Author: John Gerard Lewis, Gerard Wealth
Covestor model: Stable High Yield
Disclosure: Long mREITS CMO, IVR, ANH
A segment of our model took a significant hit during September, but we think it was due to an unusual confluence of passing concerns.
The component that is intended to drive most of the return is a collection of agency mortgage real estate investment trusts (mREITS). Over the past month or so, a “perfect storm” of threatening winds pushed that sector down. But it appears to us that the storm will soon pass.
Let’s take a look at what happened:
• To begin, there was some political talk about having the Federal Housing Administration embark on a widespread program to refinance home mortgages, without regard to the borrowers’ ability to pay. In that event, mREITS, which invest in pools of higher-yielding mortgage-backed securities, would end up holding lower-yielding MBS’s, tightening the spreads that they depend on for profits.
But FHA officials subsequently stated that the government can’t afford the losses that we, too, believe would inevitably occur, and the plan seems to have been shelved.
• Also, the Securities and Exchange Commission said it will look into whether agency REITS should continue to be granted an exemption from the Investment Company Act of 1940. While some increased requirements could be implemented, we don’t think the review will materially damage the business model of agency mREITS.
• Then came Fed Chairman Ben Bernanke and Operation Twist, which is expected to force down long-term rates. Because mREITS borrow short-term to invest in longer-term securities, their profits could be squeezed. Even so, we expect the spread between short-term and long-term rates to allow for rewarding returns among the mREITS.
Thus, it appears to us that these government-based threats to mREITs are a natural consequence of a business model dependent upon a government labyrinth, in this case the FHA, FNMA, FHLMC and the SEC. But the entity that matters most to the mREITS industry is the Fed, and we think a continuing policy of low short-term rates will allow them to arbitrage quite profitably.
As the market begins to understand this, we anticipate that prices will stabilize while we await the significant dividends that will arrive later in October.
