If “Mortgage,” then Regulation

by JT McGee

Mortgage REITs are getting an eye from the SEC.

Using leverage, mortgage REITs purchase mortgages on the open market, and pay out much of their income in the form of distributions to shareholders. Distribution yields are fat. American Capital Agency (AGNC) currently rewards investors with a 15.25% distribution yield.

Yeah, 15.25% in an environment where the 10-year Treasury pays less than 2%.

Knowing that, you probably wouldn’t be surprised to learn that American Capital Agency now has more than $100 billion in mortgage assets on its balance sheet. But I think most everyone would be surprised to learn how quickly this mREIT has grown. Assets grew 20 times over in the past 3 years.

It isn’t the only mREIT in the game. Annaly Capital Management (NLY) has $133 billion. American Capital Mortgage Investment Corp. (MTGE) has $7.6 in assets. There are a number of mREITs on the market, and they’re all attracting investment dollars like there’s no tomorrow. Who can blame investors for wanting a little yield? Double digit distributions sure beat .2%.

Where there’s money, though, there’s government.

Sheriff SEC is back in town

Regulators worry about the growing size of mortgage REITs. (We did have a financial crisis led by a housing boom, after all.) Their chief concern is growing risk to the banking system. If REITs get too large, a failure of one would mean a failure of many…perhaps the whole banking system would take a dive if a crisis once again hit the mortgage market.

Helping fuel their view is is the retail investor. Grannies and grandpas around the country are probably snatching up more mREIT assets than they really should hold.

Of course, that’s the regulator viewpoint. I think the risks to the system are mostly overblown.

Mortgage REITs aren’t that risky. I compare them to banks. A mREIT is a bank that doesn’t do…banking stuff. It borrows short term money and reinvests it in longer-term securities. It’s a game built on the yield curve. Borrowing at 2% and lending at 5% is a very profitable business.

Mortgage REITs are also in a very comfortable place. Unlike banks, they don’t have to get Fed approval for share repurchases or dividends. When a mREIT makes money, it pays out virtually all of it in distributions. When a bank makes money, it can sit on it, make new loans, or, if approved, pay a dividend. Approval is far from certain.

You can see the love for mREITs in valuation. Regional and community banks, which hold many of the loans they originate, trade for much less than book value. mREITs have actually traded at a slight premium during the same period.

The truth is banks, not the SEC, should have a problem with mREITs. Banks have to make new loans to put capital to work. How annoying it must be to expend time and effort to get a mortgage signed when your own equity – all the loans you have on your books – trades for less than book value.

Should you fear mortgage REITs?

No, not really – especially if you aren’t invested in the industry.

Mortgage REITs operate with leverage right around 7-8 to 1. That’s the “standard,” although no standard actually exists. Banks operate with significantly more leverage. Goldman Sachs currently levers itself at 13:1.

As far as insolvency goes, banks are not only more levered than mREITs, but they’re also FDIC insured, leaving taxpayers with the bill given any fallout in the banking business.

Also, in terms of the greater financial industry, mREITs are still small operators. Wells Fargo had $126 billion in mortgage backed securities as of its 2012 annual report. That needs perspective: one line-item of a single bank is just $7 billion shy of the largest mREIT in the world.

In short, mREITs are not a big part of the mortgage market. As investments, they’re exceptional for a very small part of your portfolio. Roughly 3% of your portfolio in an mREIT will add .5% in in annual pre-tax yield to your total portfolio. That’s good money.

Of course, I’ll admit my own bias. I don’t own REITs, but I do own shares in the company that manages AGNC and MTGE. American Capital Ltd. (ACAS), a 2013 stock market pick, manages AGNC and MTGE for a very lucrative management fee. I’m just a little annoyed the SEC is thinking about capping how large an mREIT can be.

{ 1 comment… read it below or add one }

The College Investor April 29, 2013 at 01:49

I’ve been a huge fan of mREITs for two years. I’m a fan of AGNC and TWO. NLY is too overpriced for me. However, it’s a game of interest rates, so I have to continually watch the market.

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