http://www.businessweek.com/news/2013-06-18/wall-street-reit-success-leaving-hangover-part-ii-mortgages

Bloomberg News

Wall Street REIT Success Gives Investors Hangover Part II

June 19, 2013

Wall Street REIT Success Leaving Hangover Part II: Mortgages

Mortgage real-estate investment trusts raised $7.4 billion in the first quarter by selling new shares, the most in two years, just before a plunge in the value of the firms. Photographer: Jae C. Hong/AP Photo

Investors in companies buying mortgage bonds are discovering that coming late to the party can still leave them with the biggest hangover.

Mortgage real-estate investment trusts raised $7.4 billion in the first quarter by selling new shares, the most in two years, just before a plunge in the value of the firms. American Capital Agency Corp. (AGNC:US) has declined 20 percent since offering $2 billion in February and Armour Residential REIT Inc. (ARR:US) has slumped 26 percent after raising $444 million that month.

“It was the absolute wrong time to raise money,” said Julian Mann, who helps oversee $6 billion in bonds as a vice president at Los Angeles-based First Pacific Advisors LLC. “Rather than turn money away, these asset gatherers chose to double-down.”

Mortgage REITs, after luring investors with returns of 46 percent over the previous three years and dividends exceeding 10 percent, are declining this quarter by the most since 2008 as Federal Reserve officials signaled they’re planning to reduce bond purchases. The underwriters that helped the REITs grow to hold more than $400 billion of debt, led by Credit Suisse Group AG and Bank of America Corp. (BAC:US), earned an average of 2 percent in fees on the share sales in the first quarter, according to data compiled by Bloomberg.

Fed Taper

A Bloomberg index of mortgage REITs has declined 15 percent this quarter, including reinvested dividends, as bond prices dropped amid speculation the central bank will taper the pace of its $85 billion of monthly debt buying, including $40 billion of government-backed housing debt.

REITs are plunging partly because the government-backed mortgage securities they purchased, mainly with borrowed money, have done even worse than Treasuries, negating their attempts to hedge against rising interest rates.

The decline comes less than six years after an earlier generation of mortgage REIT imploded. The Bloomberg index shows mortgage REITs slumped 68 percent in 2007 and 2008, with companies including New Century Financial Corp., American Home Mortgage Investment Corp. and Luminent Mortgage Capital Inc. filing for bankruptcies.

REITs are companies focusing on property-linked assets that avoid taxes when paying out 90 percent of their earnings.

The worst performers have been firms such as American Capital and Armour that target Fannie Mae, Freddie Mac and Ginnie Mae securities. REITs that buy other mortgage debt are also suffering because Securities and Exchange Commission rules that allow them to use unlimited leverage mean they also hold sizable amount of agency notes. Non-government debt, such as subprime securities, is also being roiled as investors seek to reduce risk.

Stock Declines

Annaly Capital Management Inc. (NLY:US), the largest REIT with $126 billion of assets as of the end of March, has dropped 18 percent since then. American Capital, the second biggest, and Armour have both slumped more than 25 percent in the period.

“It’s going to take a couple years of dividends to make up for the decline in stock prices,” Merrill Ross, an analyst with Baltimore-based Wunderlich Securities Inc. said in a telephone interview. “If you can tolerate it, I’d say hang in there -- realizing that loss is painful and the stock could claw its way back. But you know you are being paid to wait.”

Bond markets had stabilized on speculation that the Fed will keep “the punchbowl in sight” this afternoon after a two-day meeting, according to a report last week by Barclays Plc analysts including Moyeen Islam.

Keep Buying

Fed Chairman Ben S. Bernanke said the central bank may start reducing bond purchases later this year and end them in mid-2014 if the economy continues to improve as the central bank forecasts.

Investors have predicted higher rates in the past only to be proven wrong. Bill Gross’s Pimco Total Return Fund reduced Treasuries early in 2011, leaving him to miss a rally and have what he called a “stinker” of a performance.

Mortgage REITs had benefited as the Fed held short-term borrowing costs near zero since 2008. After record sales of $16.9 billion of common, preferred and equity-linked notes in initial public offerings and secondary offerings in 2011, they followed with $16.3 billion in 2012, according to data compiled by Bloomberg, which includes firms that invest in commercial property debt or products such as loan servicing rights.

Dividend Attraction

Investors were drawn by dividends in excess of 13 percent last year, almost twice the average yield on company junk bonds.

Firms that had virtually no assets five years ago were able to expand by using borrowed money and now hold more assets than some regional banks. American Capital, based in Bethesda, Maryland, increased its assets (AGNC:US) to $100.5 billion at the end of last year from less than $5 billion three years earlier.

Typically, the more money they raise, the more their managers get paid. American Capital’s external management company, which includes President Gary Kain and Chief Executive Officer Malon Wilkus, is paid 1.25 percent of the REIT’s shareholder equity.

