mREITS: Regulators Finally Wake Up to This Dividend Bubble

After their worst weekly performance since November, U.S. stocks began this week on a healthy note, with the S&P 500 (SNPINDEX: ^GSPC  ) and the narrower, price-weighted Dow Jones Industrial Average (DJINDICES: ^DJI  ) losing 0.5% and 0.1%, respectively, on Thursday.

Consistent with those gains, the VIX Index (VOLATILITYINDICES: ^VIX  ) , Wall Street's fear gauge, fell 4%, to close at 14.39. (The VIX is calculated from S&P 500 option prices and reflects investor expectations for stock market volatility over the coming 30 days.)

mREITs: Excess returns or dividend bubble?
I've been warning investors about the risks associated with mortgage REITs (mREITs) such as Annaly Capital Management (NYSE: NLY  ) and American Capital Agency (NASDAQ: AGNC  ) for more than a year and a half. Finally, regulators are waking up to the the potential problem these companies pose. Last Friday, The Wall Street Journal reported that the Financial Stability Oversight Council mREITs could finger mREITS as an area of vulnerability in financial markets in its annual report.

mREITs borrow money on a short-term basis to invest in mortgage securities and they collect the difference between their borrowing cost and the interest their bond inventory generates. Because they borrow in short-term funding markets, they are continually rolling those borrowings over -- an Achilles' heel in distressed markets.

Oblivious to the weaknesses in the business model, investors have flocked to these shares, attracted like moths to the flame of the huge dividends they promise: According to KBW Research, the market capitalization of the sector has nearly tripled over the past three years, from $22.1 billion to $59 billion. mREITS' assets quadrupled to more than $400 billion since 2009.

My suggestion to investors who own these shares, or who are considering owning them, is to carefully ponder the following three questions:

  1. What is mREITs' competitive advantage? (Hint: They have none, although if one or more of them reach "too-big-to-fail" status, that could be a corrupted form of competitive advantage, i.e., rent seeking -- much like the TBTF and investment banks.)
  2. When a business has zero competitive advantage, what kind of long-term returns should shareholders expect to earn relative to the index?
  3. If the shares of a business with zero competitive advantage smash the market over a multiyear period, like American Capital Agency has done (see below), what relative and absolute returns should shareholders expect over the next several years?

AGNC Total Return Price Chart

Source: AGNC Total Return Price data by YCharts.

Along with junk bonds, mREITS represent, to my mind, the most obvious example of excess directly attributable to the Fed's ultra-loose monetary policy. At some point, that policy will end, but not before investors have likely suffered significant losses on these frothy vehicles.

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Read/Post Comments (18) | Recommend This Article (16)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 22, 2013, at 7:52 PM, jad9000 wrote:

    This is exactly what the FED i doing - issuing short term paper an buying long term bonds. Maybe we need to regulate the Fed?

  • Report this Comment On April 22, 2013, at 7:56 PM, carguy54495 wrote:

    So you have been warning about these reits for a year and a half. I guess you have been wrong for a year and a half. During that time I have happily collected my double digit dividends on the three I own.

  • Report this Comment On April 22, 2013, at 9:24 PM, Doubledip41 wrote:

    I have held NLY for 10 years and collected in excess of 10% average dividends each year. It's one of my better investments. I understand the risk of the Fed. raising rates but Japan has held rates low for about 20 years. I don't expect that but you keep bad mouthing NLY like you are short. If you believe something, state it and then back off.

  • Report this Comment On April 22, 2013, at 10:14 PM, TMFAleph1 wrote:

    @Doubledip41

    Thanks for your comment.

    Rising interest rates is *not* the only risk the mREITs face.

    I have no financial interest, long or short, in any of the mREITs, and there is no reason for me to "back off" now or at any time when it comes to my opinion.

  • Report this Comment On April 23, 2013, at 12:27 AM, skireef wrote:

    The Fed probably won't raise short term rates til 2016. QE3 will probably go till the end of 2013. When that happens, the margins will increase (asset values will fall slightly) with an even bigger required payout. When the Fed raises rates, they will do it slowly if history is any guide. If you pay attention, you are bound to do very well in this sector. If you buy and then don't look for 4 years then you might have a problem.

    Secondly, the banks are much more exposed to the leveraged side of mortgage securities. The mREITS leverage (at 6 to 8?)is certainly managed and not a systemic threat.

    There is a reason the total return is impressive and for the next couple of years, that should continue. Carry trade anyone?

