What happened

The stock market is having a rough day on Friday, but compared with some of the market action over the past few weeks, it's a comparably tame day. As of 1:20 p.m. EDT today, the Dow Jones Industrial Average was down by 1.9% and the S&P 500 benchmark index was lower by 1.8%.

On the other hand, mortgage real estate investment trusts, or REITs, are getting slaughtered. Just to name some of the biggest companies in the subsector, New Residential Investment (NYSE:NRZ) was down by 29%, Two Harbors Investment (NYSE:TWO) had shed 33% of its value, and Annaly Capital Management (NYSE:NLY) was 13% lower than where it started the day. The list goes on: Ladder Capital (NYSE:LADR), Redwood Trust (NYSE:RWT), and Invesco Mortgage Capital (NYSE:IVR) were all down by 25% or more.

And that's just today. Of the six stocks I just mentioned, all but one (Annaly) are down by 80% or more since the beginning of February.

Miniature house with stacks of coins next to it.

Image source: Getty Images.

So what

The downward move may seem puzzling at first. After all, the main risk with mortgage REITs (in a normal, healthy economy) is spiking interest rates. These companies borrow money at short-term interest rates and collect interest on mortgages for 15 to 30 years. As short-term rates spike, profit margins fall or even disappear entirely.

Well, the exact opposite has happened. Interest rates have never been lower.

There are a few reasons for the recent decline in mortgage REIT prices. For one, recession fears are making the value of the mortgage-backed securities (MBS) owned by these REITs decline in value, especially for those that own mortgages not guaranteed by Fannie Mae or Freddie Mac. In a weak economy, the credit risk associated with these mortgages rises, and when risk of an asset rises, price generally moves downward. Some of the companies have been forced to sell mortgages at a loss due to liquidity concerns, which has been a negative catalyst for the stock prices.

And without getting too deep into the technical explanation, short-term borrowing costs haven't really dropped. The short version is that when financial markets experience fears about liquidity, short-term borrowing costs can jump, and that's what we've seen recently.

Mortgage REITs also use derivatives and other hedges against rising interest rates, and as volatility heated up and interest rates took an unprecedented dive, these instruments resulted in massive losses as well.

Finally, there's a great deal of pre-payment risk involved with mortgage REITs when rates plunge. If consumers can refinance their mortgages at significantly lower interest rates, it's likely that we'll see a wave of refinancing activity, which could hit the mortgage REITs' asset valuations.

Friday is just the latest day of plunging interest rates and heightened coronavirus recession fears, so we're seeing expectations of all the above negative catalysts reflected in their prices.

Now what

Some REITs are in pretty awful financial condition right now, and it's entirely possible that some of the weaker companies could go bankrupt. Some have suspended dividends, and some have been issued margin calls that have not been paid yet.

In a nutshell, there could be some value in the stronger names in the mortgage REIT space (like Annaly), but all are rather speculative investments, especially until the markets settle down.