For Mortgage REITs, Is QE3 Friend or Foe?

Investors in mortgage REITs haven't had a lot to cheer about since last September, when the Federal Reserve instituted its latest round of quantitative easing. Although many of these trusts still deliver yields in the double digits, the crimped spreads of mREITs like Annaly Capital Management (NYSE: NLY  ) have reduced yields and dividends, as well.

However, there is a flip side to this story. The added competition for mortgage-backed securities guaranteed by Fannie and Freddie has caused prices to rise, as scarcity is apt to do. This scenario has bolstered the mREITs' book value, so necessary if the trusts are to raise additional funds for investment.

Is QE3 helping or hurting mortgage REITs? As it turns out, it's doing a little of both.

Tiny spreads are lousy, but a Fed exit might be worse
Contracting spreads of agency mREITs like Annaly and CYS Investments (NYSE: CYS  ) have hogged the headlines since the advent of QE3, while the lustier metrics of American Capital Agency (NASDAQ: AGNC  ) have inspired awe in the hearts of investors.

But Gary Kain, CIO of that well-performing trust as well as hybrid mREIT American Capital Mortgage (NASDAQ: MTGE  ) , recently learned a painful lesson when rumors of a QE3 wind-down gained steam in the first quarter of this year: Book values plummeted, and both his trusts suffered losses when bond prices fell and interest rates ticked upwards a bit.

Though much of the damage has been ameliorated during the second quarter, discussion regarding an end to the Fed's bond-buying program keeps cropping up -- much of it by the members of the board itself. 

Kain: Not a question of if, but when
In an interview with Bloomberg, Kain made the point that, though he doesn't think QE3 will end soon, mREITs must prepare. While noting that the higher-priced pools of securities in which American Capital Agency invested were the reason for the losses in the first quarter, he also maintains that these types of securities are the best with which to weather an extended QE3 program. In addition, these bonds are hedged in case of interest rate increases, preserving their attractiveness as an investment -- so, when prices fell, the trust bought even more.

Kain isn't the only manager protecting his companies from the effects of QE3. Annaly is in the process of acquiring CreXus Investment (UNKNOWN: CXS.DL.DL  ) , whose stable of commercial MBSes will hopefully give the agency player's own portfolio a needed lift. And, as Annaly's CEO noted on the company's first-quarter earnings call, the company also employs interest rate swaps to protect against rate hikes.

Are mREITs doing all they can to protect against the ravages of QE3, as well as its termination? It seems so, but as Annaly's disappearing spread and American Capital Agency's recent losses show, it's a tricky environment, and sometimes things look less than stellar. But, in the end, good management should win out, just as investors would expect.

There's no question Annaly Capital's double-digit dividend is eye-catching. But can investors count on that payout sticking around? With the Federal Reserve keeping interest rates at historically low levels, Annaly has had to scramble to defend its bottom line. In The Motley Fool's premium research report on Annaly, senior analysts Ilan Moscovitz and Matt Koppenheffer uncover the key challenges the company faces and divulge three reasons investors may consider buying it. Simply click here now to claim your copy today!

Editor's note: A previous version of this article stated that Annaly Capital was purchasing Chimera Investment. The Fool regrets the error.


Read/Post Comments (5) | Recommend This Article (4)

Comments from our Foolish Readers

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  • Report this Comment On May 20, 2013, at 1:14 PM, dbc44118 wrote:

    Why don't you answer the question raised in your title? As long as exiting OE3 doesnt raise the Mreit borrowing costs (short term rates), exiting sould be beneficial. Exiting should i decrease the price of new long term investments in mortgages, thereby increasing yeild available for distribution (although NAV of exixting mortgages might decreace)

  • Report this Comment On May 20, 2013, at 2:01 PM, dsandman999 wrote:

    An exit of the fed from buying $85B/month between long term treasuries and MBS would increase the spread and help NLY and AGNC because these are the actions that squeezed the spread. As long as they left the short term interest rates near zero, the spread would increase and the margins at these mREITs would grow. Without adjusting leverage, they would increase their revenue. The primary number is the yeild of the shares/units/etc. Even if the mark to market required the book values to drop, and increase in the dividend would offset this, ie the book could go to 25 but the stock price would not drop much if the dividend went from 5/year to 8/year. Those who are already long would enjoy the increase in dividends. Those that get in shortly thereafter would enjoy a high dividend and the likely increase in the base stock price as folks pour in for the yield.

  • Report this Comment On May 20, 2013, at 2:30 PM, SheaKub wrote:

    DBC44118 - QE is both good and bad. Exiting QE is both good and bad.

    On balance, a QE3 exit is more good than bad because the spread tends to widen while pushing book value down (which gets hedged).

    The oppostie of both is true WITH QE.

    Warlord

  • Report this Comment On May 20, 2013, at 7:26 PM, jonkai3 wrote:

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

    Though much of the damage has been ameliorated during the second quarter

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

    one may want to look at what those interest rates are back to right now which is (during the second quarter), if one thinks the damage has lifted...

  • Report this Comment On May 20, 2013, at 7:28 PM, jonkai3 wrote:

    NLY is not buying CIM, it is buying CXS.

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