Like many Fools, I've enjoyed collecting the double-digit yield of a mortgage REIT -- Hatteras Financial
Federal Reserve Chairman Ben Bernanke and company have built the perfect stage for this trade by nailing short-term rates to roughly zip for the foreseeable future, and Hatteras just reported decent results, so why sell? The answer is two red flags in the latest quarterly report.
First, the interest rate spread dropped for the second quarter in a row. The spread was squeezed on both ends. The cost of funds went up and the portfolio yield went down.
Second, mortgage prepayments were up. Mortgage prepayments can hurt results in two ways. Securities need to be replaced, probably with lower-yielding paper, so the REIT will take a loss if it paid a premium to buy securities that are then paid off at face value. In addition, new rules for the Home Affordable Refinance Program make it easier for homeowners to refinance. That's great news for struggling homeowners but not so good for the companies holding the loans. About 13% of Hatteras' portfolio could be affected by the new rules.
Opinions on mortgage REITs here at the Fool can be described as cautiously positive. Coverage has included risks associated with these high yielders. Ilan Moscovitz holds Annaly Capital
Just because these risks are becoming more significant doesn't mean the stock is automatically a sell. Many pieces of the puzzle for success are still in place. Most importantly, the Fed is expected to hold short-term rates low for quite some time and the U.S. Treasury is backstopping Fannie Mae and Freddie Mac guarantees.
It's been a good run, and I may be selling early, but risks appear to be rising and after the blackout period around this article passes, I plan on selling my Hatteras shares and moving on to something else.
Fool contributor Russ Krull owns shares of Hatteras Financial, but has no position in any other stock mentioned. The Motley Fool owns shares of Annaly Capital Management and Chimera Investment. 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.