Last quarter, mortgage REITs issued $5.8 billion of new common stock, even as a Bloomberg survey released Feb. 14 showed the median forecast from economists was for 10-year Treasury yields to reach 2.51 percent at the start of 2014, from 2 percent.

“Because of the way they get paid, there’s a strong incentive for the management to continue to raise more permanent capital, and clearly an underwriter is not exactly going to be jumping up and down and saying, ‘I don’t want your business,’” said Brad Golding, managing director at Christofferson, Robb & Co., a New York-based firm overseeing $1.9 billion in assets including investments in mortgage REIT preferred stock.

Different Compensation

“Still, not all of the guys decided to party,” he said, citing firms including Anworth Mortgage Asset Corp. (ANH:US) and MFA Financial Inc. (MFA:US), which have different compensation models. MFA’s executives, for example, get paid bonuses tied to meeting profitability targets.

Justin Cressall, a spokesman for American Capital, declined to comment on its share sale, while Armour Chief Financial Officer James Mountain didn’t respond to telephone messages and e-mails seeking comment. Jay Diamond, a spokesman for Annaly, which hasn’t sold shares since 2011, declined to comment on its stock performance.

John Yiannacopoulos, a spokesman for Bank of America, and Jack Grone, a spokesman for Credit Suisse, declined to comment on their underwriting of mortgage REIT’s stock sales.

Additional Sales

Mortgage REITs, mostly commercial-mortgage investors, sold an additional $3 billion of shares this quarter. Ellington Residential Mortgage REIT, which trades under the stock symbol EARN (EARN:US), raised $126 million in a May 1 IPO led by Credit Suisse, shortly before comments to lawmakers by Bernanke started the bond slump. The firm, which was formed last year by Ellington Management Group LLC and Blackstone Group LP to buy home-loan bonds, has fallen 15 percent from its initial price.

“We launched EARN because we saw attractive opportunities in the marketplace in both the short and long term,” Mark Tecotzky, its co-chief investment officer, said in an e-mail. “We still believe that to be the case.”

Two Harbors Investment Corp. (TWO:US), a mortgage REIT that sold $774 million of stock in March, saw opportunities in agency mortgage bonds after a widening of spreads against benchmark bonds following their collapse at the start of the Fed’s latest round of buying in September, Chief Executive Officer Thomas Siering said. It also benefited existing shareholders by issuing equity at a premium to its book value, a measure of the value of its asset minus its liabilities, he said.

More Defensive

The company, which has returned (TWO:US) 24 percent over the past year even after an approximately 12 percent drop since the sale, has grown more defensive, he said in a telephone interview.

“For three-and-a-half years we’ve been on offense, which has been a great benefit for our shareholders,” said Siering. “But sometimes in the market you’ve got to go to the ropes a little bit and play defense and be in a position to go back on offense when others aren’t so fortunate.”

American Capital’s Kain said last week at an investor conference that the worst of the rout in government-backed mortgage bonds may be over after spreads widened “to levels relatively consistent with historical averages” and there is a smaller volume of loans as fewer homeowners refinance.

Earnings Potential

Still, while the firm is prepared to increase its 8-to-1 leverage (AGNC:US) when volatility subsides, it sold bonds last quarter to keep the ratio from rising and added hedges to reduce its risks from higher rates, he said at the conference.

“It will tend to reduce our earnings potential in the current environment to some extent because let’s face it, hedges do cost money and our asset size is a little smaller,” he said. “There also may be less upside to book value if interest rates fall quickly or MBS spreads tighten back to where they were.”

The company will pay a quarterly dividend of $1.05 a share, down from $1.25 in the prior period, according to a June 18 statement. The shares fell 3.6 percent today at 4:30 p.m. in New York to $24.44, the lowest since September 2009.

Firms that buy agency mortgage bonds were trading at “unusually large” discounts of 14 percent to their book values as of June 12, after a 5.8 percent decline this quarter, Michael Widner, an analyst at Keefe, Bruyette & Woods wrote in a report.

The rise in interest rates that’s punished mortgage REITs will continue as the Fed pulls back, investors withdraw money from bond mutual funds and Wall Street dealers facing new rules prove less willing to provide liquidity, according to First Pacific’s Mann.

“The whole thing is a perfect storm coming together and the regulatory environment is not helping at all,” Mann said.

Even if mortgage REITs continue to make enough money to pay high dividends, it may not provide as much protection as it once did for their share prices. The firms have drawn in large institutional investors as they’ve grown who care more about the value of the assets, said Jason Stewart, an analyst at Compass Point Research & Trading LLC.

“Retail investors thought they could own them for 10 or 15 years and didn’t care where book value went since they wanted the dividend yield,” he said. Now, “nobody cares about what dividend yields are, they care about what book value is. People want to know where it bottoms.”

To contact the reporters on this story: Heather Perlberg in New York at hperlberg@bloomberg.net; Jody Shenn in New York at jshenn@bloomberg.net

To contact the editors responsible for this story: Rob Urban at robprag@bloomberg.net; Alan Goldstein at agoldstein5@bloomberg.net


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