With the Federal Reserve planning on reducing its support for the economy, we are entering a dangerous period for mortgage real estate investment trusts (REITs). Mortgage REITs invest heavily in mortgage-backed securities that are guaranteed by the U.S. government, which the Fed has been buying ever since the beginning of the COVID-19 pandemic. Mortgage REITs like Annaly Capital (NLY) have been taking steps to insulate themselves from the danger. Here's what they're doing. 

Mortgage REITs differ from typical REITs

Mortgage REITs are unlike traditional REITs, which invest in property. Those REITs generally build office buildings, shopping malls, or apartment buildings, and rent out the units to tenants -- a relatively simple business model. Mortgage REITs don't buy property; they buy property debt. Their gross profits come from the amount they earn on their portfolio of mortgages, minus their interest costs.

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Mortgage REITs tend to use a lot of borrowed money. This is how they turn a bunch of mortgages that pay 3% into a double-digit dividend yield. Like using margin to buy a stock, this borrowing magnifies the companies' gains and the losses. During the third quarter, Annaly had $13.8 billion in equity, and borrowed another roughly $60 billion to put into a $74.4 billion portfolio. Annaly earned 2.29% on its portfolio, and it paid 0.32% on its borrowings. 

So far, we aren't seeing a repeat of 2013

In 2013, the Federal Reserve announced that it would begin reducing its purchases of mortgage-backed securities and Treasuries. This caused rates to move up violently (journalists dubbed it the "taper tantrum"), and mortgage REITs like Annaly saw big declines in book value per share and dividends. At the November FOMC meeting, the Fed announced that it would start reducing its purchases of Treasuries and mortgage-backed securities. This had been widely expected, and bonds only saw minimal movement following the announcement. So far, we aren't seeing a repeat of 2013, but Annaly has been taking steps to insulate itself from any adverse effects. 

Annaly has been increasing its exposure to mortgages that are not guaranteed by the U.S. government. These loans represent a growing piece of the U.S. mortgage market as more professional real estate investors buy properties for rentals. This portfolio has risen 70% since the end of 2020.

As a general rule, mortgages that are not guaranteed by the government generally require much more equity in the property. Borrowers can theoretically put down as little as 3% for a house they intend to live in. Professional investors are generally required to put down at least 25%-30%. With home prices rising rapidly, these loans have so much equity in them that any borrower will be highly motivated to make payments. These loans are much more sensitive to the overall economy and house prices than interest rates. This helps insulate the company from any changes being made by the Fed. 

Mortgage servicing rights are another asset that Annaly uses to hedge against rising interest rates. Mortgage servicing rights are an esoteric asset: They can be hard to value, and they don't behave like the vast majority of financial assets. A mortgage servicer collects the monthly payment from the borrower, sends the required monthly payment to the investor in the loan, handles insurance and taxes, and deals with the borrower if they get in trouble. In return for doing all this, the servicer gets 0.25% of the loan per year. The right to perform these tasks is worth something, and servicing rights are one of the rare financial assets that increase in value as interest rates rise. 

The biggest driver for Annaly is hard to track

The big driver for mortgage REITs is something called MBS spreads: the difference in yield between the typical mortgage-backed security and a Treasury. Unfortunately, unless you have a Reuters or Bloomberg terminal, there's no way to track these spreads that I'm aware of. They aren't available on any free sites that I am aware of. MBS spreads are serious bond-geek stuff that you simply won't get on Yahoo! Finance. This makes it hard for individual investors to track what is going on the markets. Investors in Annaly (or any mortgage REIT) need to watch book value per share closely, since that will be the first indication if MBS spreads are widening. Mortgage REITs will generally give periodic updates during the quarter with new book value numbers. 

During the quarter, Annaly reported a small increase in book value per share and paid $0.22 in dividends. Compared to 2013, Annaly is performing admirably. Mortgage REITs are generally vulnerable in periods of rising rates, but they pay some of the highest dividends out there. Annaly is trading at a yield of 10.5%, which is around its historical level. That said, Annaly is trading at a slight premium to its $8.39 book value per share, which is rich given the inhospitable market conditions. I can't get excited about the stock at these levels, but if it starts trading at a decent discount to book value (around 10% or so), then I could start getting more interested in the name.