Armour Biggest REIT Share Loser as Fed Weighs Exit

Jeffrey Zimmer, co-head of Armour Residential REIT Inc., says this isn’t a tough time for the mortgage investment firm. Shareholders disagree.

Armour, which has about $22.5 billion of government-backed home-loan debt, has lost 16 percent this year, including reinvested dividends, trailing all real estate investment trusts that buy mortgage bonds in a Bloomberg index of 33 companies. The other REIT that Zimmer and co-head Scott Ulm run -- Javelin Mortgage Investment Corp. -- is the second-worst.

Armour’s decline comes after the Vero Beach, Florida-based company has expanded from $1.2 billion in assets at the end of 2010, helped by Federal Reserve efforts to stimulate the economy, which enabled the firm to borrow cheaply to buy Fannie Mae, Freddie Mac and Ginnie Mae securities. It’s now leading the declines in mortgage REITs as concern grows that the central bank will slow its bond-buying program as soon as June with the economy showing improvement.

“Interest rates moving higher and the Fed talking about tapering its purchases much earlier than the market had originally thought have sent mortgage REITs lower,” said Jason Stewart, an analyst at Compass Point Research & Trading LLC. “With Armour, when they continued to raise equity, they were buying new production mortgage-backed securities, and as rates go up, those bonds perform the worst.”

Fed Purchases

The Fed has been buying $45 billion of Treasuries and $40 billion of mortgage bonds a month to push down borrowing costs, fueling a 46 percent return in mortgage REITs through the end of last year from 2009. Armour gained 36 percent in the period.

As the housing market continues to recover and the unemployment rate declined in April to 7.5 percent from a peak of 10 percent in 2009, speculation is growing that the central bank will retreat earlier than anticipated. The average rate for a 30-year fixed mortgage jumped to 3.81 percent in the week ended yesterday from 3.59 percent, according to Freddie Mac.

Mortgage REITs have declined 13 percent this month, their worst drop since October 2008. Armour slipped 3.2 percent to $5.16 today in New York and has lost 20 percent since April, including reinvested dividends. American Capital Agency Corp, the second-largest of the firms has decreased 23 percent.

Mortgage REITs are seeking to persuade investors to stay after Fed Chairman Ben S. Bernanke said in testimony to the U.S. Congress last week that if improvement continues as expected the bank “could take a step down” in its pace of purchases in the next few meetings.

Market Reaction

“The bond markets have over-reacted to Fed comments, and the mortgage REITs have over-reacted to the bond market,” Michael Widner, an analyst at Keefe, Bruyette & Woods said in a report this week. He recommends buying shares of the firms while prices are low. “Nevertheless, this whole episode highlights risks and difficulties in predicting impacts of” quantitative easing, he said.

This isn’t a tough time for the company, Zimmer wrote in an e-mail. “This year, we are likely to be the number one return on equity player as far as taxable REIT income goes,”  he wrote.

REITs, whose primary income streams are from real estate, are required by the Internal Revenue Service to distribute at least 90 percent of their taxable earnings to shareholders as dividends. In exchange, they pay little or no income tax.

The company’s dividend return last year was 18.3 percent, according to Armour, which said that’s the most in a group of seven REITs that includes Annaly Capital Management Inc. and American Capital.

“The ARR stock price is down now, which we cannot control, but our return performance is at the top of the group,” he said, using the ticker symbol for Armour.

Armour Founded

Zimmer and Ulm built Armour through a merger with Enterprise Acquisition Corp. in July 2009 after losses from mortgage bonds had infected the global banking system and triggered the worst financial crisis since the Great Depression.

Ulm, a former Credit Suisse First Boston executive and a member of the fixed income operating committee was also chief executive officer of Connecticut-based Litchfield Capital Holdings from 2005 to 2009. Zimmer, who worked at Drexel Burnham Lambert and RBS Greenwich Capital, previously founded another publicly traded REIT now called Bimini Capital Management Inc.

