What happened

Shares of mortgage real estate investment trust (REIT) Annaly Capital Management (NYSE:NLY) dropped roughly 43% in March, according to data from S&P Global Market Intelligence. Peer AGNC Investment Corp (NASDAQ:AGNC) declined a little less, down around 38%, while MFA Financial (NYSE:MFA) saw its shares plummet over 78%. It wasn't a good month for these REITs.

To see just how bad March was for these mortgage-focused REITs, compare their performance to the 13% drop in the S&P 500 Index -- or even to other REITs, as measured by the Vanguard Real Estate ETF, which were "only" down around 20%, on average. It was a brutal month throughout Wall Street, but mortgage REITs definitely got hit harder than most other market niches.

Two hands holding blocks spelling out the words RISK and REWARD

Image source: Getty Images.

So what

The big story here isn't really about any individual mortgage REIT -- it's driven by the general business model, which involves using leverage to buy mortgages. The REITs make the spread between their interest costs and the rates on the mortgage securities they buy. Investors should always remember that leverage involves risk because it amplifies both returns and losses. 

This is important today because the COVID-19 pandemic is a situation that no mortgage REIT has ever lived through. This disease appears to be highly contagious and more deadly than the common flu. Moreover, because it's new, humans have no resistance to it.

Governments around the world, including in the United States, are taking aggressive actions to limit its spread. The biggest effort has been around social distancing, with people asked to stay home as much as possible, and non-essential businesses being asked to close. 

Uncertainty is high, and investors are avoiding risk as much as possible. The immediate impact was a flight to cash that threatened to freeze capital markets. That limited the ability of mortgage REITs to access the capital they need to support their leveraged business models.

Then there's the value of the mortgage securities these companies own, which basically act as collateral for the loans they take on. If the value of their collateral falls, as is likely to happen when investors shift to cash en masse, they may be asked to provide more collateral -- which they may not be able to. The Federal Reserve stepped in quickly to deal with this situation, gaining praise from AGNC in a late March investor update on its business. However, it may be too soon to claim a win here.

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Many people aren't currently working, with recent unemployment claims increasing at rates not seen before. There's a material risk that, because of these unprecedented times, mortgages will go unpaid. That would not be a good outcome for mortgage REITs.

Further, the ability of these REITs to deal with the leverage they've taken on could become a bigger issue if credit markets tighten up again. Indeed, it appears likely that the efforts to contain COVID-19, including forcing businesses across the country to shut down, will push the U.S. economy into a recession. It wouldn't be surprising to see credit markets tighten again. 

Although all three of these mortgage REITs experienced the last downturn to some degree -- AGNC was founded in 2008, with the others opening their doors well before that recession -- COVID-19 is a vastly different situation. Uncertainty remains high, and the mortgage REIT business model is inherently risky because it's built on leverage.

That's not a problem in good times, but when bad times hit, the pain can be material. The stock drops here are clear evidence of that, but it could get much worse if the economy falls into a deep enough recession.

It's worth noting that MFA eliminated its dividend at the end of March in an effort to preserve liquidity. While that helps explain this REIT's deep stock decline, it also shows the depth of the risk that investors are taking on when they buy a mortgage REIT. 

Now what

Mortgage REITs are not for the faint of heart. They offer high and enticing yields when times are good, but there are material risks because of the way in which these REITs use leverage. At this point, most investors should be avoiding Annaly, AGNC, and MFA. But the truth is, most investors should be avoiding them at all times.

The downturn today is simply an example of why the mortgage REIT business model is not appropriate for moderate to risk-averse dividend investors

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.