  • Report this Comment On April 23, 2013, at 2:10 AM, zadajo wrote:

    You overlook 3 fundamentel points

    1. The Fed competes with NLY/AGNC. If they stop buying the spread earned by mReits will go up[although it is true that their book values will take a hit.]

    2. The vast majority of the mReits holdings are AAA Agency paper. So the lending parties are fully secured.

    3. NLY has never failed to make an dividend payment; even when there was an inverted yield curve.

    Finally with any investment there are risks,but with the mReits stockholders are being very well compensated.

  • Report this Comment On April 23, 2013, at 8:04 AM, assisgnmeaname wrote:

    Utterly misleading and sophomoric diatribe.

    Even at the worst of the banking crisis NLY fared relatively well because their securities (at the time) were 100% agency and highly liquid. Leverage, interest rate spread and the housing market for traditional mortgages are all you need to keep in mind. Agency mREIT's aren't some exotic, dangerous derivative...like say muni's.

  • Report this Comment On April 23, 2013, at 9:31 AM, TMFAleph1 wrote:

    @assignmeaname

    Pray tell, what is misleading about it?

  • Report this Comment On April 23, 2013, at 9:37 AM, TheDumbMoney wrote:

    Reading comments on fool.com articles, which I apparently do because I have a mental deficiency, I am often reminded of Casey Stengel's quote while managing the 1962 Mets: "Can't anybody here play this game?!"

    (Where the game is logical, objective, cold-hearted Vulcan analysis of stocks, ESPECIALLY those we already own.)

  • Report this Comment On April 23, 2013, at 10:00 AM, Dumbaussie wrote:

    So mREIT's, like savings and loan banks, are all doomed? Isn't this the same business model the major banks use, or a derivation of that model? How long have banks been around?

    The way I see it, the only difference between banks and mREIT's (particularly those backed by MBS's) is they don't offer all the other rubbish services banks offer.

  • Report this Comment On April 23, 2013, at 3:48 PM, assisgnmeaname wrote:

    TM/Author...it's misleading by omission. It doesn't give any sense of the fact that agency paper is considered as safe as treasuries, that these company's have track records of reducing leverage and raising capital to offset risk and enhance returns as the underlying conditions fluctuate. You don't define mREIT's or distinguish agency REIT's from non-agency...there is no real information here. Have you gone back ten years and analyzed the all-in returns on NLY?

  • Report this Comment On April 23, 2013, at 6:19 PM, FrankJEllis wrote:

    Fool is the appropriate designation for one who has no position, no intimate knowledge, but is merely the power of negative thinking. Opinions are like ... Fools have negative oppinions, while due diligence investors have experience and real knowledge as the basis for deliberate decisions. Your total failure to understand a position seems to entitle you to an opinion based on a complete lack of comprehension, but entitles you only to be negative, vainly imagining things you know not of.

    If you can't be positive about something you know about, pointing out positive aspects that you have carefully researched, sharing the positives with readers, better to keep quiet, least you show the fruits of lack. Understanding RIC's, tax laws, regulations, agency mortgages, and the individual home owners who could not own homes without businesses owning their mortgages requires a little willingness to be open minded to facts instead of focusing on blind beliefs in false conceptualization of false presumptions.

    Whether you ulterior motive is to short, tear down, destroy, or merely display ignorance for all to see, it is better to keep negative and false assumptions to yourself. The majority, the stock holders of these REITS and the owners of MORL, laugh at you, all the way to the bank. You have no respect for the many investors, the inside owners, the entire industry, and all that you give is returned to you. Reap what you sow. If you have no positive thoughts, assume that the majority know something you don't know, and keep your ignorance to yourself. It is safe to say that the managers, boards of directors, emploees, inside owners, and share owners know what you lack in knowledge because theirs lives, families, and livlihoods depend on knowing what you do not know, and are unwilling to know. Stick to what you know, and leave the rest to those who know their areas of expertise.

  • Report this Comment On April 23, 2013, at 7:19 PM, sailrmac wrote:

    The analogy to don't fight the fed is follow the fed. mREIT's do just that. The fed has stomped on short term rates with one foot and long term rates with the other. It has promised to keep that foot down on short term rates through mid-2015. Should it decide to lift a foot, it is therefore very likely to be the one on long term rates first. This would actually increase the spread. Additionally, for those mREIT's which also hold non-gauranteed paper, as real estate has turned around, that non-gauranteed paper has had less risk of default (the gauranteed already had no risk of default). Hence I conclude mREIT's are likely to be able to continue to pay their dividends through mid-2015.

