I was reading Herb Greenberg's "Reality Check" column yesterday. It focused on Motley Fool Income Investor recommendation Annaly Mortgage
The culprit for Annaly's earnings reduction is higher interest rates, which are increasing the amount of prepayments as well as its cost of capital. Higher rates will affect Annaly and other mortgage-investment companies, including MFA Mortgage Investments
Simply stated, Annaly and its peers make money by investing lots of capital across an interest-rate spread. That spread is defined as interest earned minus interest costs, or rate of return minus cost of capital.
When the Federal Reserve tightens monetary policy, it raises interest rates. When that happens, some people with adjustable-rate mortgages (ARMs) start making bigger mortgage payments to reduce the amount of total interest paid on their mortgage: The more principal you can repay in a low-rate environment, the less high-rate interest you have to pay. (This is, of course, dependent on the severity of prepayment penalties). The incentive to prepay has increased as of late because there is a lag between when the Fed raises interest rates and when the ARM adjustments occur.
Annaly and other like companies account for a certain level of these prepayments based on historical data. But when prepayments accelerate, they cause a problem. Prepayments reduce the principle owed, thus reducing the effective rate of return from the mortgage portfolio. So the interest-earned part of the equation goes down. Couple that with the higher-interest cost because of the tightening, and you get a double-whammy on the interest-rate spread.
At least Annaly is known to be a conservative and forthright player in the game. CEO Mike Farrell spoke with James Cramer on CNBC's Mad Money program (here's the video clip) about why Annaly's dividend yield is down relative to the competition. The answer? Because Annaly does not use excessive leverage or assume additional credit risk (riskier mortgages, in other words) to pump up returns.
Not all mortgage REITs are the same. Being conservative may limit the upside, but it also protects the downside. And while Annaly's yield is no longer 10%-plus, an 8% yield in a low-return environment is nothing to sneeze at.