There are some very high yielding US mortgage REITs and mortgage originators that I wonder about…because I think it’s a good chance their mid-teen yields are sustainable with the new US stimulus package helping out.

Mortgage REITs suffered some of the worst losses of any sector in March and the first week of April.  Their book value and dividends took it on the chin.  As did their stock prices.

But over the last couple weeks the mortgage market has stabilized – or at least unthawed – on the backs of unprecedented government intervention in the debt markets. 

Many mREITs now offer double digit yields – even after having reduced their dividends considerably.  All of them trade at a fraction of their current book value. 

March was one of the worst months the sector has ever experienced.  Many mREITs suffered losses of 70-80% from peak to trough.  Even after a strong rally last week, these names are down more than 50% on average.

Three factors led to the collapse:

1. Liquidity dried up for mortgage securities – even those guaranteed by the government.
2. Their sources of funding faced margin calls from worried lenders.
3. The massive 100 bps cut by the Federal Reserve pummeled their hedge books overnight.

But now the dust appears to be clearing.  Where we stand now, mREITs have already taken large hits to their book value.  Dividends have been slashed.  While the full impact of the lockdowns is still not clear through much of the economy – with guidance pulled by many companies – the mREITS have been up front about the extent of the damage.

The news is already out.  The past is in the past. 

Take one of the largest agency-mREITs – Annaly Capital Management (NLY – NYSE).  It pays $1/yr, 25 cents paid each quarter, for a 16.7% yield.

While the details of their business are very complicated, it can be summed up in very simple terms – NLY buys agency mortgage securities, levers them up with repurchase facilities, and tries to hedge out the downside.

Most of the time the strategy works well.  Annaly has been paying dividends for over 20 years. 

But NLY got whacked in March for all the reasons I have already mentioned.  They were squeezed on all ends as their funding costs soared, agency MBS values plummeted, and their hedge book fell as well.

As a result, NLY’s book value took a hit from $9.40 at year end to $7.50 at the end of March.  The stock fell from a high of $10 pre-crisis to below $3.50 at one point.

Today the stock trades at $5.80, where it is valued at 77% of book value.  Is that discount fair?

Well here’s the thing.  While NLY saw all angles of its business squeezed in March, it is now almost entirely backstopped by the Federal Reserve.

Consider that:

1. The Fed is buying their primary asset – MBS securities – putting a floor on that market.
2. The Fed is supporting their funding – the repo market – making further margin calls unlikely.
3. The Fed has already cut rates to zero and the ten-year yield is down to 0.75%.  You will need full-on negative rates to see a further collapse in yields (and their hedge book) from here.  NLY said they have reduced their hedges here because there is simply no way that rates are going up.

A similar but far smaller name name is Orchid Island Capital (ORC – NYSE).  Orchid provides an interesting perspective. They are basically in the same business as NLY (even more straightforward really as NLY has diversified into some other lending) but Orchid has already reported early first quarter results on April 7th.

In that update Orchid announced that they will pay out a monthly dividend of 5.5c for April.  This is down from 8.5c in March.  Nevertheless, even with the cut Orchid yields 18%.

Orchid also reported their book value at the end of March was $4.64 – down from $6.27 at year-end.  But book value is not static – it improves with the market.  ORC said that by April 7th (the day of the release) book value had already risen to $4.83 and $4.93. 

The stock trades at $3.60 – 74% of book.  
 

Monopoly Profits in Mortgage Originations

A third name is PennyMac Financial Services (PFSI – NYSE).   

PFSI is a bit different business that NLY and ORC.  They are a hybrid mREIT, meaning they perform more than one mortgage related business.

PFSI originates and services mortgages.  It is the mortgage origination side that is very interesting right now.

While people aren’t buying houses, record low interest rates make refinancing existing mortgages very attractive for homeowners.  Refinancing volumes have been up as much as 500%+ yoy the last few weeks. 

Source: Wedbush Securities

At the same time gain-on-sale margins (the profit margins of an origination), are going through the roof. 

