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Real Estate Inv. Trusts: REITs
Mortgage Lender REITs

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By RodgerRafter
December 21, 2005

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Searching back, I've found some interesting discussion of Mortgage REITs on this board (REITs that invest primarily in mortgage backed securities rather than Real Estate), but not much specifically on the topic of mortgage lenders who have recently decided to become REITs for tax and other reasons. I'd like to throw out some of my own thoughts on this topic to the board here and ask some questions to see if anyone would like to help me improve on my ideas.

For the self-originating Mortgage REITS I believe there is a strong temptation and potential for management to overstate earnings, which therefore makes an interesting short-selling opportunity if macro-economic conditions continue to make business conditions difficult for lenders. In the short term, strong earnings and the appearance of financial health can boost share price, reduce the cost of borrowing, and increase the size of executive compensation packages. I'm not making the claim that these companies are intentionally cooking the books, but earnings may indeed be overstated in many cases, and the issues I bring up might be worth exploring in greater depth for mortgage lender REITs in particular, and for all REITs in general.

The most obvious way that mortgage lenders can overstate their profits is in setting aside too little in reserves for losses on under performing loans. They make assumptions based on the performance of past loans and book profits. For some, making generous assumptions based on recent history can lead to bigger profits now and bigger write-offs when the economy sours. The biggest risk in investing in mortgage REITs is that rising interest rates will lead to more defaults and lower home prices. That in turn will wipe out the companies' equity and limit their ability to expand their loan portfolios.

I'm sure that more people on this board are more knowledgeable REIT dynamics than I am. To me it appears that the most important features that appeal to mortgage lenders are:
1. Being a REIT allows a mortgage lender to avoid paying corporate taxes. In turn, at least 90% of stated profits must be distributed to shareholders. This is tax efficient for the owners of the company (shareholders), especially if the shares are in a tax-exempt account.
2. Being a REIT justifies a mortgage lender's keeping its own loans on its books, rather than selling them off as mortgage backed securities. The lender is then able to rely on its own assumptions about what loans are worth (booking profits accordingly), rather than letting the MBS market decide what they are worth.
3. Being a REIT requires that the lion's share of stated earnings be distributed to shareholders through dividends. On the one hand, this makes company stock very attractive to shareholders seeking high dividend yields. On the other hand, if the earnings are indeed overstated, then this results in a rapid deterioration of the true value of net assets. When and if assets are restated, a mortgage lender REIT could be quickly thrust into insolvency because too much capital had been distributed to shareholders. In this way, becoming a REIT greatly increases the risk factor for shareholders and creditors.
What other features of REITs make their structure attractive to mortgage lenders?


On the surface, the valuations of mortgage lender REITs appear to be extremely low. New Century Financial (NEW), for example, has a trailing P/E of 5.85 and a forward dividend yield of 18.1% according to Yahoo Finance this morning. While some investors are undoubtedly attracted to such high returns, many other investors are probably scared away by the changing economic climate associated with rising interest rates and mortgage-backed securities. Profits of loan originations have been very high and as loan profits from loans made in the past few years are amortized total profits continue to stay high, but:

While a big interest rate spread lead to high profits on originations from 2002 to 2004, the flattening curve is leading to falling profits on new originations.

While falling rates led to a spike in demand for refinancing and new originations, rising rates are cutting into loan volumes.

While reduced defaults during the period of rising home prices and cash-out refinancing lead to higher profits, increased defaults lead to lower profits going forward.

While rising demand for mortgage backed securities lead to higher profit margins on sales of these securities and higher values for loans kept on the books, falling demand for mortgage backed securities is leading to lower profit margins.

Key questions for Mortgage REIT investors include:
Are profits likely to deteriorate substantially as economic impacts trickle through the loan portfolios of Mortgage REITs?
Will the interest rate climate change and increase the volume and profitability of new mortgages?



What will happen to interest rates depends largely on the motivations of the Fed and economic conditions. Some believe that the Fed wants to protect banking sector, including mortgage bankers and will widen the spread if they get in trouble. Others believe the Fed wants to serve Wall Street's biggest banks by eliminating the upstart mortgage banker competition. My own expectation is that the Fed will continue squeezing the Mortgage REITs with an unfavorable rate environment until the industry suffers the same fate as the S & L industry in the 1980s.

Some believe that foreign central banks and investors will continue supporting our economy and funding our current account balance by purchasing vast quantities of mortgage backed securities because they want to keep up their high levels of exports and asset accumulation. Others believe that the current imbalances are unsustainable and eventually will lead to a financial crisis. My own expectation is that a financial crisis will come sooner rather than later.

Not wanting to take this fine, focused and productive message board too far off topic, I ask simply and finally:
Do short positions in Mortgage REITs make an appealing hedging option for investors who' s portfolios are heavily weighted toward real estate market?

I eagerly await opinions on all of the questions mentioned above, and hope this discussion topic is interesting to members of the REIT board.

Thanks in advance,

Rodg


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