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Are Mortgage REIT Dividends Free Money?

Alex Dumortier
March 7, 2012

I've written in the past about the risks associated with mortgage real estate investment trusts Annaly Capital Management (NYSE: NLY  ) and American Capital Agency (Nasdaq: AGNC  ) , and I've become increasingly disturbed by reader comments that make it clear that some shareholders believe mREIT dividends are "free money." As a result, I think it's crucial to dispel a few fundamental misunderstandings about these companies and their stocks.

This is no straw man
If you are among the mREIT shareholders who have a solid grasp on the risks inherent in these shares, you may think this "free money" attitude is purely a straw man position that I have created. To prove that isn't the case, just take a gander at the following comments, which I lifted verbatim from one of the most highly rated bullish CAPS pitches for Annaly Capital: "By ensuring [Fannie and Freddie's] survival, the government ensures that Annaly Capital Management won't go belly up as well. So basically we have an almost guaranteed yield in double digits every year, unless the stock price skyrockets, which wouldn't be bad at all."

I rest my case for the utility of an article like this one.

First reality: There are no barriers to entry in this business
You might think mREITs have a defensible franchise. After all, not just anyone can manage a large portfolio of mortgage securities. Well, yes and no. Yes, managing a mortgage bond portfolio requires knowledge and experience. However, any reasonably established trader fresh off a Wall Street mortgage desk can launch a hedge fund and go head-to-head with Annaly in a matter of months; all you need is some office space, a Bloomberg, and a few signed documents with a prime broker.

Strictly speaking, it's not entirely true that there are no sources of competitive advantage in this area. In theory, a strict value discipline and the ability to adopt a long-term time horizon are the twin pillars of success. I'm willing to believe that Annaly's management has a value orientation (although I think Redwood Trust (NYSE: RWT  ) is a better example of this than either Annaly or American Capital). The trouble is that mREITs lack financial flexibility because they must, by law, pay out 90% of their profits to shareholders, and they depend heavily on short-term financing. That's a huge structural impediment to implementing a value approach -- particularly during periods in which it would be most profitable.

Second reality: Businesses with no moats don't earn excess returns
It's a basic principle of finance: If you have no competitive advantage, you cannot expect to earn excess returns over an extended period of time. Does that mean mREITs have a competitive advantage? Take Annaly, for example, which has delivered an 11.3%