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Gems Amid the Rubble:
Mortgage REITs Yielding 9.9% |
Published:
February 25, 2008
The housing crash of 2007 hardly turned out to be the "soft landing"
originally predicted by San Francisco Federal Reserve President
Janet Yellen at the start of last year. The mortgage meltdown has
affected homeowners, homebuilders, and bankers, among others.
But of all these groups, real estate investment trusts (REITs)
that invest in mortgage-backed securities have been among the hardest hit. The benchmark Mortgage REIT Index of 25
leading home and commercial lenders plunged a staggering -47.7% last
year, making the S&P 500's +5.5% total return appear absolutely robust.
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Yet, if you dig deep enough, you can find some real gems amid
the rubble. While most mortgage REITs slid to new depths in
2007, a select group that I found broke out to new multi-year highs
and averaged total returns of +43% last year. Despite seeing
average share price gains of some +36% last year, these REITs
also carry an average yield of nearly 7%.
Top-Flight Portfolios
What gives these firms the leg up on their long-suffering industry
brethren? For starters, they own top-flight securities. These
securities are insured or guaranteed by the Government National
Mortgage Association (Ginnie Mae), the Federal National Mortgage
Association (Fannie Mae), or the Federal Home Loan Mortgage
Corporation (Freddie Mac).
Ginnie Mae is a U.S. government-owned corporation within the
Department of Housing and Urban Development (HUD). Its
mortgage-backed securities are backed by the full faith and credit
of the U.S. government, just like U.S. Treasuries. Fannie Mae (NYSE:
FNM) and Freddie Mac (NYSE: FRE) are government-sponsored
enterprises (GSEs) and have special authority to borrow from the
U.S. Treasury. Although both these mortgage giants have been plagued by
accounting scandals, their securities carry the implicit backing of
the federal government and have an "agency" credit rating close to
that of U.S. Treasuries.
Lower Borrowing Costs
With "AAA"-rated portfolios that aren't exposed to downgrades and
writedowns, these REITs are prime beneficiaries of the
Federal Reserve's recent short-term interest rate cuts. Like other
financial institutions, they make money from the spread between the rate at which
they borrow money and the returns they can get on their investments.
Many of the firms borrow money using short-term repurchase
agreements (repos). These repos allow them to sell their securities
to a lender and agree to buy them back within a month at a price
that includes interest. The interest rate is typically pegged to
short-term benchmarks like the federal funds rate or LIBOR rates.
Thanks to the recent series of rate cuts -- the Fed has
cut its target rate by -1.75% since September -- borrowing costs on
these repos are falling and profit margins ("net interest margins")
are improving.
As a high-quality mortgage REIT president said recently, "We
are enjoying marked improvements in financing spreads...due
primarily to lower borrowing rates as a result of the recent
reductions in the federal funds target rate." And since most
analysts expect more rate cuts in the months ahead, the positive
impact on earnings should be favorable for the foreseeable future.
Slower Mortgage Prepayments
The current environment of tighter lending standards and lower
housing prices may be hard on homeowners, but the mortgage REITs
I've found
are benefiting. That's because homeowners are less inclined to
prepay their mortgages. As a result, mortgage prepayments have
slowed considerably in the past few months.
That may not sound like a big deal, but in fact mortgage prepayment
speed is one of the key drivers of interest income and earnings
growth for mortgage investors. When people pay their mortgages
faster than expected, investors don't get the interest income they
were counting on. Slower prepayment rates also extend the duration
of existing mortgages, which can reduce their value as interest
rates rise. But in today's environment of falling interest
rates, that is not a significant threat.
Outlook
Mortgage REITS are positioned to benefit from expected low interest
rates over the coming year, which should reduce borrowing costs and
improve profit margins. And the billions of dollars they have raised
through recent share issues are being deployed in new investments
that should have a positive impact on future earnings. In
particular, the select REITs I feature below should benefit.
. .
Important Note: In the remainder of this article,
High-Yield Investing editor Carla Pasternak provides
a table of 14 of the best mortgage REITs on the market right
now. And even better, these securities yield as high as
9.9%! Additionally, Carla zeros in on four favorites, with
in-depth profiles for each. However, in order to view the remainder of this
article, you'll need to subscribe to our premium investing
newsletter --
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receive immediate access to this full article, as well as our
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links to continue. . .
Good investing!
Carla Pasternak
Editor
High-Yield Investing
http://www.StreetAuthority.com
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