Two Harbors Investment (NYSE: TWO  ) $11.3 billion 4,225% (December 2008)

Source: S&P Capital IQ.

Many mortgage REITs just started operating within the past few years, becoming substantial operations from the ground up in a very short time. All told, Bloomberg estimates the size of asset holdings among mortgage REITs at $270 billion, having tripled in less than three years.

Danger ahead?
Many analysts at the Fool and elsewhere have warned of the potential problems that mortgage REIT shareholders will likely face when short-term interest rates start going up. Mortgage REITs derive much of their profits from highly leveraged bets on mortgage securities, and that leverage in turn depends on favorable spreads between the rates they pay to borrow money and the returns they earn by investing it. If those spreads get narrower, it squeezes profits and reduces the amount of money the REITs have to distribute to shareholders, reducing their dividend yields.

But another potential problem goes further than just mortgage REIT shares to go to the heart of the mortgage industry itself. During the financial crisis, two sets of stakeholders ended up bearing the brunt of the housing collapse: banks and the government-sponsored enterprises Fannie Mae and Freddie Mac. In both cases, those groups needed taxpayer support to survive.

This time around, mortgage REITs have taken on an ever-increasing role in maintaining the health of the mortgage industry. With sales of $5 billion in shares so far in 2012 and $16.8 billion last year, mortgage REITs are able to leverage up equity capital as much as 10 times or more. If things go badly a second time, then it will be shareholders of those mortgage REITs who will suffer the most, as forced liquidations of mortgage-backed securities could potentially create wave after wave of mortgage-bond declines that once again bring systemic risk back into the equation.

Get out now?
With mortgage REITs currently in a regulatory blind spot, the increasing size of the market has attracted the attention of regulators of related entities. The SEC has looked into provisions that could limit mortgage REITs' use of leverage, while the Financial Stability Oversight Council could determine that mortgage REITs pose a systemic risk and justify supervision in the name of preserving the mortgage markets.

One possible saving grace for mortgage REITs is that their leverage levels have actually come down from their highest levels a few years ago. But if interest rates start going up, then we could see very quickly just how exposed mortgage REITs are to changing conditions in the mortgage market -- and we could discover too late that they held the key to the next housing-related bubble.

If you like strong, dependable income from your portfolio, mortgage REITs aren't your only choice. Accept this invitation to read the Motley Fool's special free report on nine promising dividend stocks. Your free look is on us -- just click here to get started.

Fool contributor Dan Caplinger decided mortgages weren't for him. You can follow him on Twitter here. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Annaly Capital. Motley Fool newsletter services have recommended buying shares of Annaly Capital. Try any of our Foolish newsletter services free 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's disclosure policy helps you put a roof over your head.


Read/Post Comments (4) | Recommend This Article (4)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 10, 2012, at 1:35 PM, plange01 wrote:

    a mortgage bubble! thats a good one! all of three houses have been sold in the last four years!

  • Report this Comment On May 10, 2012, at 2:10 PM, macaded wrote:

    What's tomorrow's headline? How about:

    Is the Plague coming back?

  • Report this Comment On May 10, 2012, at 3:04 PM, Hawmps wrote:

    "Similar trends exist at Annaly's rivals:"

    CIM is not one of Annaly's rivals.

  • Report this Comment On May 13, 2012, at 12:57 AM, Palido wrote:

    This author exposes their lack of knowledge of REITs with this "article".

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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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