Please ensure Javascript is enabled for purposes of website accessibility

MFA Financial's Strategy of Shifting Risk Is Paying Off

By Brent Nyitray, CFA - Updated Mar 13, 2020 at 11:47AM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

MFA Financial is swapping interest rate risk for credit risk.

The lower interest rates get, the trickier it becomes for mortgage real estate investment trusts (REITs) to turn a profit -- and today's interest rates are low and falling. As other mortgage REITs fruitlessly chase "safe" investments that return almost nothing, MFA Financial (MFA 3.72%) is shaking up its holdings instead, pursuing riskier investments with the promise of greater rewards. While that might seem like a dangerous play for a stock that appeals to safety-minded income investors, it could help the company sustain and increase its double-digit dividend yield in the long run.

How mortgage REITs work

Mortgage REITs invest in debt securities, earn interest income, and pass it on to investors via the dividend. They generally concentrate on residential mortgages (like the mortgage on your house) or commercial mortgages (the debt of office buildings and malls). MFA historically has concentrated on residential mortgage-backed securities (MBS) guaranteed by the U.S. government. These instruments carry no credit risk -- if the borrower doesn't pay, the government will.

MFA is changing its portfolio

MFA Financial recently reported fourth-quarter earnings of $0.21 per share, compared to $0.19 per share a year ago. The prior year's earnings were affected by special charges, so it doesn't represent necessarily represent organic growth. The EPS number came in above Wall Street expectations of $0.20 per share. 

MFA's earnings were pretty stable in 2019. Over the past year, the company has been reducing its investments in government-guaranteed mortgages and investing in more credit-sensitive instruments, particularly non-government guaranteed mortgage loans. This is not a matter of adding more risk -- it about adding the right kind of risk. This makes sense in the current economic environment, where delinquencies are at 40-year lows and the return on government-guaranteed mortgages is approaching the cost of borrowing. When the potential returns on an asset become too small, it is time to deploy that capital to something better. That is what MFA is doing.

An interest rate chart

Image source: Getty Images.

The issue with new residential home loans is sourcing investments. Mortgage-backed securities are highly liquid -- buying or selling $100 million in one transaction is easy, and a dozen big banks specialize in trading them. That is not the case with residential whole loans. They are sold in smaller amounts, and they don't trade on any exchange. Gaining enough exposure to generate a meaningful return can be difficult.

MFA solved that issue by investing $148 million in five mortgage originators, which then sell a portion of the the loans they make directly to MFA. Most of these loans are in the non-qualified mortgage space -- typically loans that don't fit neatly in the underwriting box for Fannie Mae or Freddie Mac. These loans are high-quality loans, designed for professional real estate investors and self-employed borrowers who can't report W-2 income. These loans often carry higher interest rates to compensate for the credit risk.

MFA's portfolio of non-QM loans has an average loan-to-value ratio of 67% and an average FICO score of 716, management said in the latest earnings call, which means the loans are pretty conservatively underwritten and have nothing in common with the low-quality loans that were underwritten before the housing crisis. MFA also invests in rehabilitation loans (fix-to-flip) and rental loans, which are part of the whole loan portfolio.

Agency MBS versus whole loans

The table below compares the opportunity in whole loans versus agency mortgage backed securities, which explains why MFA is beefing up its whole loan portfolio.

Metric Agency MBS Residential Home Loans
Assets $1,665 million $6,066 million
Leverage 14.6 2.3
Yield 2.38% 5.31%
Cost of funds (2.33%) (3.59%)
Spread 0.05% 1.72%

Data source: Company filings.

Look at the differences between agency MBS and residential whole loans in terms of returns. Check out the difference between the yield and the cost of funds (the spread) on the agency MBS portfolio. It's almost nothing. Now compare it to the residential home loans portfolio. See the difference? The yield is much higher, and the spread between yield and borrowing costs is much larger.

The leverage number is important as well. Leverage is like margin -- it magnifies gains and losses, and the more you have, the riskier the portfolio. With the agency MBS portfolio, even though the government guarantees you will get paid, you can still lose money. Interest rate risk is very real. In 1994, after the Fed's unexpectedly hiked interest rates, California's Orange County was forced to declare bankruptcy because of losses on its investment portfolio of mortgage-backed securities. Just like normal bonds, when interest rates rise, bond prices fall. So it makes sense for MFA to shift toward assets with better risk / reward characteristics. 

MFA is making the right moves to keep the dividend safe

The current economic environment is benign for credit risk, since delinquencies are at 40-year lows. MFA has paid a $0.20 dividend for 25 consecutive quarters. That's a double-digit yield at the current stock price. By shrinking the agency MBS portfolio and redeploying capital to whole loans with much better returns and more favorable risk characteristics, MFA is making its dividend safer. Investors seeking income should take a look at mortgage REITs in general, and MFA's history of steady income makes it a good candidate in particular.

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Stocks Mentioned

MFA Financial, Inc. Stock Quote
MFA Financial, Inc.
MFA
$11.15 (3.72%) $0.40
Federal Home Loan Mortgage Corporation Stock Quote
Federal Home Loan Mortgage Corporation
FMCC
$0.43 (3.55%) $0.01
Federal National Mortgage Association Stock Quote
Federal National Mortgage Association
FNMA
$0.45 (4.20%) $0.02

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning analyst team.

Stock Advisor Returns
316%
 
S&P 500 Returns
112%

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 07/05/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.