Hatteras earnings disappoint, liquidity hurt in long-duration adjustable-rate mortgages
Hatteras Financial is a mortgage REIT that focuses on agency adjustable rate mortgages
Hatteras Financial (HTS) is a real estate investment trust that focuses on adjustable-rate mortgages that are guaranteed by the U.S. government. Adjustable-rate mortgages (ARM) generally have much lower interest rate risk than 30-year fixed-rate mortgages. A typical adjustable-rate mortgage is a 5/1 ARM, which means that the initial interest rate is fixed for five years, and after that, the rate resets every year at some specified spread to a short-term interest rate, usually LIBOR.
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Because adjustable-rate mortgages reset every year after the initial period, they have much lower interest rate risk. Unlike a 30-year fixed-rate mortgage, where the lender takes all the interest rate risk, in an adjustable-rate mortgage, the borrower bears most (not all) of the interest rate risk. The borrower is compensated for taking that risk in that they get an initial interest rate that’s much lower than the rate you could get on a fixed-rate mortgage.
For an agency REIT, interest rate risk is by far the biggest risk. Agency mortgage-backed securities (MBS) don’t have credit risk because the government guarantees the principal and interest payments. However, they do have interest rate risk both with respect to prepayment risks and duration and convexity risk. Hedging these risks eats into returns, so a REIT that invests in ARMs may have lower gross returns on investment, but they also have lower hedging costs. This also allows them to have more of a margin for error when using leverage.
Quantitative easing has been driving the difference between MBS with fixed-rate mortgages and MBS based on ARMS
While adjustable-rate To-Be Announced (TBA) securities technically exist, they’re very illiquid. So when the Fed conducts quantitative easing (QE), it directly influences the rate of the 30-year fixed-rate mortgage, and it indirectly influences the 5/1 ARM mortgage rate. Historically, the spread between the 30-year and the 5/1 ARM was close to 80 basis points. In other words, the Fed is purchasing 30-year fixed-rate mortgage-backed securities and not ARMs. So at the margin, the Fed is squeezing rates for fixed-rate mortgages and not ARMs. This means a higher relative return for REITs that invest in ARMs.
As the market began to anticipate the end of QE towards the end of last year, the 30-year/ARM spread widened over 100 basis points. Since then, we’ve had some disappointing economic data. Federal Open Market Committee (FOMC) minutes seemed to indicate that quantitative easing would last at least through this year, and the Bank of Japan has started its own quantitative easing program. As a result, the spread has tightened to just under 80 basis points.
Highlights from Q1
Hatteras suffered a 20% decline in book value per share, as duration risk hit its portfolio and MBS spreads widened—especially in the long-duration sector. Book value fell to $28.28 from $27.08 the prior quarter. Hatteras noted that there was a big seller of 7/1 ARMS late in the quarter, which hit the value of its portfolio. Interestingly, it wasn’t simply end-of-quarter liquidation—so far, there hasn’t been any meaningful increase in value.
Due to the decrease in book value, its leverage ratio increased to 9.3 from 7.4 the quarter before. As far as REITs go, this is a pretty leveraged position. This is probably another reason why the stock has been hit so hard on the back of earnings. Most investors knew that agency REIT risk is all interest rate risk and that the jump in rates was going to hurt. That said, most people thought the ARM REITs would provide a margin of safety.
Implications for the other mortgage REITs
Hatteras’s earnings per share of $0.60 were below the Street expectation of $0.64 per share. ARM REIT Capstead (CMO) ended up faring much better, as it has a focus on seasoned low-duration agency ARMS. Low duration means lower interest rate exposure. We should hear from agency ARM REIT MFA Financial (MFA) in a couple of weeks. For the other mortgage REITs, like Annaly (NLY) or American General (AGNC), there probably isn’t that much of a read-across.
As laid out in the mortgage REIT strategy preview, agency ARMS are one of the better postures to have for this economic environment—although in a period of increasing economic growth, you want credit risk.