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1 mREIT Sailing Toward Calmer Seas

Jordan Wathen
November 1, 2013

Has American Capital Mortgage (NASDAQ: MTGE) found calm waters in choppy markets, or is it stuck in the doldrums?

That's the question I'm left asking after the company reported earnings on Wednesday. The presentation revealed that American Capital Mortgage is making big moves to insulate its portfolio from rising rates.

Here are two ways it's mixing things up:

1. Hello, 15-year mortgages
Like its sister mortgage REIT American Capital Agency (NASDAQ: AGNC), American Capital Mortgage moved its portfolio to moderate its duration. The company slashed 30-year mortgages, added to 15-year mortgages, and initiated a new position in adjustable-rate mortgage-backed securities in its agency portfolio.

Here's a quick quarter-over-quarter portfolio composition comparison:

Source: American Capital Mortgage third-quarter earnings presentation.

Fifteen-year mortgages have become the new safe haven for American Capital Agency and American Capital Mortgage. American Capital Agency once noted in a shareholder presentation that holding 15-year mortgages at nine times leverage is similar to holding 30-year mortgages at six times leverage.

Fifteen-year mortgages are inherently safer when interest rates rise because they have less convexity risk -- 15-year mortgages don't move as much as 30-year mortgages when rates rise or fall.

Obviously, this additional layer of safety comes at a cost. American Capital Mortgage's 15-year MBSes offer much lower yields than 30-year agency paper.

Securities with fewer than 15 years to maturity yield only 3.12% compared to fatter 3.57% yields on longer-dated paper, according to the earnings presentation. However, much like American Capital Agency, American Capital Mortgage is willing to give up lower returns for some book value protection. That might not be a bad idea if interest rates tick higher.

2. Welcome aboard, mortgage servicing rights
The most interesting development at American Capital Mortgage is its move to acquire Residential Credit Solutions, a mortgage loan servicer. Other mREITs like Two Harbors (NYSE: TWO) have acquired similar assets as a way to generate a return and hedge their mortgage portfolios.

At a JMP Securities Presentation with analysts, Two Harbors' Chief Investment Officer Bill Roth had nothing but praise for mortgage servicing rights, saying, "We're very excited about it because MSR provides us an [interest-only] like cash flow that not only throws off an attractive yield, but also hedges not only interest rate risk but also mortgage basis risk."

Currently, mREITs pay money to hedge their portfolios. MSRs provide a hedge that pays the mREIT -- a win-win situation.

Without word from American Capital Mortgage, there's not yet a way to know how big this acquisition really is. An earlier and unrelated press release from Fitch notes that Residential Credit Solutions had a portfolio of "credit-sensitive and servicing-intensive residential mortgage assets" worth as much as $8.2 billion. However, it's not clear from a high-level view who owns the assets or how Residential Credit Solutions has a financial interest in those MSRs. We likely won't know until the deal is finalized, but it will be in