An indicator of gain-on-sale margin is the primary-secondary spread.  This measures the difference between the interest rate that the borrower pays and the yield on a mortgage security. 

This spread was already widening into the crisis, but it has absolutely blown out in the last couple of weeks.

Spreads are wide because demand for refinancing is high while the mortgage origination market faces constraints.

Smaller originators are being bogged down by liquidity and hedging issues.  Warehouse lines (funding for originations) have been pulled or can’t be counted on.  Banks are taking advantage of the market as best they can, but their capacity is already stretched with CARES Act applications and as they scramble to manage their own loan book.   

The industry is just poorly prepared for the surge in business.  Overall, the mortgage industry has shrunk by one-third over the last 15 years.

A large originator like PFSI is perfectly positioned.  They can capture share and out-sized profits – for a while.

Credit Suisse estimates 2020 EPS for PFSI of $9.45.  Piper-Jaffrey estimated that PFSI could earn $10/share this year. 

The stock is trading at $25. 

The origination market will normalize of course.  Capacity will be added, and margins will shrink back to historical levels.  But even then, PFSI does not appear expensive.  While earnings will come down in 2021, analysts are still expecting $5+ EPS next year.

Mortgage Servicing – Avoiding the next Black Swan

PFSI is also a mortgage servicer.  Mortgage servicing is an ugly duckling right now.  This stems from the CARES Act. 

The CARES Act was signed to support American families and businesses. Part of that intent was to keep recently unemployed workers in their homes. 

The act allows up to 6 months of forbearance for mortgage holders.  Forbearance – a fancy way of saying you don’t have to pay your mortgage for 6 months.

This is great for homeowners but is less so for mortgage servicers.  One of the key roles of a mortgage servicer is the temporary extension of mortgage payments to bond holders (called servicing advances) when the homeowner doesn’t pay. 

Over the long run advancing payments isn’t a problem.  Any payments a servicer makes are the first one’s to be repaid, either when the homeowner becomes current or when the home is liquidated.  They aren’t out the money.

But in the short-run, when a large percentage of homeowners don’t make payments – all at the same time! – well… that could be a problem.

You only have to look as far as the collapse of New Residential (NRZ – NYSE), a large mortgage servicing REIT, to see what’s going on there. 

If the government doesn’t come up with a lending facility to help servicers cope with the advances they face, companies like NRZ are going to have to find very large private pools of private capital that will lend them money to make all these mortgage payments on behalf of homeowners.

But those concerns lie primarily with mortgages that were made through Fannie and Freddie.   PFSI almost exclusively services Ginnie Mae securities.  Ginnie Mae, because they are owned directly by the U.S government, has already put in a backstop for servicing advances.  PFSI can fund their advances from this backstop.

So that de-risks PFSI  – kind of…

I say kind of, because there is one really big risk out there that applies to all the mREITS.  Because the mortgage market is so big – we are talking a $25 TRILLION market – it really applies to the economy as a whole. 

That risk is really what happens if servicers can’t advance the funds. 

It can be summed up simply – this is unchartered territory.

Already we are seeing 3.5% delinquencies on mortgages. 
 

Source: Wedbush Securities

Low estimates are that 5-10% of borrowers are eventually going to take advantage of the CARES act.  But some are predicting that number could be much higher.  Maybe even 25% of borrowers.

If 25% of homeowners don’t pay their mortgage in May or June, it raises the question of whether the plumbing can handle that?

This situation exacerbates if the government doesn’t provide some sort of backstop for servicers.  That risk seems so great, it is almost inevitable that the government will step in.

But even assuming they do, the logistics of making sure all the mortgage servicers have access to funds for servicing advances and that all that money gets into the hands of mortgage holders on time – well, to keep with the plumbing analogy, you are counting on a whole new set of pipes.

That isn’t to say it won’t go smoothly.  It may.  Right now, the market is telling us that with Uncle Sam backstopping many of the payments, there will be no problem.

But like everything else these days, it’s a whole new world, so its hard to say for sure.