Mortgage real estate investment trusts (REITs) invest in real estate securities using borrowed money. In normal markets, that strategy work fine, and isn't much different than your neighborhood savings bank.

But when investors and institutions become fearful, they go on a "buyer's strike," and the banks that loaned money to the REITs start to worry about getting repaid. This can create a negative feedback loop where forced selling drives prices down, which triggers even more forced selling. For REITs with assets that are illiquid or hard to value, it can become a death spiral. Disruptions in the mortgage market tend to occur every decade or so. We saw one after the housing bubble burst in 2008. Before that, old-timers will remember 1994, when Orange County in California went bankrupt and the biggest mortgage arbitrage hedge fund on Wall Street blew up.

This year, the COVID-19 crisis has been rough on mortgage REITs in general and Invesco Mortgage Capital (NYSE:IVR) in particular; Invesco had to dramatically shrink its investment portfolio and has cut its dividend twice. Now that the dust has settled, is the stock safe to buy?

Margin Call

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A portfolio of mainly government-guaranteed securities still got slammed

Invesco entered the year with almost half its $21.9 billion portfolio consisting of agency residential mortgage-backed securities (RMBS) and 22% of the portfolio made up of commercial mortgage-backed securities (CMBS). All of that was guaranteed by the government. The rest of the portfolio was largely non-agency CMBS and a smattering of other assets.

Against that portfolio, Invesco borrowed about $17.5 billion in the repurchase market. Repurchase agreements are typically the cheapest way for a REIT to borrow money. They work this way: Say an investor wants to leverage a portfolio of bonds.  The investor agrees to sell them to a bank at a discount to fair value and then agrees to buy back the portfolio at a higher price later on. It is basically a secured loan, and the difference between the initial sale price and the repurchase price is the interest.

While repurchase agreements are the cheapest way to finance a portfolio, that cheaper financing includes added risks. Repurchase agreements are generally shorter-term, which means they are subject to rollover risk. In a typical market, the bank would just roll over a maturing repurchase agreement at the prevailing interest rate. The bank doesn't have to do that, however, and in crises it will want its money back instead. Repurchase agreements are also subject to margin calls, which happen when the value of the collateral falls below the loan value. The banks generally will then require the investor to put up more cash.

That happened to more or less every mortgage REIT in March, and Invesco was hit the hardest. In response to margin calls and cash demands, the company sold what it could, which was primarily its agency portfolio, and ended up negotiating a forbearance agreement with its banking counterparties.

The investment portfolio shrinks by 93%

As of March 31, Invesco had sold $16.2 billion of its portfolio and used the proceeds to close out $11.2 billion in repurchase agreements. Book value per share as of March 31 was $5.02. After the quarter ended, the company sold another $6.2 billion in assets and used the proceeds to pay off the balance of its repurchase agreements. As of May 31, Invesco's investment portfolio stood at $1.6 billion in assets. The company paid off some of its Federal Home Loan Bank secured loan.

On the earnings conference call, John Anzalone, Invesco's CEO, estimated that book value as of May 31 was between $2.65 and $3.15 per share. The company also cut its dividend from $0.05 to $0.02 per share. Invesco Mortgage also said that it intends to redirect its focus to the agency mortgage-backed securities market, and some of its CMBS portfolio will benefit from the Fed's buying in the market.

Essentially, Invesco exits the crisis a shadow of its former self and will try and rebuild its investment portfolio. Other mortgage REITs, like AGNC Investment Corp. were also forced to de-leverage and shrink the balance sheet, but not as dramatically as Invesco, which makes them likely to recover more quickly.

Despite the carnage, the stock is still expensive

So, to recap, at the end of 2019, Invesco had a book value per share of $16.29 and paid a $0.50 quarterly dividend. Five months later, book value is down something like 82%, based on the midpoint of the estimate, and the dividend has been cut by 96%. The stock was punished in the market after the earnings release, falling 6.7% to $4.18. With the stock still trading at a substantial premium to book value and a sub-market 2.1% dividend yield as of midday Thursday, Invesco is impossible to recommend as a buy.

With big agency REITs like AGNC that avoided forbearance trading at double-digit discounts to book value, it is hard to get excited about one trading at a 40%-ish premium to book value.