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mREITS: Regulators Finally Wake Up to This Dividend Bubble

By Alex Dumortier, CFA - Apr 22, 2013 at 7:26PM

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What's behind those high dividends?

After their worst weekly performance since November, U.S. stocks began this week on a healthy note, with the S&P 500 (^GSPC 2.47%) and the narrower, price-weighted Dow Jones Industrial Average (^DJI 1.76%) losing 0.5% and 0.1%, respectively, on Thursday.

Consistent with those gains, the VIX Index (^VIX -6.47%), Wall Street's fear gauge, fell 4%, to close at 14.39. (The VIX is calculated from S&P 500 option prices and reflects investor expectations for stock market volatility over the coming 30 days.)

mREITs: Excess returns or dividend bubble?
I've been warning investors about the risks associated with mortgage REITs (mREITs) such as Annaly Capital Management (NLY 2.15%) and American Capital Agency (AGNC 1.83%) for more than a year and a half. Finally, regulators are waking up to the the potential problem these companies pose. Last Friday, The Wall Street Journal reported that the Financial Stability Oversight Council mREITs could finger mREITS as an area of vulnerability in financial markets in its annual report.

mREITs borrow money on a short-term basis to invest in mortgage securities and they collect the difference between their borrowing cost and the interest their bond inventory generates. Because they borrow in short-term funding markets, they are continually rolling those borrowings over -- an Achilles' heel in distressed markets.

Oblivious to the weaknesses in the business model, investors have flocked to these shares, attracted like moths to the flame of the huge dividends they promise: According to KBW Research, the market capitalization of the sector has nearly tripled over the past three years, from $22.1 billion to $59 billion. mREITS' assets quadrupled to more than $400 billion since 2009.

My suggestion to investors who own these shares, or who are considering owning them, is to carefully ponder the following three questions:

  1. What is mREITs' competitive advantage? (Hint: They have none, although if one or more of them reach "too-big-to-fail" status, that could be a corrupted form of competitive advantage, i.e., rent seeking -- much like the TBTF and investment banks.)
  2. When a business has zero competitive advantage, what kind of long-term returns should shareholders expect to earn relative to the index?
  3. If the shares of a business with zero competitive advantage smash the market over a multiyear period, like American Capital Agency has done (see below), what relative and absolute returns should shareholders expect over the next several years?

AGNC Total Return Price Chart

Source: AGNC Total Return Price data by YCharts.

Along with junk bonds, mREITS represent, to my mind, the most obvious example of excess directly attributable to the Fed's ultra-loose monetary policy. At some point, that policy will end, but not before investors have likely suffered significant losses on these frothy vehicles.

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Stocks Mentioned

Dow Jones Industrial Average (Price Return) Stock Quote
Dow Jones Industrial Average (Price Return)
$33,212.96 (1.76%) $575.77
S&P 500 Index - Price Return (USD) Stock Quote
S&P 500 Index - Price Return (USD)
$4,158.24 (2.47%) $100.40
Annaly Capital Management, Inc. Stock Quote
Annaly Capital Management, Inc.
$6.64 (2.15%) $0.14
AGNC Investment Corp. Stock Quote
AGNC Investment Corp.
$12.21 (1.83%) $0.22
CBOE S&P 500 Volatility Index Stock Quote
CBOE S&P 500 Volatility Index
$25.72 (-6.47%) $-1.78

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

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