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Will Regulators Squelch Mortgage REITs' Juicy Yields?

By Amanda Alix - Apr 1, 2013 at 2:04PM

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New concerns arise about the expanding mREIT industry.

For yield-starved investors, the plethora of mortgage REITs going public over the past few years has been a godsend. As fans of the sector well know, the requirement that these trusts share 90% of their profits with investors usually results in yields in the double digits. Even Annaly Capital (NLY 2.15%), which has had to shrink its dividend because of the policies of the Federal Reserve, still sports a yield over 11%.

The mREIT explosion has drawn the attention of regulators, though, and talk of squelching these superlative returns by imposing limitations on the way these companies do business has begun to pick up, after several months of silence.

Expanding assets prompt concern
As mREITs rack up a larger asset base, some rule makers began to express concern that one or more failures in this sector could harm the mortgage industry -- or, more troubling, the economy at large. In August 2011, the Securities and Exchange Commission announced it would be looking into regulating mREITs as if they were investment firms, much like mutual funds. This followed a tough time for these REITs, in which concerns regarding Europe caused selling that sent values plummeting.

Since then, things have been quieter on that front, but a recent Bloomberg article shows that regulators have recently restarted the debate. Of particular concern are the two largest mREITs, Annaly and American Capital Agency (AGNC 0.83%). Together, these two companies hold approximately $234 billion in assets -- primarily government-insured mortgage-backed securities.

What's the risk?
In addition to their exploding girth, some officials worry about the high leverage these trusts use to make money as well as their use of repurchase agreements, since this was the formula that helped cause the financial crisis. As entities that invest in real estate, mREITs have been exempt from certain rules. If mREITs are folded into the category of investment funds, however, they will fall under the auspices of the Investment Act of 1940 -- effectively quashing their ability to use high leverage to produce their historic yields.

Will recent comments about mREIT risks from Fed Governor Jeremy Stein or Federal Reserve Bank of New York President William Dudley nudge the SEC to take action? Perhaps not. As some analysts point out, the industry is still tiny, holding less than 10% of all MBS products. In addition, most report lower leverage ratios today than they used in 2008.

Many commenters also note how important management is in this business, seeing little risk in the leadership of Annaly and American Capital Agency. One mREIT that seems to inspire less faith is Armour Residential (ARR 0.67%). This company holds less than $21 billion in assets, but it has seen its asset base skyrocket by nearly 30% year over year, and some question the ability of management to keep up.

Are the sector's tasty yields soon to be a thing of the past? For mREIT investors, this may well be the most important issue facing the industry this year.

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Stocks Mentioned

Annaly Capital Management, Inc. Stock Quote
Annaly Capital Management, Inc.
NLY
$6.64 (2.15%) $0.14
AGNC Investment Corp. Stock Quote
AGNC Investment Corp.
AGNC
$12.21 (0.83%) $0.10
ARMOUR Residential REIT, Inc. Stock Quote
ARMOUR Residential REIT, Inc.
ARR
$7.57 (0.67%) $0.05

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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