Watch stocks you care about
The single, easiest way to keep track of all the stocks that matter...
Your own personalized stock watchlist!
It's a 100% FREE Motley Fool service...
In July, Freddie Mac (NASDAQOTCBB: FMCC ) closed a $400 million mortgage-backed bond offering of a new product called Structured Agency Credit Risk. This new product is part of a trend to shift credit risk to the private investors buying the bonds from the government-sponsored enterprise. As a taxpayer, this may be a welcome innovation, but for mortgage REITs the impact is, well, risky.
What makes this security different?
The security, which closed on July 24, represents a slice of a $22.8 billion pool of residential mortgage loans not guaranteed by the government. Freddie has agreed to take the first losses from the portfolio -- if they occur -- to the tune of $68.5 million, about 0.3% of the entire pool. Further, the offering includes increased disclosures to give investors a much clearer picture of likely losses in the event a portion of the pool defaults.
Fannie Mae (NASDAQOTCBB: FNMA ) , the other government-sponsored mortgage company, is preparing an alternative structure for later this year that uses mortgage insurance to spread the credit risk. Details on the exact structure of this product aren't yet final, but the takeaway from both products points to a potential and significant change in the business: Investors in mortgage-backed securities may soon be taking on more risk in their MBS portfolios.
What to expect
Over the short term, the effects of this trend will be muted as the impact of changing interest rates will drown out other influences. Rising interest rates and a still flat yield curve have driven mREIT prices sharply lower over the past few months.
The interest-rate story will continue to dominate mREIT trading for the foreseeable future. However, as the yield curve stabilizes and becomes steeper, higher long-term interest rates will increase interest income, which, over the long term, will benefit the mREITs. To assess the impact for individual mREITs if credit risk moves from the government to the private sector, look to the REIT's experience managing non-agency -- that is, non-government-guaranteed -- mortgages, as well as their historical credit risk performance.
Two players to watch
American Capital Agency (NASDAQ: AGNC ) is an agency-only mortgage REIT, meaning it invests only in mortgage-backed securities issued by Fannie and Freddie, now explicitly backed by the full faith and credit of the U.S. government. As such, we must look to management to determine the REIT's future in a hypothetical world where agency bonds carried credit risk. CIO Gary Kain, a career Freddie Mac executive coming up through the trading desks, only entered the REIT industry in 2009. While Kain is a highly experienced executive, he lacks significant experience outside the world of Freddie Mac and agency-issued securities. If the industry does swing to a broader base of mortgage security products, it may take Kain and American Capital Agency a little longer to catch up on the learning curve compared with some competitors.
One of those competitors, Two Harbors Investment (NYSE: TWO ) , is a hybrid REIT, meaning it invests in both agency and non-agency mortgage-backed securities. At the end of the first quarter of 2013, the company's portfolio consisted of approximately 80% agency bonds. That experience investing outside Fannie and Freddie is all well and good; however, the company's focus is increasingly in subprime mortgages.
At the end of the first quarter, Two Harbors reported that 87% of its non-agency bonds were subprime, an increase of 3.3 times from Q1 2010. That indicates, in my view, that the company is too comfortable with high credit risk on the balance sheet. The question going forward is: Could Two Harbors successfully diversify the portfolio outside agency bonds if credit risk increases?
In the case of Two Harbors, management has a diversified background with solid experience managing risk in a variety of arenas. Chief Investment Officer William Roth has a background in investment banking at Salomon Brothers, mortgage experience at Citigroup, and hedge fund experience at Pine River Capital Management. CEO Thomas Seiring has a background in portfolio management across a variety of investment classes, including distressed debt. With this management team in place, it provides a level of confidence in Two Harbors' ability to manage the portfolio with increasing credit risk.
The future of Fannie and Freddie is all about credit risk
Politically, there is tremendous pressure to reduce the mortgage market's reliance on Freddie and Fannie. It's unacceptable for taxpayers to bear the burden of the huge and unprecedented bailouts in the turmoil of the financial crisis, and it's justified to make fundamental changes to the mortgage system to that end. Whether Fannie and Freddie eventually wind down to zero or if they evolve into something new is yet to be seen.
But while the politicians, economists, and policymakers work out the eventual solution, one thing is certain. Mortgage REITs will have a role in the future of home financing in America, and that role will, in my view, include greater credit risk than exists today.
Look to the management teams with experience outside agency mortgage bonds to be best suited to guide these companies through the transition.
Dividend stocks can make you rich. It's as simple as that. While they don't garner the notability of high-flying growth stocks, they're also less likely to crash and burn. And over the long term, the compounding effect of the quarterly payouts, as well as their growth, adds up faster than most investors imagine. With this in mind, our analysts sat down to identify the absolute best of the best when it comes to rock-solid dividend stocks, drawing up a list in this free report of nine that fit the bill. To discover the identities of these companies before the rest of the market catches on, you can download this valuable free report by simply clicking here now.