This year has been a perfect storm for the mortgage space. Mortgage originators struggled as rising rates crushed origination volumes, while mortgage real estate investment trusts (REITs) dealt with rising rates and relative underperformance of mortgage-backed securities. This caused the stock prices of mortgage REITs to struggle and many had big losses this year.
These stock price declines translated into some pretty large dividend yields for the mortgage REIT sector. For example, Two Harbors (TWO 1.38%) is one REIT with close to a 13% yield. Why is Two Harbors' dividend yield so high?
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Mortgage REITs have a different business model than the typical REIT
Mortgage REITs are different than typical REITs. The classic REIT business model is to develop properties and then charge rent to tenants. These REITs follow a landlord/tenant business model and report their earnings using the funds from operations metric. Mortgage REITs don't invest in real estate; they invest in real estate debt, or mortgages. They buy up multiple mortgages from issuers to create a portfolio and collect the interest on those mortgages, then generally report earnings like most companies using earnings per share. The mortgage REIT business model ends up looking more like how a hedge fund operates.
Two Harbors is considered an agency REIT, which means it invests primarily in mortgage-backed securities that are guaranteed by the U.S. government. It will get its principal and interest payments even if the borrower skips a payment, so the company bears almost no credit risk.
Two Harbors also invests in mortgage servicing rights, which are an unusual asset. The mortgage servicer performs the administrative tasks of managing the mortgage on behalf of the ultimate investor. The servicer sends out the monthly bills, collects payments, forwards the principal and interest to the investor, ensures property taxes are paid, and works with the borrower in the event of a delinquency. The servicer is paid 0.25% of the principal balance per year for this service. The right to perform this service is worth something, and these mortgage-servicing rights are considered an asset.
Mortgage-backed securities have underperformed Treasuries this year
The last year has seen a dramatic underperformance of mortgage-backed securities as interest rates have risen and investors have feared the Fed might sell off some of its $2.7 trillion mortgage-backed security portfolio. Bond fund outflows have also weighed on the asset class. As a result, the value of Two Harbors' assets has fallen, while its hedges (which are based on Treasuries) haven't been enough to make up for the losses. This has meant declining book value per share. At the end of the third quarter, this underperformance reached a peak generally only seen in financial crisis periods.
Two Harbors doesn't have a large margin for error
So far, Two Harbors hasn't had to cut its dividend, but it recently did a reverse stock split, which is never a good sign for a company. While Two Harbors reported a $3.35 per share loss in the third quarter but still paid its $0.68 per-share dividend, it was able to accomplish this because much of the loss was due to mark-to-market losses on the portfolio. Its funds available for distribution was $0.64 per share, so earnings didn't cover the dividend. This is a red flag and a signal that the dividend isn't a sure thing going forward.
That said, mortgage-backed security underperformance is potentially beginning to reverse, so those unrealized losses could turn out to be gains in the fourth quarter. This should translate into rising book value per share, and hopefully positive earnings per share. That said, Two Harbors doesn't have a large margin for error here, and that explains why the dividend yield is so high.