In 2005, when Bimini had about $5 billion in assets, it bought mortgage lender Opteum Financial Services LLC, which made mostly Alt-A loans, a type of mortgage that typically didn’t require documentation such as proof of income. After foreclosures started to soar, the company reported a loss of more than $78 million in the first quarter of 2007 and its shares plunged.

Alt-A Foresight

“If we knew what we knew today, we would never have wanted to make an investment that would lose shareholders’ money,” Zimmer said in an interview with Bloomberg in May 2007.

The firm said that month it would sell its home-lending unit for less than a tenth of what it had paid 18 months earlier and in April 2008, Zimmer resigned from his positions with the company, according to a statement at the time.

Zimmer says his foresight to shut down the Alt-A platform in April 2007, more than a year before other failed lenders, allowed Bimini to survive as a public company.

After the Enterprise merger, Armour sold shares in June 2010 and was fully invested a month later with a portfolio of agency mortgage bonds valued at $510 million. Armour more than tripled its assets last year with its use of borrowed money and through sales of stock. The firm offered 5 million shares to raise capital in the first quarter of 2013.

Javelin Started

Ulm and Zimmer also set up Javelin last year to buy government-backed and non-agency bonds, such as subprime debt.

Javelin is similar to Armour “but benefits from having a portion of its capital allocated to non-agency mortgage-backed securities, which helps to diversify its risks and exposure to things like interest rates and Fed behavior,” said Trevor Cranston, an analyst at JMP Securities LLC in San Francisco. Javelin shares have lost 16 percent since they started trading in October of 2012.

While central bank officials signal the curbing of stimulus efforts, the economy is showing some signs of a slowdown in growth, expanding less than previously estimated in the first quarter, according to Commerce Department data, and consumer spending in the U.S. unexpectedly declined in April as incomes stagnated.

The Fed may also have difficulties pulling back. “Extracting itself from its eight-month domination in the agency mortgage market is not quite as straightforward as entering the fray back in September 2012,” Merrill Ross, an analyst with Baltimore-based Wunderlich Securities Inc. said in a report this week.

Incremental Premium

Armour’s strategy is to invest in mortgage bonds that it believes “will persist” and the firm is “willing to pay an incremental premium to acquire” them, according to Chief Financial Officer James Mountain.

Mortgage bond investors monitor prepayment rates, as they influence returns. Bondholders risk losses when buying debt for more than 100 cents on the dollar as the value can be erased when homeowners take out new mortgages too early to repay existing debt. As the government and Fed encouraged homeowners to refinance, those types of bonds became more attractive to firms like Armour and American Capital.

“The slower prepayments we see on the horizon should result in lower premium amortization,” Mountain said. “That will tend to offset the pressure on earnings from lower leverage.”

Fed Intervention

American Capital, which increased assets over three years by more than 20-fold to $100.5 billion at the end of 2012, has plunged this month after reporting an 8.6 percent drop in book value from the previous quarter, driven by the firm targeting higher-priced bonds that would benefit from continued Fed intervention.

Gary Kain, the REIT’s president, joined Bethesda, Maryland-based American Capital in 2009 after 20 years at Freddie Mac. He said the firm is investing knowing that the Fed will disrupt markets even though he disagrees with the likelihood of a midyear exit.

“The expected path is tapering over the next few months and concluding around the end of the year,” Kain said in an interview earlier this month. “Mortgages should perform reasonably well under those circumstances and they may do even better in that scenario.”

Annaly, the largest mortgage REIT, with $125.5 billion in assets, said its book value, a measure of its assets minus its liabilities, fell 4 percent in the first quarter.

Cut Payments

With mortgage REITs’ shares under pressure, firms may have to cut dividend payments, which have averaged about 14 percent. Armour, the only one of its peers that pays a monthly dividend, is currently yielding 16 percent, according to data compiled by Bloomberg. Javelin also pays a monthly dividend.

“We’ll likely see reductions in dividends rather than increases in the next few quarters,” said Christopher Donat, an analyst at New York-based Sandler O’Neill & Partners LP. “If people have been buying mortgage REITs for dividend yields and those come down, it might cause some investors to leave. There are risks of over-reactions and real risks to the stocks because so much of the ownership is made up of retail investors.”

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