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Is It Time to Throw in the Towel on Mortgage REITs?

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Falling mortgage interest rates have been a boon to homeowners, but for mortgage real estate investment trusts, the results have been more worrying. Throw in the effects of the Federal Reserve's open-ended QE3 program, and the sector is beginning to look downright anemic.

As the Fed carries on with its mortgage-backed security buy-a-thon, the profit on the spread between borrowing short-term and buying long -- the primary way mREITs make their money -- is being pitifully squeezed. Consider heavyweight mREIT Annaly Capital (NYSE: NLY), whose spread dropped to 1.54% by the end of June, compared with 2.45% from the previous year.

As a thinking investor, you may be considering getting out of the mREIT arena, while the getting is good. Despite these headwinds, I would suggest that sitting tight and waiting out the tough times might be the better option, and here's why.

QE3 twists the knife
Although mortgage interest rates have been falling for some time, many mREITs fear that the newest round of quantitative easing will depress them even more. As the government buys up MBSes backed by agencies like Fannie Mae and Freddie Mac, these securities will become scarcer than hen's teeth.

However, things may not be as bad as they seem. As this graph shows, the rate of net agency MBS creation has actually been declining since 2009, so this is an issue that mREITs have been dealing with for some time -- and fairly successfully when you consider the yields most have been providing. Previous Fed QE programs have also entailed purchasing MBS products, prompting the CEO of CYS Investments (NYSE: CYS  ) to comment recently that the government has turned into the sector's main competitor.

While legacy MBSes owned by companies like Annaly (NYSE: NLY  ) and CYS Investments (NYSE: CYS  ) will jump in value due to this shortage, it's not much help when selling them would only result in more money that can't be invested for a higher yield. Indeed, some analysts note that hedging against interest rate spikes by mREITs like Annaly, CYS Investments and American Capital Agency (NASDAQ: AGNC  ) may negate any significant gains in book value.

Net interest margin freefall
As Q3 results from the likes of Wells Fargo (NYSE: WFC  ) and JPMorgan Chase (NYSE: JPM  ) show, the mortgage business has helped plump their bottom lines, but they suffer from the same malady as mREITs: net interest margin squeeze.

Although mortgage origination and refinancing has helped Wells more than double its income year over year from that department, the bank has seen its net interest margin fall precipitously. JPMorgan is in the same position, though its margin is not pinched as tightly as Wells'. This new reality has prompted Wells to hold more mortgages on its own balance sheet rather than bundle and sell them, since MBS yields are so low. This, of course, has the effect of further reducing the number of MBSes available for purchase by mREITs.

Foolish bottom line
Although the situation may seem dire, I think it is important to know all the facts before deciding how to proceed with a possible portfolio reshuffle. There are many bright spots here, despite the gloom, for investors willing to stick around the mREIT sector for the long haul.  It might not be easy -- accepting lower payouts and yields for a time will surely be part of the package. But, maybe, not for very long.

Just last week, Freddie Mac noted that both the 15-year and 30-year mortgage rate went up, rising from a low not seen since the early 1970s. Higher employment and rising housing demand are working their magic, and home prices have risen, too.

Even with QE3 in play, these rising indicators will naturally push up long-term rates, which is when those hedges will come into play.  Even though short-term borrowing costs will likely rise as well, higher mortgage rates will help quell the refinance activity that has been causing so many headaches for mREITs lately.

It is important to note that many of these companies, like Annaly, have been around for many years, surviving other downturns in fine fettle. When the bounce-back begins, savvy investors will be glad they waited it out, as they look forward to once again feasting on those tasty payouts that have made this sector so popular.

Annaly Capital Management has a history of paying huge dividends to shareholders. But there are some crucial issues investors have to understand about Annaly’s business model before buying the stock. In this brand new premium research report on the company, our analyst runs through these absolute must know topics, as well as the future opportunities and pitfalls of their strategy. Click here now to claim your copy.

Fool contributor Amanda Alix has no positions in the stocks mentioned above. The Motley Fool owns shares of JPMorgan Chase, Annaly Capital Management, and Wells Fargo. Motley Fool newsletter services recommend Wells Fargo. 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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