William Dudley. Photo: New York Fed

What: In a speech on economic outlook and monetary policy last Tuesday, the President and CEO of the Federal Reserve Bank of New York, William C. Dudley, suggested, "In terms of the level of rates over the longer-term, I would expect them to be lower than historical averages."

Moreover, he noted the federal funds rate (the rate that guides which the rate which mortgage REITs borrow) is likely to "be well below the 4.25% average level." 

He offered three reasons for this:

  1. Persistent economic headwinds remain from the Great Recession
  2. Less economic growth potential due to an aging population
  3. And, low rates encourage banks to lend despite higher capital requirements

So what: Mortgage REITs Annaly Capital (NYSE:NLY) and American Capital Agency (NASDAQ:AGNC) depend on stable borrowing costs to fund their investments in mortgage-backed securities. However, due to the threat of rising interest rates affecting borrowing costs, the two companies have been steadily increasing their use of hedging.

Essentially, the two companies trade their floating interest rates (roughly tied to the federal funds rate) for fixed interest rates. On the plus side, this creates more predictable borrowing costs. The downside is instead of having an average borrowing cost of approximately 0.2%, the companies' are paying closer to 2%. The difference has a severely negative impact on profitability. 

The increase in hedging activity was a bet on short-term interest rates rising, however, considering Dudley's remarks -- as well as similar comments by Federal Reserve Chair Janet Yellen -- we may not see a significant rise in interest rates for well over a year.

Thus, Annaly and American Capital Agency entered into expensive hedging contracts that negatively affected profitability all to protect against rising interest rates that may not actually rise in the foreseeable future.  

Now what: Annaly and American Capital Agency's hedges can be separated into buckets by contract duration, or "maturity" -- Annaly is shown in the chart below. 

Interest Rate Swaps Q

Similar to Annaly, American Capital Agency also has the greatest amount of interest rate swaps (the most highly used form of hedging) in the zero-to-three year maturity bucket.

Considering Dudley's comments it's unlikely short-term interest rates will rise above the 1.78% "Pay Rate" Annaly swapped for in the next two years. Therefore, as Annaly's CEO Wellington Denahan noted in the company first quarter conference call, Annaly is in the process of ending a percentage of these contracts. American Capital Agency is likely to follow suit.

While ending hedging contracts comes at a price, both companies should more than make up the difference by taking advantage of the lower borrowing costs. Ultimately, I see this as one of the few tailwinds mREITs have seen in a long time, and should help the companies post potentially stronger second quarter earnings.  

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Dave Koppenheffer has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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 Motley Fool has a disclosure policy.

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