The Mortgage REIT Explosion: What's the Real Risk?

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When it comes to financial risk, it's difficult to be too vigilant considering the long-term damage done to the global economy since the financial crisis. Certainly, it is a good thing when regulators prove that they are on task, keeping a watchful eye on all things financial in an effort to keep the economy on an even keel.

The recent rumblings regarding mortgage REITs, and their possible negative impact on the economy, is a case in point. How much of a risk do these entities really pose to the financial system, with what some consider their high leverage and expanding asset base?

Putting things in perspective
Perhaps in response to such concerns, hybrid mREIT Two Harbors (NYSE: TWO  ) recently released a useful investor primer on the industry, giving a much clearer view of just where mREITs stand compared to other mortgage players.

The primer notes that, by far, commercial banks, the Federal Reserve, and government sponsored entities like Fannie and Freddie hold most of the U.S. mortgage debt, with mREITs ranking No. 7 out of nine categories. Additionally, of the $600 billion of market capitalization occupied by the REIT industry as a whole, mortgage REITs come in at a little under 10%, at $59 billion.

Two Harbors is the third largest mortgage REIT, at a cap rate of $4.5 billion, and is the largest hybrid, investing in both government sponsored entity-backed securities, as well as non-agency. The two largest mREITs, Annaly Capital (NYSE: NLY  ) and American Capital Agency (NASDAQ: AGNC  ) buy only agency-backed paper.

Two Harbors is the parent of the newly minted Silver Bay Realty (NYSE: SBY  ) , one of only two single-family residential REITs currently cashing in on the foreclosure-to-rental craze that has been a hot sector over the past year or two. Two Harbors' stock has fallen since the end of March as the company has paid a quarterly dividend of $0.32 per share, sold 50 million additional shares, and partitioned out shares of Silver Bay to its own investors. Two Harbors, like American Capital Agency, has also experienced a growth spurt since its inception, growing its portfolio from $520 million at March 31, 2010 to its current $14 billion. 

Non-agency risk
What of the non-agency portion of Two Harbors' portfolio? While this is a relatively small piece of the total pie -- $2.7 billion compared to the $11.3 billion in agency paper -- these mortgage-backed securities give the entire portfolio a lift since the spread here is more robust than that of the agency MBS pool.

This is because of higher credit risk, of course. Just how high is that risk? Not terribly high, according to recent data. Loan delinquencies are decreasing nicely, dropping to the lowest rate in the fourth quarter of 2012 since 2008. As for leverage, Two Harbors notes that it maintains rather moderate levels of 7.1 times for agency paper, and 3.4 times for non-agency.

Mortgage REIT investing is certainly not risk-free, but the diminutive size of the sector, as well as the superlative risk-management approach of the three largest mREITs should be of comfort to both regulators and investors. As hybrids like Two Harbors grow in size and popularity, the spreads they offer will be much more attractive, as well. Considering that Two Harbor's overall spread is a juicy 2.9% compared with American Capital's 1.63% and Annaly's anemic 0.95%, it looks as if Two Harbor's pledge to "be recognized as an industry leading mortgage REIT " is well under way.

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  • Report this Comment On April 22, 2013, at 7:13 AM, tpicciani wrote:

    I own several Agency and Hybrid REITS and have done so for at least 3 years. Is the dividend safe? I think so. I think in these times they are a great investment. At times they're a better investment than gold or bonds and have increasingly become the safe haven device retail and institutional investors are looking for.

    I play the REITS like this: If the economy is improving, Hybrid REITS tend to do better. Agency reits do better during less profitable times. That's a generalization of course. Right now my REIT section of my portfolio is around 50/50 between the two. As times get better I'll add more into the hybrid side.

    Remember this about the leverage aspect. The agencies take on the risk of early refi's and defaults. And all the mortgages are prime mortgages that go into a reit. So the fears of a massive collapse aren't there. The mortgages themselves have value. And these reits are some of the best managed companies out there from what I understand.

    Finally, should QE3 or 4 or 5 go away, especially with Bernanke leaving, the spread should increase. I would expect the 10 year Treasury to go up as well as the zero to .25% short term bills. But the spread should widen and give reits a boost, possibly reducing leverage for the same yield. And I think that's a good thing.

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