Investors Abandon Home Loan REITs Under Fed Assault: Mortgages

Wellington Denahan-Norris helped deliver returns of 99 percent to investors in Annaly Capital Management Inc. over the past five years. Now, after becoming co-chief executive officer, she’s being forced to play defense.

Real estate investment trusts that invest in mortgage debt have lost about 6 percent in the past week through yesterday, extending a decline that started after the Federal Reserve said Sept. 13 it would buy an additional $40 billion of the securities a month. That’s pushed down bond yields, narrowed spreads and reduced homeowner borrowing costs -- squeezing the firms’ earnings and dividends.

“As a company we’ve been through a lot of challenges,” said Denahan-Norris, 48, who last week was named co-CEO of Annaly, the largest. “Having such a large non-economic competitor is certainly posing a unique set of challenges.”

Mortgage REITs are losing investors who have been attracted by average annual dividend yields currently at about 13 percent, or almost seven times that of Standard & Poor’s 500 companies. The firms use cash raised through share sales and borrowed money to invest in government-backed mortgage securities, housing debt at risk from defaults, or both.

While dividends are set to fall, they’re far above those on competing investments such as high-yield corporate bonds, which are also being pushed lower by central bank efforts to stimulate their economies. Junk yields fell to a record low 6.95 percent last month, according to a Bank of America Merrill Lynch index.

‘Under Assault’

“It’s not just at the mortgage REITs where the returns in this market are being put under assault,” New York-based Annaly’s Denahan-Norris said yesterday in a telephone interview. “It’s the general global landscape where you have an incredible mispricing of risk that’s being delivered at the hands of academics at the central banks of the world.”

Annaly rose 1 percent today, halting an eight-day slide. After the close of trading the company said it may repurchase up to $1.5 billion of shares over a year. A Bloomberg index of mortgage REITs gained 1.1 percent.

The immediate challenge to mortgage REITs comes from a jump in homeowner refinancing driven by record rates. That will force the companies to write off the premiums they paid for bonds faster and reinvest at lesser yields. Applications to replace mortgages rose last month to the highest since 2009.

“We are getting to a crossroads where refinancing activity will be pretty severe,” said Merrill Ross, an analyst for Baltimore-based Wunderlich Securities Inc. “The days of wild returns are in the rear-view mirror.”

Lowest Yields

While the Fed’s actions drive up the value of some existing holdings, in the longer term, new investments will be at some of the lowest ever yields, increasing the risk of losing value when rates rise. To keep dividends high, REITs will be tempted to expand risk-taking with greater leverage or other tactics, according to Brad Golding, managing director at hedge fund Christofferson, Robb & Co. in New York.

“Rates go down you get killed, rates go up you get killed,” Golding said. “With a smaller and smaller coupon and higher and higher dollar prices, it’s a very dangerous game to play.”

The companies have expanded in size and importance since the 2008 financial crisis as the Fed held their borrowing costs near zero. U.S. mortgage REITs raised $17 billion through stock sales this year, after a record of almost $20 billion in 2011, according to data compiled by Bloomberg.

Executives at firms including Annaly and Two Harbors Investment Corp. said they’re aware of the risks and plan on being conservative.

Historic Opportunities

“The last several years have been a period of time where the kinds of strategies that we and some others have pursued were very much an anomaly relative to the historic opportunities,” said Bill Roth, co-chief investment officer at Minnetonka, Minnesota-based Two Harbors.

The REIT buys both government-backed and non-agency securities, such as subprime debt, whose yields have tumbled amid a flood of demand as the housing market showed signs of recovery and the Fed pushed down rates.

“We’re not in a game where we’re going to jack up leverage or change our risk profile to manufacture some return,” he said in an Oct. 3 telephone interview.

Annaly, which only buys government-backed debt, has no plans to use greater degrees of borrowed money. It manages other REITs that buy a variety of home loan debt and commercial mortgages.

“It’s a fantasy to say the days of the past can be replicated by employing more leverage,” said Denahan-Norris, who refers to herself as Welly. “It’s a different risk profile.”

Increased Challenges

She’s facing increased challenges as she takes on a new role 15 years after she and Mike Farrell, the company’s chairman and CEO, started Annaly.

The two met at Wertheim Schroder & Co., where Farrell was head of fixed income and Denahan-Norris came to work with him on the mortgage trading desk in 1991.

She was Annaly’s vice chairman, chief operating officer and CIO before rising to co-CEO last week with Farrell. The company said the change would let Farrell focus on his cancer treatment after he disclosed the illness in January. He said at the time it was caught early and is treatable.

“Mike and I have always operated as partners, we’ve always treated each other as co-CEOs” said Denahan-Norris. “We have a very strong team of people here. I don’t want people to think it’s been a Mike and Welly show.”

Annaly Assets

The two earned $35 million each in 2011, making them among the highest-paid financial services executives in the world. The stock has lost 7.6 percent since the Fed’s announcement last month, trimming this year’s gain to 8.5 percent, including reinvested dividends. Annaly had assets of $128.3 billion at the end of June, making the firm bigger than banks such as Regions Financial Corp. and Fifth Third Bancorp.

It’s grown as mortgage REITs more than doubled their credit-market investments to $388.6 billion since 2009, boosting their influence in the property market.

Those buying government-backed securities are contending with record low yields on Fannie Mae-guaranteed debt trading closest to face value. Those yields fell to 1.68 percent last month, from this year’s high of 3.24 percent in March, Bloomberg data show. They climbed to 2.11 percent yesterday.

Flip Side

Prepayments on the debt are rising after the REITs paid more above face value for the holdings. Premiums represented 47 percent of their book values as of June 30, up from 34 percent a year earlier, according to a report last week from Stifel Nicolaus & Co.

Those targeting non-agency debt face lower yields stemming from a rally in prices that fueled 30 percent gains in subprime mortgage debt in the first nine months of this year, according to Barclays Pc index data.

”The world we’ve lived in it’s been great for book value and the flip side of that coin is it’s challenging for new investing,” said Roth of Two Harbors.

Mortgage REITs may still be better than alternatives as investors face the risk of Europe’s debt crisis and slowing global growth.

“Investors’ appetite for even a reduced dividend is still pretty high,” Wunderlich’s Ross said. “Where else are you going to get that? Greek debt?”

Morgan Stanley also sees the recent declines in mortgage REITs as overdone, driven by retail investors that are basing their decisions on “negative newsflow rather than new data points,” analysts at the bank wrote in a report today.

The 26 percent contraction in dividends and earnings priced into the stocks is ”overly bearish,” Cheryl Pate and Vincent Caintic wrote. Their base case forecasts a 4 percent dividend cut for REITs that buy agency debt in 2013 and a 15 percent increase for the so-called hybrids that purchase both types. These will benefit from higher asset prices for non-agency debt and quicker prepayments on debt bought below par.

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