Like many Fools, I've enjoyed collecting the double-digit yield of a mortgage REIT -- Hatteras Financial (NYSE: HTS ) -- for the past couple of years. Mortgage real estate investment trusts generate returns by borrowing at the short end of the yield curve and buying mortgage-backed securities. A REIT structure that requires nearly all earnings to be paid to shareholders completes the recipe for big yields.
Federal Reserve Chairman Ben Bernanke and company have built the perfect stage for this trade by nailing short-term rates to roughly zip for the foreseeable future, and Hatteras just reported decent results, so why sell? The answer is two red flags in the latest quarterly report.
First, the interest rate spread dropped for the second quarter in a row. The spread was squeezed on both ends. The cost of funds went up and the portfolio yield went down.
Second, mortgage prepayments were up. Mortgage prepayments can hurt results in two ways. Securities need to be replaced, probably with lower-yielding paper, so the REIT will take a loss if it paid a premium to buy securities that are then paid off at face value. In addition, new rules for the Home Affordable Refinance Program make it easier for homeowners to refinance. That's great news for struggling homeowners but not so good for the companies holding the loans. About 13% of Hatteras' portfolio could be affected by the new rules.
Opinions on mortgage REITs here at the Fool can be described as cautiously positive. Coverage has included risks associated with these high yielders. Ilan Moscovitz holds Annaly Capital (NYSE: NLY ) and Chimera (NYSE: CIM ) in his Rising Stars portfolio, Jim Royal holds Annaly in his World's Best Dividend portfolio, and Anand Chokkavelu covers Annaly, American Capital Agency (Nasdaq: AGNC ) , Chimera, Hatteras, and MFA Financial (NYSE: MFA ) in his "Highest Dividend Yields" series. These companies have slightly different business approaches, but all follow the "borrow short, buy long" model and all would be hurt by an interest margin squeeze or higher prepayment rates.
Just because these risks are becoming more significant doesn't mean the stock is automatically a sell. Many pieces of the puzzle for success are still in place. Most importantly, the Fed is expected to hold short-term rates low for quite some time and the U.S. Treasury is backstopping Fannie Mae and Freddie Mac guarantees.
It's been a good run, and I may be selling early, but risks appear to be rising and after the blackout period around this article passes, I plan on selling my Hatteras shares and moving on to something else.