The 10-year bond has sold off dramatically since May 1st as the yield has increased from 1.67% to 2.74%. This has driven the average 30 year fixed rate mortgage to 4.64%. The conventional wisdom for the move has been that the market is discounting an end to quantitative easing. The sell-off started on a better than expected jobs report, and continued as companies announced generally good first quarter earnings. Economic data over the month has been mediocre, certainly nothing that would cause the Fed to change course. Then the market started getting hints that the Fed was considering ending quantitative easing and Bernanke made it official at the last FOMC meeting – the default path is start reducing quantitative easing this year and end it fully by mid-2014.
Mortgage REITs and interest rate risk
The Fed has been buying around $3 billion dollars a day of mortgage backed securities, primarily in the To Be Announced (TBA) market. TBA prices are the basic input that mortgage originators use to price their mortgages. So, if the Fed is purchasing TBAs, they are essentially lowering mortgage rates. The idea was to help people refinance into lower mortgage rates, which would give them additional disposable income which they would (hopefully) spend.
The steepening of the yield curve has been a disaster for levered mortgage REITs. As rates have increased, the value of the mortgage backed securities they hold has decreased. Given that REITs borrow to increase the size of their assets, what appears to be a small decline in the value of an asset can have an outsized effect on their equity. That is why their stocks are down 23% since rates started going up.
Convexity risk – the new buzzword?
One issue with mortgage backed securities in general is that prepayments make hedging interest rate risk difficult. Because a borrower is allowed to prepay a mortgage early, the actual life of the mortgage backed security is uncertain. While most mortgages are 30-year mortgages, in practice very few ever make it that far. The typical duration of a newly issued mortgage backed security is anywhere from 7 to 10 years. To hedge their interest rate risk, REITs generally short Treasuries in some manner. The problem is that mortgages and Treasuries behave differently as interest rates change. When rates fall, mortgage backed securities will underperform Treasuries as investors assume that borrowers will prepay. However, when rates increase, mortgage backed securities will also underperform, as their duration increases when prepayments dwindle. Since longer duration securities are more sensitive to interest rate moves than shorter duration securities, REITs will underperform as rates rise. REITs outperform Treasuries in a stable interest rate environment. The difference between Treasuries and mortgage backed securities is described by “convexity.” And “convexity risk” is what blew up Orange County in 1994.
The mortgage REIT (MORT) has gotten clobbered since rates started increasing in early May. American Capital (AGNC) is down 38%, and Annaly (NLY) is down 28%. The REITs that focus on adjustable rate mortgages like MFA Financial (MFA) and Hatteras (HTS) have fallen less, but are still down double digit percentages. Where has been the port in the storm? The servicers like Nationstar (NSM) and Ocwen (OCN). They hold mortgage servicing rights, which increase in value as interest rates rise. Unsurprisingly, their stocks have risen since rates started going up.
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