Mortgage REITs across the board have taken losses this week due in part to Wells Fargo downgrading Annaly Capital Management (NYSE:NLY), American Capital Agency (NASDAQ:AGNC), and a slew of other mortgage REITs on Monday.
Why did Wells change its stance and what does it mean for Annaly Capital and American Capital investors?
The Federal Reserve
One of the likely reasons for the downgrade is that the probability of the Federal Reserve increasing short-term interest rates is becoming more realistic. Because Annaly and American Capital Agency borrow based on short-term rates this creates an unpleasant situation.
While, in my opinion, there is no question that both companies have the ability to manage this scenario, it does require Annaly and American Capital Agency to be very defensive.
For instance, both companies' total assets are down 30% from their height at the beginning of 2013. One of the chief reasons for this is that Annaly and American Capital Agency are using less leverage.
Leverage is a measure of how much debt compared to equity companies are using to make their investments. The beauty of leverage it that it allows companies to buy additional assets and amplify their returns. The downside, however, is that if assets lose value it magnifies losses. So, to protect their portfolios from excessive risk, Annaly and American Capital Agency have been taking on less debt.
Although taking less risk helps protect investors from major losses, being defensive rarely goes hand-in-hand with outperforming the market.
Along with borrowing based on short-term rates, both companies buy longer-term mortgage securities and earn the difference between what it costs to borrow and the yield on their assets. This is also called the spread.
When the spread starts to narrow -- borrowing costs rise and asset yields fall -- both companies' dividends face serious pressure.
Historically, Annaly and American Capital Agency's dividends have followed the spread between the two- and 10-year Treasury bonds. When the gap is wider the companies' dividends are bigger; however, during the past four years, the spread has narrowed significantly and both companies' dividends have been cut in half.
If this trend continues, and there is no guarantee that it will, things will only get more challenging for Annaly and American Capital Agency.
It is their job
Interest rates and spreads are predominantly short-term issues. The Federal Reserve has manipulated rates up and down over time and the same can be said for the more market-driven, long-term interest rates.
But that is what Wells Fargo does. It speculates as best as it can about the current environment and then recommends investments. If I was in a similar position, based on what I am seeing, I would downgrade Annaly and American Capital Agency, too.
So, is it time to sell?
Investors should not ignore when a company's stock gets upgraded or downgraded. In fact, understanding why that recommendation was made is a great way to improve your knowledge of how a company works.
Also, as in this case, if you realize that the issues facing a company are short term in nature, then the price declines created by traders and Wall Street followers offer a fantastic opportunity to buy your favorite companies at a discount.
With that said, while I do believe the short-term future for both Annaly and American Capital Agency will get more difficult, I do not see this a long-term problem or a reason to sell.
Dave Koppenheffer has no position in any stocks mentioned. The Motley Fool recommends Wells Fargo. The Motley Fool owns shares of Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.