Recommendation: Think about upcoming mortgage REIT earnings (Part 1)

Mortgage ETFEnlarge GraphSecond quarter earnings season is upon us

Alcoa (AA) traditionally starts the U.S. earnings season, and it announced better-than-expected earnings. As the economy generally improves, we should expect to see increasing earnings from economically sensitive sectors like the homebuilders. A generally improving economy isn’t necessarily good for all sectors—in fact, the agency mortgage REITs are hoping for weakness. We’ll discuss this dynamic further on in this series.

There are many flavors of mortgage REITs

There are generally four different classes of mortgage REITs, and they all have different sensitivities to the economy and changes in interest rates. (For a tutorial on interest rate risk, click here.) The main categories of REITs are:

1) Fixed- or adjustable-rate agency REITs: These are the names that everyone typically thinks about—Annaly (NLY) and American Capital (AGNC). They have the biggest market caps of the mortgage REITs and tend to use the most leverage. They buy government-guaranteed mortgage-backed securities, or MBS (meaning they buy Fannie Mae, Freddie Mac, and Ginnie Mae MBS). This means all of their risk is interest rate risk—they take no credit risk.

2) Adjustable-rate agency REITs: These are REITs that invest in adjustable-rate mortgage-backed securities. Big names are MFA Financial (MFA) and Capstead (CMO). They still only purchase mortgage-backed securities that are guaranteed by the U.S. government, which means they have no credit risk but still have interest rate risk. That said, adjustable-rate mortgages have less interest rate risk than 30-year fixed-rate mortgages.

3) Non-agency REITs: These companies invest in mortgage-backed securities that do not have a government guarantee. They may purchase 30-year fixed-rate securities or adjustable-rate mortgages. They may choose to be anywhere in the seniority structure as well. An example of a non-agency REIT is Two Harbors (TWO). These REITs take credit risk and interest rate risks.

4) Non-traditional non-agency REITs: These include names like PennyMac (PMT), which invests in mortgages and also has a mortgage origination business, or Nationstar (NSM), which is big in mortgage servicing rights. These companies have completely different risk profiles than the traditional REITs. In fact, the REITs that focus on maintaining mortgage servicing rights benefit from an increase in rates.

This analysis continues in Recommendation: Think about upcoming mortgage REIT earnings (Part 2).