3 Great Side Effects of the Fed's Taper

Source: Dan Smith.

The Federal Reserve's move to pull back, or "taper," its stimulus efforts hasn't caused the volatility or spike in rates that many feared. The 10-year Treasury rate is holding steady at roughly 2.7%, and although many economists predict rates will begin to creep up to the low 3% range later in 2014, it is this stability, not the rates themselves, that should be on investors' minds. 

With that in mind, how could this affect my three favorite types of investments for 2014: bank stocks such as Wells Fargo (NYSE: WFC  ) , mortgage REITs such as Annaly Capital Management (NYSE: NLY  ) , and real estate?

The banks: lend, lend, lend
The major way banks will be affected is through lending, and mortgages in particular. This goes hand in hand with real estate, which I'll discuss in a bit, but people are generally more hesitant to buy (and refinance) when interest rates are unstable, unless they are at extreme lows like they were a year ago. As a result, mortgage lending has declined a bit, particularly refinancing.

However, even after the spike during the latter half of 2013, mortgage rates are still pretty low on a historical basis. Once homeowners begin to realize that 3.5% 30-year mortgages are not coming back anytime soon, we'll begin to see refinancing drift back up.

This will be especially beneficial to banks that derive a large portion of their revenue from mortgages, including Wells Fargo, the largest mortgage originator in the U.S. 

Additionally, we could see credit standards begin to loosen as banks see stability in rates, which creates a lower perception of risk. We're already seeing 5% down traditional mortgages from Wells and several other banks, which was unheard of in the years immediately following the housing crash. Once the market perceives that rates are going to be stable for a while, other looser lending standards could make a reappearance, such as lower minimum credit scores.

Mortgage REITs: When you're dealing with leverage like this, stability is a must!
Mortgage REITs make excellent money when rates are stable, while spiking interest rates can erode their profits very quickly, and even lead to losses. These companies make their profits by borrowing money to buy up mortgage securities. The idea is that the cost of borrowing money is less than the interest rate earned on the mortgages in the portfolio, and the mREIT pockets the difference as its profit.

The recent dividend cuts seen virtually across the board in mortgage REITs can be attributed to the rate spike caused by the uncertainty of the Fed's monetary policy. As a result, the spread (the difference between the interest rates collected and paid by the companies) eroded significantly, and many mREITs are paying out dividends of roughly half of what they were paying in 2012.

As rates stabilize, the mortgage REITs will begin to use their leverage more aggressively. Annaly Capital Management, in particular, had the foresight to reduce the leverage in its portfolio until rates stopped spiking. This puts them in an excellent position, as they will have more available spending power once good investment opportunities begin to present themselves.

Real estate: Proceed with the housing recovery
Pending sales of existing homes in the U.S. fell to their lowest level in more than two years in December, falling by 8.7%. This continues the trend that has been apparent since the end of the summer. Simply put, the housing market cooled off in the second half of 2013. 

Now that the Fed has given us some clarification by beginning the taper, mortgage rates are settling a bit and have actually dropped a little since the peak of the recent spike. Because of the volatile rates we've seen lately, potential homebuyers may have been waiting on the sidelines in hope that rates would come down to the ridiculously low levels we saw earlier in 2013. Once people begin to realize that rates in the low 3% range are a thing of the past, we'll see a new influx of buyers into the market, since rates of about 4.5% are still very low on a historic basis.

Foolish bottom line
The point here is that stability is a good thing. Banks will be able to use leverage more safely and comfortably, which drives profits for investors and makes borrowing money easier for consumers. Mortgage REITs are in a better position to capitalize on interest rate spreads and don't have to worry as much about volatility in rates destroying their profits. Stability also provides some comfort for homebuyers and can allow the still-fragile housing recovery to continue.

So, while extremely low rates are good for the financial sector and housing market, stable rates can be even better.

Great dividend stocks regardless of the Fed's actions
One of the dirty secrets few finance professionals will openly admit is the fact that dividend stocks as a group handily outperform their non-dividend paying brethren. The reasons for this are too numerous to list here, but you can rest assured it's true. However, knowing this is only half the battle. The other half is identifying which dividend stocks in particular are the best. With this in mind, our top analysts put together a free list of nine high-yielding stocks that should be in every income investor's portfolio. To learn the identity of these stocks instantly and for free, all you have to do is click here now.

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Matthew Frankel

Matt brought his love of teaching and investing to the Fool in order to help people invest better, after several years as a math teacher. Matt specializes in writing about the best opportunities in bank stocks, real estate, and personal finance, but loves any investment at the right price. Follow me on Twitter to keep up with all of the best financial coverage!

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8/31/2015 4:01 PM
NLY $10.06 Down -0.11 -1.08%
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