Disaster Strikes Mortgage REITs: What Investors Need to Know

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When Hatteras Financial (UNKNOWN: HTS.DL  ) declared second-quarter earnings earlier this week, it was not a pretty sight, as earnings per share missed the mark by $0.04. But that wasn't what set the stage for the carnage that spread throughout the sector: Hatteras reported a huge -- more than 20% -- drop in book value from the first quarter, sending the stock down more than 10% on Wednesday.

Everyone got stung
The huge drop in share price, along with the unusually heavy trading volume, smacked of investor panic. Adjustable-rate mortgage investors like Capstead (NYSE: CMO  ) , which reported earnings on Thursday, also took a dive. Even players in the 30-year mortgage market, such as American Capital Agency (NASDAQ: AGNC  ) and Annaly (NYSE: NLY  ) got dinged, right along with the ARM crowd.

This constant battering of mREITs is understandable, of course, as investors used to seeing big dividends from this sector worry about more cuts to those juicy payouts. Last week, fellow ARM-buyer CYS (NYSE: CYS  ) started another upset for mREITs when it also reported a decrease in book value from last quarter of nearly 19%.

As earnings season progresses, what can investors expect?

More trouble on the way
With mortgage rates ticking upwards, no mortgage REIT will escape some damage to book value. Add in the threat that the Federal Reserve's QE3 program may be tapering off soon -- which would decrease the value of MBSes even further -- and you've got a perfect storm of bad luck brewing for the sector.

Short-term, things will be less than rosy. For example, American Capital Agency will declare second-quarter earnings on Monday and will very likely throw everyone into a tizzy. American Capital Agency started the book-value plunge worries with its first-quarter results, which showed a nasty turn of events for the rising star, with a $1.57 per share loss, and a plunge in book value of 8.6% from the previous quarter.

While there were extenuating circumstances for this event, such as a secondary offering at the beginning of the year, things may have gotten worse for Gary Kain's biggest mortgage REIT, so investors shouldn't be thrown for a loop. As for Annaly, which is also expected to announce earnings soon, it will be interesting to see if its absorption of CreXus Investments, with its stable of commercial mortgage bonds, offered the company any insulation from the recent firestorm.

Things won't be this way forever
For the near future, things look a little bleak. Remember, however, that this, too, will pass. In 2005, for instance, Annaly was paying a mere $0.13 dividend, and Capstead was doling out a pitiful $0.02 in the face of rising short-term interest rates. Yet, both survived, going on to pay out luscious dividends -- a fact to which their investors can attest. Mortgage REITs are navigating rough seas right now, but smart investors will do well to stay the course.

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  • Report this Comment On July 26, 2013, at 7:53 PM, bnachumi wrote:

    When you're buying an mREIT, you're mostly buying a revenue stream. So valuing mREITS on book value alone (which seems to be what most of these big moves are about) is a bit weird. As I understand it, the underlying mortgages aren't defaulting; moreover, they are less likely to prepay in an environment of rising rates. On the other hand, yes, if the securities you have are really sticky and hard to dump, you might have less to spend on new ones that take advantage of the widening difference between short term and long term rates. But if I am not grossly mistaken, reselling isn't how the mREIT business lives, so the revenue stream they bought back when is still flowing.

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