The rebound of the housing market is prompting a big resurgence in the jumbo mortgage market -- those oversized loans that are generally the bailiwick of the wealthiest of home buyers. These loans had fallen out of favor since the financial meltdown, mainly because they aren't backed by any government sponsored entity, and are therefore considered risky.
But times are changing, and jumbos have been making a recovery -- and making sweet profits for banks and mortgage REITs. One particular mREIT that has been garnering some attention lately is Redwood Trust (NYSE: RWT ) . This company has been packaging and selling jumbo mortgage-backed securities for some time, and it has been making a tidy sum doing so. Is there a lesson here for other mREITs -- particularly agency-only enterprises like Annaly Capital (NYSE: NLY ) and Armour Residential (NYSE: ARR ) ?
Non-agency market increasing
Jumbo loans have been increasing as the high-end housing market recovers. In New York, for example, the jumbo market nearly doubled on Long Island in the first six months of 2012, reaching $4.3 billion compared to $2.4 billion for the first half of 2011. In this context, jumbo loans were defined as those exceeding $625,000, though the bar is lower in other areas -- often sitting right around $417,000.
Another trend is helping to boost this market: The growth of the non-agency MBS sector. With the Fed's QE3 program depressing yields in agency paper, the rate of private label securities has seen an uptick.
Redwood Trust has been leading the charge and has brought several such offerings to market since 2010. These securities have been filled with top-notch loans from credit-worthy borrowers, experiencing no defaults since Redwood started creating these instruments.
Redwood's success is clearly reflected in its recent fourth-quarter earnings report, where it showed net income of $42 million versus a $3 million loss in the year-ago quarter. The company has found this business so lucrative that is has declared its intention to continue despite pending regulations that may add additional risk.
The current and potential profits involved haven't escaped the biggest banks, either. JPMorgan Chase (NYSE: JPM ) recently announced its intention to float just this type of MBS, which it expects to close by the end of the month.
A little variety for agency mREITs?
The beauty of these securities is that they are offered only to borrowers of means -- a recent offering from Redwood contained loans from loan recipients with two years' worth of cash reserves, according to Bloomberg -- and they also sport a higher interest rate. With current rates moving upward rather than downward, however, the risk of prepayment seems nearly nil.
What does this mean for Annaly and Armour? In my opinion, it presents a golden opportunity. While Annaly has stuck to its agency-only mantra for its entire existence, it has recently shown some flexibility in its bid for commercial MBS investor CreXus Investment (NYSE: CXS.DL ) . And, though Armour hasn't taken the plunge yet, it did change its charter to allow for non-agency paper investments if management saw opportunities in that sector.
Will either of these mREITs take the plunge? The market for jumbo loans is expected to jump by at least 15% this year, and as long as housing improves, there seems no end in sight. As a way to increase those spreads, it looks like a great investment.
Annaly Capital Management has a history of paying huge dividends to shareholders, which has been somewhat muted lately. Will diversifying their portfolio with CreXus help? Find out all the headwinds and tailwinds facing the venerable mortgage REITi 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 the company's strategy. Click here now to claim your copy.