Recommendation: Think about upcoming mortgage REIT earnings (Part 3)

Recommendation: Think about upcoming mortgage REIT earnings (Part 3)

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Continued from Part 2

Some possible scenarios

Scenario 1: The economy is beginning to slow and it appears we’ll be heading into a recession

This scenario is one where you’ll be worried about increasing credit risk, and you’ll most likely see rates start to fall, as the Fed eases. In this scenario, you want long duration. Agency REITs that focus on 30-year fixed-rate mortgages will outperform, as they have the highest exposure to interest rates. Steer clear of non-agency REITs, which will see an increase in delinquencies.

Scenario 2: The economy is expanding and we’re starting to see inflation

Increases in inflation generally mean increasing short-term and long-term interest rates. Increases in short-term rates affect the borrowing rates for REITs, and the increase in long-term rates is generally negative for 30-year fixed-rate mortgage-backed securities. In this situation, you want to be in adjustable-rate agency REITs. Why? Because the yield on their mortgage-backed securities increases as short-term rates increase. These REITs will have much less interest rate risk, and therefore they have less mark-to-market risk.

Scenario 3: The economy is rapidly recovering from a recession and starting to take off

This scenario would be associated with easing credit, investors being more comfortable with taking risk (the risk-on trade), and increasing interest rates. Given that interest rates are increasing, you’d want to minimize your interest rate risk. Because the economy is expanding, you’d want exposure to improving credit profiles. This means you want non-agency REITs—especially ones that tend to invest in the lower tier of credit, where tightening credit spreads can offset the effect of increasing interest rates. These companies usually have origination businesses, which generate fee income as mortgage applications rise.

How to decide

You should base your choice of mortgage REIT on your risk tolerance and also your top-down macro view of the economy. As we’ve seen since rates started going up, you can make (or lose) a lot of money at inflection points, where the story changes.

This analysis continues in Recommendation: Think about upcoming mortgage REIT earnings (Part 4).

The Realist Discussions

  • Kory Long

    Anyone considering investing in MSRs should consider the possibilty that the CFPB may impose the same Basel III rules on them in one way or another, sooner than later. Interest rates aside, the massive transfers to MSRs in the past 4 quarters is based on the assumption that they are exempt from the recent flood of new regulatory requirements and can do this cheaper. The reality is they are NOT going to invest the capital needed to meet the new demand and there is going to be a flood of compalints to the CFPB by performing borrowers.


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