    A difference of opinion is what makes markets. No-one should be upset the author expressed his/her opinion, they instead should be happy there are people out there warning others away from the risks of mREIT's. It just gives you a better return on your dividend re-investments.

  • Report this Comment On April 23, 2013, at 10:28 PM, dbtheonly wrote:

    Mr. Ellis:

    My Grandmother always said, "If you don't have something nice to say, say nothing at all". This is good advice for personal relations. It is much less wise when referring to stocks. There are good reasons, pro & con, about investing in any stock.

    M. Dumortier is not a fan of NLY. Good. He states his position. You & I are free to agree or not. For myself, I've been reducing my stake in NLY over a bit. For me the management is getting too incestuous for my taste.

    But hammering M. Dumortier because he doesn't put a smiley face on the stock? Hardly fair or wise.

  • Report this Comment On April 24, 2013, at 11:00 AM, prginww wrote:

    @dbtheonly: I share your view of NLY's "incestous" management makeup and pretty much everything else you said... but Mr. Ellis has some valid points, even though he's pushing the envelope a bit with the respectful aspect of his comments. The general thrust of most comments thus far seems spot on, in my opinion. When I view my unrealized gains page on all three portfolios I manage, my positions in half a dozen MREIT's have been consistently green, and rather significantly larger than my other holdings. I closed out my NLY last year, but not because of anything Mr. Dumortier has written. I flatly disagree with his ideas. At my age, I am primarily an income-oriented investor, and the MREIT sector has provided very nicely, indeed. Even if they were to be cut in half, they would still generate dividends roughly double what the so-called "safe" dividend payers do. Having said that, I do watch the sector like a hawk, as well as the Fed.

  • Report this Comment On April 24, 2013, at 1:51 PM, mainelegal wrote:

    All the comments about treasury security protection because these companies invest only in agencies misses the point. These companies are playing the long end (mortgages) against the short end (short term rates.) Their financial statements are incomprehensible to mere humans, amd NLY, for instance, distributes dividends based on their own internally defined financial metrics.

    When interest rates move up in the short end, the long end will fall (or crash) due to the high, and highly leveraged, and therefore compounded, interest rate risk.

    A $100,000 2.5% 15 year mortgage is only worth $40,000-$50,000 if the ten year US Treasury goes to 5%. Any company holding those naked, or only counterbalanced by worthless derivatives, simply cannot have enough capital to survive.

    Investing in these companies is a bet they will time the market well. Welcome to the casino.

  • Report this Comment On April 24, 2013, at 5:01 PM, jonkai3 wrote:

    --------------------

    Their financial statements are incomprehensible to mere humans, amd NLY, for instance, distributes dividends based on their own internally defined financial metrics

    -----------------------------

    true, and they've been doing it for FIFTEEN YEARS.. exactly the same by the way... don't you think if something was "wrong" with it, that the market's would have noticed by now? including like 3 finincial and market meltdowns atleast, one of which was nearly a bigger depression than the one in '29... yet NLY made MORE MONEY during the time of the market meltdown...

    the fact is that while their actual instruments are 'incomprehensible" the idea is extremely simple, and you really can't get it wrong... seriously....

    when your assets are guaranteed by the USA, and those assets have fairly forecastable earnings coming in... it is pretty easy to make money...

    during the financial crisis a couple years ago, My 92 year old grandma could have spent in the wind and made money in this business... witness AGNC and a dozen other companies that sprang up that noticed that hey, you can make good money in the business.... unfortunately their eyes are bigger than what is infront of them, and will suffer... but NLY knew and knows what exactly is going on and has a lower leverage rate than most any financial company of similar make up... including regulated banks.

  • Report this Comment On April 24, 2013, at 5:10 PM, jonkai3 wrote:

    and do us a favor and put up a "total return" chart since NLY's birth, rather than AGNC's birth... so you can see how misleading that chart you put up is.

    or better yet, put up a chart since July....

    or this, AGNC has issued nearly half of it's shares in the last year... so put up a chart to see how 1/2 of the people are doing in AGNC as far as Total return....

    it is one thing to say your literally only a few million dollars in revenue in it's first year grew, it is quite another to see how those dollars are doing when they finally caught up with other company's sizes....

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