The past year has been extraordinarily difficult for companies in the mortgage space. The Fed's aggressive regime of rate hikes caused refinance activity to disappear, which caused mortgage origination to collapse.
The increase in interest rates also weighed on mortgage-backed security valuations, which negatively affected mortgage real estate investment trusts (mREITs).
Toward the end of last year, it looked like the clouds were parting for the sector, but the stress in the banking arena has brought back a return to the bad old days. Leading mortgage REIT Annaly Capital (NLY -0.32%) just cut its dividend by 26%, with a new quarterly payout of $0.65 per share. With other industry peers having already made some cuts, some investors wonder whether the mREIT sector is still investible.
Image source: Getty Images.
Trouble returns for the mortgage REITs
After getting a reprieve in the fourth quarter, the mREIT sector is again faced with a difficult market. The failure of SVB Financial's Silicon Valley Bank has increased volatility in the bond market, which has blown out mortgage-backed securities spreads. It didn't help that the bank lost money on mortgage-backed securities, which bear no credit risk but do have interest rate risk.
The chart below shows the 30-year fixed rate mortgage and the yield on the 10-year Treasury bond. The lower chart is the difference (called the spread) between the two. When the spread is falling, that means that mortgage-backed securities are outperforming Treasuries. When the spread is rising, it means that mortgage-backed securities are underperforming. By late 2022, mortgage-backed security spreads were the highest since 2008.
30-Year Mortgage Rate data by YCharts
For most of 2022, mortgage-backed securities underperformed Treasuries, which is why mREITs in general reported declines in book value per share. The last six weeks have been extremely volatile as the bond market whipsawed between higher-than-expected inflation and a bank crisis. This volatility pushed out mortgage-backed securities spreads again, and that was probably the catalyst for Annaly's dividend cut. In the fourth quarter, earnings available for distribution came in at $0.89, which barely covered the $0.88 quarterly dividend.
Most mortgage REITs have cut their dividends
Most mREITs cut their dividends last year, and AGNC Investment (NASDAQ: AGNC) is one of the last holdouts. Unfortunately for the mortgage REITs, the mortgage-backed security asset class will probably remain under a cloud for the foreseeable future. If banks are going to need to sell mortgage-backed securities to raise capital, fund managers will wait for that to run its course before adding to the sector. That said, mortgage-backed security spreads are high, and that means that they are cheap relative to Treasuries. The mREITs have a lot of potential return in these assets.
Unfortunately, one of last year's star assets was mortgage servicing rights, and the issue with the banks means that the Fed might be cutting rates before long. Mortgage servicing rights are one of the few assets that increase in value as rates rise, and if rates begin to fall, mortgage servicing rights' theoretical valuations will decline. Annaly holds $1.7 billion of mortgage servicing rights, and it could see some major write-downs if rates fall dramatically.
Annaly also has a business investing in real estate loans that are not guaranteed by the U.S. government. These types of loans are highly sensitive to stress in the banking system, as securitization markets are the usual exit. Liquidity in the non-government guaranteed mortgage space can sometimes disappear overnight.
The mREIT space will probably struggle until the banking crisis has passed and volatility in the interest rate market calms down. For Annaly, the dividend cut has already happened, so the biggest negative catalyst is out of the way. If mortgage-backed securities spreads start to tighten again, that will be good news for mortgage REITs in general, but mortgage servicing rights have room to fall. Annaly still has a 13.9% dividend yield, which is quite attractive, and is trading at a 11% discount to book value per share. The worst is probably over, but the mortgage REIT sector will suffer from negative sentiment for a while, or at least until the Fed starts cutting rates.
